Daniel Zajac, CFP®

Incentive Stock Options and Executive Compensation

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A Look at Your Employee Stock Purchase Plan During Times of Market Volatility

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An employee stock purchase plan is a company-sponsored benefit that gives employees a convenient way to purchase company stock.

Typically funded through payroll deductions, an ESPP can be a great way to participate in the success of the business you work for; if the company does well and the stock price increases, employees who participate may reap the benefit of owning shares that appreciate in value.

Of course, there’s a flipside to that. Owning company stock comes with the risk of loss should the share price fall below the price you paid to acquire it.

But after understanding the risks, you may still want to participate in an ESPP, because they’re not just convenient — they may actually provide some unique short-term protection against the risk of loss during periods of market volatility as compared to alternatives like the outright purchase of company stock or other forms of equity compensation.

To understand why, it makes sense to consider how an ESPP works, particularly features that your plan may include such as a lookback provision and a discount to the purchase price.

A Simple Illustration of How an ESPP Works

As always, you want to check your ESPP document to see exactly how your ESPP works — but in general, most plans are very simple in concept. You enroll in the plan offered by your company, you contribute via payroll deductions, and shares of stock are purchased on your behalf (In reality, however, there may be a lot of nuances).

If you participate in an employee stock purchase plan, you likely contribute cash into the plan for a specific period of time. This is known as an offering period.

An offering period begins with an offering date and ends with a purchase date. The time between the offering date and the purchase date is referred to as the purchase period, which is often 6 months. For some plans, the offering period can last as long as 27 months and include multiple purchase periods.

During the purchase period, you contribute payroll deductions to your ESPP. As you contribute to the plan, you’re not actually purchasing shares; your money is held in escrow for the duration of the purchase period.

On the purchase date, your contributions are used to purchase shares on your behalf as a participant of the ESPP.

How the Stretch of Time to the Purchase Date May Offer Downside Protection

On the purchase date of the ESPP, contributions collected during the period purchase are used to buy shares of stock for the plan participants. If you contributed to the ESPP, then your stock shares are deposited into a brokerage account for you.

During the purchase period, the price of the stock price will likely move. It can be up or down, subject to typical market volatility.

If the stock price is up, the ESPP will purchase shares for the plan at a higher price than had you otherwise not participated in the plan and purchased shares on the open market on Day 1.

If the price is down during the purchase period, shares purchased in the ESPP will have benefited from contributions being held in escrow, allowing the purchase of shares to occur at the now-lower purchase date price.

This is a simplified scenario, but it illustrates how an ESPP can offer downside protection on the purchase price during the purchase period. During a period of volatility, particularly when markets lose value, the ESPP purchase process may be seen as an attractive benefit to limit the risk of loss.

Using an ESPP with a Lookback Provision During Times of Market Volatility

A lookback provision is a benefit offered by some employee stock purchase plans. This allows for the purchase of company stock at the offer date price of the ESPP or the purchase date price — whichever is better (in this case, whichever is the lower cost). This can add to the ability to protect against downside risk during periods of market volatility.

Let’s assume that you enroll in an employee stock purchase plan. The company stock’s share price is $20 on the offering date — but the value rises over time and on the purchase date, the price is $50 per share.

A lookback provision allows for the purchase of shares at the better price. In this hypothetical, the ESPP participants benefit from the plan because their shares are being purchased at $20 each even though the stock is worth $50 per share.

Obviously, this is a great deal as you could immediately lock in a gain if you took your shares and sold them on the open market.

If the stock price is down during the purchase period and on the purchase date the stock price is $5 per share, shares will be purchased at the better purchase date price of $5 per share.

This lower purchase date price might provide additional benefit moving forward. As we mentioned, it’s possible that an ESPP can have an offering period, with a lookback provision, for up to 27 months. In this example, it would be possible to buy the stock at the original offer date price of $20 per share.

Some plans, however, may sweeten the deal and offer multiple offering periods at the same time, resulting in offering periods that overlap.  If you have multiple offering periods at the same time, you’ll also have multiple offer dates price. If the volatile markets lead to a lower offering date price than your existing one, it may mean that you can lock in that lower offer date price on future contributions.

For example, let’s assume that following the original offering period and purchase date, the ESPP purchased stock at $5 per share. If the plan includes multiple offering periods, it’s possible that the current $5 per share price may actually occur at the beginning of a new offering period too, with a new offer date price.

If so, “switching” to a new offering period with a lookback price of $5 is certainly more advantageous than one with an offer date price of $20. As this example illustrates, an ESPP with a lookback provision allows a participant to benefit from upside volatility and may offer added benefits on downside volatility.

How the Added Benefit of an ESPP Discount Can Fit into the Plan

Some companies will even offer a discount to the purchase price of company stock acquired through ESPPs. Discounts are usually set between 1-15% of the purchase price. This even more protection against market volatility, as the discount is directly from the actual purchase price of the stock.

If we assume a 15% discount and continue our lookback examples above, we can assume the following:

Offer Date Price Purchase Date Price Purchase Price Discount Actual Price Paid
No Lookback $20 $50 $50 $7.50 $42.50
No Lookback $20 $5 $5 $0.75 $4.25
Lookback Up $20 $50 $20 $3 $17
Lookback Down $20 $5 $5 $0.75 $4.25

 

In all scenarios, the discount offers an additional reason to participate in an ESPP even if the stock price is down.

Employee Stock Purchase Plans During Market Volatility

It’s important to note that while a good ESPP may offer some purchase period protection on downside volatility of a stock price, that shares you own outright are not afforded this same luxury. Shares owned outright, possibly from an earlier purchase of ESPP shares, are subject to the full market volatility.

This means that good financial planning might be required to determine if you should participate in your company offered ESPP, how actively you should participate, and what if anything you should do once your shares are purchased.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   All investments are subject to risk, including the risk of principal loss.  Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

The information in these articles may change at any time and without notice.  Laws of a specific state or laws relevant to a specific situation may affect the applicability, accuracy, or completeness of this information. The information presented here is not specific to any individual’s personal circumstances. There is no guarantee that any strategies discussed will result in a positive outcome.  The purchase of certain securities may be required to effect some of the strategies.

You should discuss any legal, tax or financial matters with the appropriate professional. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results.

How to Consider Equity Compensation When You Work for a Private Company

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Many private companies offer equity compensation in the form of employee stock options. For employers, offering this benefit is one way to attract and retain talent.

Equity compensation can create a shared interest in the company’s overall success. If the company does well and the stock price appreciates, employees who hold company shares can increase their own wealth by exercising and selling valuable stock.

But when you work for a private company, employee stock options you get through equity compensation plans may come with a few strings attached that you may not need to worry about if you work for a public company. The biggest is that you may not be able to sell the company stock you hold.

Often, it’s only if the company goes public that you may get the chance to sell your stock. If you’re lucky enough to work for a company that goes from private to public, equity compensation could be a great way to increase your own wealth – but that’s a big “if.” Other times, some private companies may offer a secondary market that can facilitate a sale, but there may be restrictions on that too.

The limitation on selling stock can add an additional complication when you consider how the potential value of equity fits into your financial plan. This limitation can also impact the way you strategize on exercising shares, paying taxes, and addressing the risk of owning something you might not be able to sell.

So, if you have private stock, should you wait until the stock goes public and address the issues then? Or do you plan now, maybe exercise and hold some of your shares, and hope that you put yourself in a better position later?

Let’s review some of the things you should understand in order to make a plan for what to do with your equity compensation when you work for a private company:

1 – Understand the Basics of What You Have Been Awarded

Whether your company is publicly traded or privately held, you should review your equity compensation package and fully understand the details before trying to make any plans or decisions.

Here are a few key points that you’ll want to consider as you review your company’s plan document, which should detail what you need to know about your equity compensation:

  • The type of option you’ve been granted: Do you have incentive stock options or non-qualified stock options?
  • The strike price: This is the price you pay to buy shares of stock if you exercise your options.
  • The vesting schedule: Generally speaking, this represents the time between when your award is granted and when you can rightfully take ownership of the shares.
  • The expiration date: Options aren’t good forever. The expiration date is the last day that you can exercise your stock option.
  • The current value (bargain element): The difference between the strike price and the current stock price is the bargain element per share. This value helps determine how much the shares are potentially worth, and what the tax implications of an exercise may be.

Knowing these specific details for your options may give you the information you need to make informed decisions about what to do with your equity compensation.

2 – A Low Strike Price Might Mean a Low Cost to Exercise – But That’s Not the Only Thing to Consider

Stock options at private companies are often issued with a low strike price. This allows you a chance to buy shares for a low cost, which requires less cash up front.

This is a good thing when you consider how your cash flow will be impacted by an exercise – but this is only one thing to consider.

You should also evaluate the cash you may need to pay a potential tax liability if you exercise and hold your options. Exercising stock options is a reportable taxable event regardless of whether or not your company is private or public.

You’ll want to know how much cash you may need to purchase shares and to cover the tax bill if you exercise and hold your shares. Once you know the total amount you need to do both, you can better determine whether or not it’s a good idea to exercise.

3 – You May Buy Something That You Cannot Sell

Before you exercise private company stock, you’ll want to know whether or not you can sell your shares.

One benefit of a publicly-traded stock is that if you want to sell your shares, you can likely do so on a public exchange. You may need to confirm you’re in an open trading window before doing so or aren’t otherwise restricted, but generally speaking, it’s easy to sell shares of public companies.

Some private companies will allow you to sell shares in a secondary market, which gives you a chance to sell shares you own after exercising. However, not all private companies offer this luxury. Even if your company allows for the sale of shares in a secondary market, they may have other restrictions in place that you must adhere to as well, such as a right of first refusal.

If your company is private and has no secondary market where you can sell your shares, you should consider how this will impact your willingness to exercise your options. It’s possible to find yourself with options you exercised and shares you paid for… and no way to make that money back through selling those shares.

4 – The Tax Rules Don’t Distinguish Between Equity Compensation from Public and Private Companies

When you exercise stock options, it is a taxable event. How you report the taxable event and how much tax you pay depends on several factors, like whether or not you have incentive stock options or non-qualified stock options.

If we assume that you have incentive stock options, the tax rules state that if you exercise and hold the shares past calendar year-end, the bargain element is a reportable event for calculating the alternative minimum tax. If you owe the alternative minimum tax, you’ll need to find a way to pay for it.

Non-qualified stock options, on the other hand, may be taxed as ordinary income when you exercise. But no matter what kind of options you have, exercising them may cause you to pay taxes — regardless of whether the company is public or private.

5 – Even with Limited Ability to Sell Your Shares and a Pending Tax Bill, Exercising Might Still Make Sense

There can be considerable risk associated with exercising private company stock and the cash call necessary to exercise and hold shares.  Other things like a pending tax liability and uncertainty around how to “get out” are reasons to evaluate how exercising private stock options fit into your financial plan.

But while the risk is real, there may be some advantages to exercising your private company stock, too.

One potential advantage of exercising private stock is that the AMT impact may be lower now than it may otherwise be in the future. A key factor in determining how much AMT you owe from an exercise of incentive stock options is the spread between the fair market value at exercise and the strike price.

If we assume that the spread between the two is smaller now than it will be later, the AMT you may need to pay will likely be smaller, too. The net result of this may mean that you can exercise and incentive stock options now with a lesser tax impact than you will have in the future.

Exercising sooner rather than later may also be beneficial when you want to sell your shares. You could not only secure a lower bargain element when you exercise and hold, but you also begin the holding period requirements for a qualifying disposition.

This means that you can sell your shares sooner rather than later (assuming there is a market to sell) and still obtain long term capital gains treatment.

6 – If the Company Does Go Public, You Might Need to Wait Even Longer to Sell Your Shares

Sometimes, a private company goes public through an IPO, or an initial public offering. The process of going public takes private company stock and turns it into a publicly-traded stock that trades on an exchange.

A key benefit for stockholders in this situation is access to a publicly-traded market where you may more readily sell your shares. However, going public does not always mean that you will be able to sell your shares right away.

Many times, companies that IPO place restrictions on your ability to sell your shares for 6 months after the offering. You may also be restricted by your status in the company, your ties to a 10b5-1 plan, or lock-up periods set by your company.

While an IPO might make your shares more liquid than they otherwise were as a private company, your ability to sell may still be restricted to certain times and by certain rules.

7 – There Might Be Other Liquidity Events Besides an IPO

When we talk about liquidity events for private companies, we usually talk about IPOs – but it is possible that your company experiences something very different. Your liquidity event might be a merger, acquisition, or takeover that could impact your stock compensation.

If another company acquires yours, for example, your stock options might be converted to stock options of the new company. You could then cash those out if you chose to do so. But this is just one example; there are many ways equity compensation could be impacted by something like a merger or acquisition.

Some of these decisions might be out of your control, while others might give you more choice about the route you take with the equity comp you bring forward from your previously-private employer. The specific details will likely be part of the agreements between the buyer and the seller.

What to Do Next with Your Equity Comp When You Work at a Private Company

When you work for a private company, you may want to take additional time deciding whether or not you should exercise your shares. Not only may you need to address the pending cash flow needs, but you’ll also want to address the risk associated with buying a stock that you may not be able to sell.

Don’t forget to consider how private stock fits into a big-picture financial plan, too. An illiquid stock, even one with the potential of future wealth, likely adds additional complications to a financial plan. That’s not necessarily a dealbreaker, but it’s something that you should factor into long-term planning.

Going through this process of evaluation and planning can help determine what your best course of action may be. It can also provide insight on how to plan well for your private company stock moving forward.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   All investments are subject to risk, including the risk of principal loss.  Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

The information in these articles may change at any time and without notice.  Laws of a specific state or laws relevant to a specific situation may affect the applicability, accuracy, or completeness of this information. The information presented here is not specific to any individual’s personal circumstances. There is no guarantee that any strategies discussed will result in a positive outcome.  The purchase of certain securities may be required to effect some of the strategies.

You should discuss any legal, tax or financial matters with the appropriate professional. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results.

5 Advantages of a Qualified Employee Stock Purchase Plan

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An employee stock purchase plan is an employee benefit that allows you to purchase shares of your employer’s company stock. It’s a convenient way to buy the shares, thanks to the fact that contributions are often deducted pre-tax directly from payroll.

Some purchase plans offer more than convenience, too, with additional perks like discounts on the share price. This can make participation in a plan seem like a no-brainer. However, before you make the decision to enroll, you should consider potential complications or downsides.

If you maintain a significant position in company stock through your other equity compensation holdings, such as incentive stock options, non-qualified stock options, or other restricted stock units (or awards), adding more exposure through an ESPP may or may not align with the objectives of your overall financial plan.

Or, if you’re risk-averse or otherwise unsure about owning stock, buying shares through an ESPP may not be the right choice for you.

This doesn’t mean you shouldn’t participate — only that you should carefully consider how an employee stock purchase plan fits into your overall financial plan.

To understand why it’s helpful to evaluate some of the key advantages of using an employee stock purchase plan.

How Employee Stock Purchase Plans Work

Let’s begin by making sure you understand a few key terms associated with employee stock purchase plans, and the timelines on which they operate. Generally speaking, an employee stock purchase plan follows this process:

  • Enrollment Period – The enrollment period is the time that you can choose whether or not to participate (and enroll) in your employee stock purchase plan.
  • Offering Date – The offering date is the date the employee stock purchase plan commences, and deductions from payroll begin. You should note the stock price on the offering date, because it may impact how much you pay to purchase shares of stock and the tax implications when you sell.
  • Offering Period – The offering period extends from the offering date, up to a maximum of 27 months, for a qualified employee stock purchase plan.
  • Purchase Period – A purchase period may be the entire offering period or a subset of the offering period. Commonly, a purchase period is every six months.
  • Purchase Date – A purchase date is the last day of a purchase period. On the purchase date, contributions to the plan are used to buy shares of stock.

Using an example to illustrate how this could work, let’s assume you have an employee stock purchase plan with an offering period of 24 months and a purchase period of 6 months.  When you enroll, your contributions to the plan often come right from your paycheck.

These contributions are held in trust during the first 6 months until the first purchase date. On that date, the company uses all contributions from the employees participating in the ESPP to buy shares of stock. This same contribution-and-purchase cycle will occur 3 more times, for a total of 4 purchase dates, until the 24-month offering period ends.

Not all ESPPs operate in such a straightforward manner, and there can be many nuances to the specific one your employer offers. You can look for your ESPP plan document (or request a copy from HR) to dig into the details — but in general, the process above is one that most ESPPs will follow in some form or fashion.

Now that you understand some of the basics, let’s look at why it’s worth considering enrolling and contributing to an ESPP.

1. It’s Usually Easy to Enroll and Get Started with an Employee Stock Purchase Plan

As mentioned, the process to enroll and contribute to an employee stock purchase plan is easy. Your company will typically inform you of your ability to participate in the plan and send the appropriate documentation. If you choose to participate, you notify your employer of that decision by completing the requisite paperwork.

When you enroll, you will need to indicate how much money you plan to contribute. This is often determined as a percentage of your salary or a stated dollar amount. Contributions are often deducted, pre-tax, from your paycheck.

For a qualified employee stock purchase plan, the annual contribution for a plan is typically $25,000. The maximum you can contribute to your ESPP may be limited by several factors, including your income and your plan rules.

2. An ESPP Often Lets You Purchase Shares Below Market Value

On the purchase date of the employee stock purchase plan, contributions are used to buy shares of stock. The cost of the shares may be equal to the fair market value of the stock on the purchase date — but many ESPPs include certain provisions like a purchase price discount and a lookback provision.

A purchase price discount is just as it sounds: if your company offers a discount, you will be able to purchase shares for less than you would have otherwise been able to do so. Typically, the discount is between 1 and 15% off the fair market value.

A lookback provision is a second feature that may positively impact the price you pay to purchase shares of stock. If your company offers a lookback provision, the ESPP will buy shares of stock at the better of the offering date price or the purchase date price.

Should the stock price increase between the offering date and the purchase date, you pay the lower grant date price of the stock. Should the stock price decrease between the offering date and purchase date, you pay the purchase date price.

The potential discount on share price and the lookback provision are great on their own — and some employee stock purchase plans offer both benefits. If your ESPP gives you the opportunity to use both, the two benefits can be “stacked.” That allows you to enjoy a discount on a lookback price.

3. You May Pay Long-Term Capital Gains on Some of the Proceeds

If you have a qualified ESPP, you do not owe any taxes when shares are purchased through the ESPP on your behalf. When you sell these shares, however, you create a taxable event that you must report when you file income taxes.

How you report this taxable event, and the subsequent tax due because of it, will depend on whether or not you achieved a qualifying disposition or a disqualifying disposition.

A qualifying disposition is a final sale of employee stock purchase plan stock that occurs at least 2 years from the offering date of the plan and 1 year from the purchase date of the shares. Anything that doesn’t meet both of these two rules is a disqualifying disposition.

If you have a qualifying disposition that has a gain, you may be able to pay long-term capital gains taxes on some of the taxable gain. Long term capital gains tax rates are lower than rates you’d otherwise have to pay if you were taxed at your ordinary income tax rate.

But there’s a downside of trying to achieve a qualifying disposition just so you can secure a favorable long-term capital gains tax rate: You have to buy and then hold the shares for at least one-year post-purchase. During this time, the stock price can go up and down, exposing you to market volatility and risk of loss of value.

4. You May Not Pay Social Security or Medicare Tax on Some of Your ESPP Profits

The nuance of income tax with an employee stock purchase plan can be complicated, and is beyond the scope of this article — but to give you a quick overview of this benefit, when you sell your shares via a qualifying or a disqualifying position, you will likely need to report some combination of compensation income and short- or long-term capital gains income.

You do not, however, need to report income that would be subject to Social Security or Medicare payroll tax. This may be different from other equity compensation that you may have, like non-qualified stock options or restricted stock units.

5. A Good ESPP Might Increase Your Overall Income

An employee stock purchase plan that offers a purchase price discount or a lookback provision might be an opportunity to increase your overall income and net worth — even if you already own a significant position in company stock. Here’s why:

Let’s assume that you participate in a plan and that you are allowed to purchase shares at a 15% discount. Then, you sell those same shares immediately after the purchase date. The plan’s discount may reduce the potential investment risk associated with participating in a stock plan.

Regardless of the purchase price and the potential tax bill associated with the sale, you may end up with more after-tax money than you would have had you not participated at all.

This possibility is a byproduct of buying something at a price that is less than what you sell it for. If you have this ability due to the features of your ESPP, it seems like something to consider this as part of your financial plan. Along with understanding how your ESPP works and how you may benefit from it, you will want to confirm that your plan allows for you to sell your shares immediately after they are purchased, or that you aren’t otherwise prohibited from selling.

Moving Forward with Your Employee Stock Purchase Plan

Employee stock purchase plans can be a great benefit to leverage because they allow for easy enrollment and purchase of company stock.

With the right provisions, ESPPs can also provide you with a quick, simple way to buy shares below market value and then immediately resell at market price to lock in a profit equal to your discount. If you also have a lookback provision? Even better. And of course, the potential for an appreciating stock price is always nice, too.

Just make sure you have a strategy in place to manage your cash flow before jumping into an employee stock purchase plan.

Remember that contributions usually happen via payroll deductions, so participating in an ESPP probably means less take-home pay. You also want to assess the investment risk of holding a more concentrated position, and evaluate how you will do your tax planning going forward to account for the added complication of buying and selling these shares.

Thanks to the benefits and features of these plans, ESPPs can be a great way to generate meaningful wealth.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

8 Advantages of Incentive Stock Options You May Want to Know

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Incentive stock options are a powerful compensation tool that can help you grow your wealth. Companies award them to employees as a retention vehicle, to reward specific successes or as an incentive when trying to attract new employees.

There are several advantages to incentive stock options. Because they can provide you with a significant opportunity, it’s important to understand them more fully.

The Mechanics of an Incentive Stock Option

To begin with, it’s helpful to understand more about incentive stock options, including how they work and how you can take advantage of their potential. An incentive stock option is a stock option that gives you the right to purchase shares of stock at a predetermined price.  Unlike other forms of stock options, such as non-qualified stock options, incentive stock options can only be given to company employees.

When you are awarded incentive stock options, the company will provide you with an option grant, a document that specifies the number of shares you’re eligible to purchase and what’s called the “vesting schedule,” which dictates the dates the options are available to be sold. The incentive stock option grant will also include a share price, called the “exercise” price, which is typically based on the stock price on the day the company grants your options. The exercise price determines how much you will pay for each incentive stock option. This price, multiplied by the number of granted options will tell you how much it will cost you to exercise all your options.

Let’s look at several advantages to incentive stock options.

Advantage 1. Simple Process for Exercising

When you purchase shares through a stock option grant, the process is known as exercising your incentive stock options. Assuming the company stock price has risen since the time that you were awarded the stock option, you will have the potential benefit from that price appreciation. The process for exercising your incentive stock options is relatively straightforward, and you can exercise your options in one of several ways, depending on your short- and long-term financial goals.

Generally speaking, you can exercise your options once they have vested. Some plans, however, will offer an early exercise option that allows you to exercise before your shares are vested. If you do exercise your shares prior to the vesting, you are likely buying some that you cannot yet sell.  The ability to sell the shares is subject to the vesting schedule.

When you exercise, you can typically do it in one of several ways. First, you can pay cash to purchase the shares. For example, let’s say you were granted 5000 options at an exercise price of $20 per share. One thousand shares have vested since you received your option grant. You could purchase those 1000 shares for $20,000 in cash. (1000 x $20 = $20,000.) By purchasing the shares upfront, you have the opportunity to hold them to take advantage of certain tax benefits, which we’ll discuss below regarding long-term capital gains. One risk associated with this approach is that your investment is subject to a possible downturn in the stock price. It may also reduce your ability to maintain a diversified portfolio by tying up your cash in the company’s stock.

Second, you can exercise your incentive stock options through what’s called a “cashless exercise” or “sell-to-cover” where you immediately sell some of your exercised shares, using the profits to pay for the option costs, and potential taxes, keeping the remainder, as discussed below.

The third approach is to exercise and sell all your shares immediately, commonly referred to as a same-day sale.

While the actual steps for exercising your incentive stock options are relatively simple, the method you choose depends on several factors, including when you need the income from the stock sale, possible tax strategies, and your confidence in the future growth of the company. A financial professional can advise you on a sound strategy and help you maximize your return based on your situation.

Advantage 2. You Choose When to Exercise Your Incentive Stock Options

Once your incentive stock options have vested, you have the flexibility to choose when to exercise your stock options. Some of the factors you’ll want to consider include how much the shares have appreciated in value since they were awarded, the likelihood of the company continuing to prosper, and whether you need cash in the near term. All these factors can impact when you decide to exercise your options. Note that there are also many factors outside of the company’s control that can affect the stock price, both positively and negatively, so this should be taken into consideration when deciding when to exercise your options.

There are two definitions associated with exercising incentive stock options, depending on how long you hold your shares before selling them after exercising your options. If you sell the resulting shares less two years from the grant date and less than one year from the time of exercise, the sale will be considered a “disqualifying disposition.” The benefits of a disqualifying disposition may include reducing the risk of volatility of the company stock by selling the shares sooner and receiving the proceeds more quickly. If you hold the exercised shares for more than one year before selling, they will be considered a “qualifying disposition” allowing you to take advantage of the lower, long-term capital gains tax treatment, saving you money at tax time.

There is an important exception regarding the timing of exercising incentive stock options. In your company role, if you have advance knowledge of company earnings results or other significant business information, you may be deemed an “insider” and restricted to selling stock during a specific trading window. This window typically opens immediately following earnings announcements and closes by mid-quarter. If you’re deemed an insider, the company will likely notify you in advance to help protect you from any inadvertent wrongdoing. Within the confines of the trading window, you are free to exercise your vested options at your discretion.

Advantage 3. Potential to Participate in Stock Price Appreciation

Ordinarily, purchasing company stock on the open market requires you to use your funds to acquire the stock. If the stock appreciates, your money is working for you. If the stock price declines, your investment is worth less than when you started. Incentive stock options give you the potential to participate in the appreciation of a stock with no capital outlay or financial risk on your part.

As an example, let’s say you were granted 1000 shares of company stock through an incentive stock option, priced at $15. Over five years, the 1000 options fully vested, and the stock price increased to $50. If you exercised your options and immediately sold your shares, your profit from the options would be $35,000, minus appropriate taxes and fees. In this scenario, you would receive a $35,000 profit with zero initial financial investment.

Incentive Stock Option Grant Cost – 1,000 shares @ $15/share = $15,000

Current Share Value – 1,000 shares @$50/share = $50,000

Potential Profit – $50,000 – $15,000 = $35,000

If you had purchased the same 1000 shares for $15 with your cash and held them for five years, your capital outlay would have been $15,000, rather than zero. You would still earn the $35,000 in gains from the share appreciation, and you may benefit from long-term capital gains tax treatment. However, in this scenario, you would need to come up with the initial investment, which would have been subject to potential market volatility, and your funds would have been tied up for five years to accomplish the same profit.

Cost to Exercise and Hold – 1,000 shares @ $15/share = ($15,000)

Current Share Value – 1,000 shares @$50/share = $50,000

Potential Profit – $50,000 – $15,000 = $35,000

As you can see, incentive stock options can be a powerful way to participate in stock price appreciation without having to put your own money at risk.

Advantage 4. Not subject to Payroll Taxes

Tax treatments are an important part of financial planning and a topic that requires careful consideration. One of the advantages of incentive stock options is the tax treatment they receive. As discussed, there are two approaches to exercising your options – qualifying and disqualifying dispositions. Qualifying dispositions are treated as long-term capital gains. Disqualifying dispositions are treated as ordinary income, with an important difference. There are no payroll taxes associated with the income from a disqualifying disposition, saving you a potentially significant amount of tax dollars.

Your earned income is not only subject to standard income tax, but also payroll taxes for Medicare and FICA. Medicare tax helps provide health insurance to retirees 65 and older, as well as some who are disabled.  Medicare is taxed at a rate of 2.9% of your total wages, half of which are paid by your employer, and half of which (1.45%) you pay. Medicare taxes are applied to all earnings, regardless of your income level and an additional 0.9% tax for married couples filing jointly with incomes of $250,000 or higher or individuals earning $200,000 or more (in 2020).

FICA, the Federal Insurance Contributions Act, helps pay for Social Security. In 2020, the Social Security tax rate is 6.2%. The maximum Social Security tax employees and employers will each pay in 2020 is $8,537.40.

Because the profits or income from Incentive stock options are not subject to FICA or Medicare payroll taxes, you can keep a meaningful amount of the profits from your stock exercise.

Advantage 5. Opportunity to Obtain Long-term Capital Gains

There are times when you need to be able to access the profits from an incentive stock option quickly, perhaps to cover the cost of a down payment on a home, college costs, or other needs. However, if you have the flexibility to exercise and hold your shares for more than one year before selling them, the sale is considered a qualifying disposition, as discussed above.

One of the key benefits of qualifying dispositions is the tax treatment they receive. Qualifying dispositions are treated as long-term capital gains, which can lower your tax burden on the profit you’ve realized from the sale. This is attractive because long-term capital gains are typically a lower tax rate than ordinary income or short-term capital gains rates. In addition, many other compensation programs, such as non-qualified stock options, are treated as ordinary income on your W-2, creating a potentially significant tax burden. Incentive stock options are a type stock option type that may allow you to take advantage of long-term capital gains tax rates, making them an attractive component of your overall compensation.

Advantage 6. May Get Alternative Minimum Tax Back as AMT Credit

When you exercise your incentive stock options, you may be subject to the alternative minimum tax.

In the given tax year, when you exercise your incentive stock options, the difference between the exercise price of the options and the fair market price at exercise is considered income that can trigger an AMT liability. Fortunately, you may be able to take advantage of the AMT credit for the year you sell your incentive stock option shares as a qualifying disposition. The AMT credit may help to reduce your tax liability.

Because of the complexity of these tax issues, it’s often valuable to review your financial situation with a professional who can help you get the most out of the current tax programs and limit your tax liabilities.

Advantage 7. Participate in the Success of the Company

Typically, if you’ve received incentive stock options, it is a recognition that you are a key contributor to your company’s success. As the company prospers, the stock price often will rise, and the value of your options will increase along with it.

It’s not uncommon when working for a larger organization for there to be a feeling of distance between an individual’s work and the overall success of the company. Incentive stock options help to create a feeling of ownership, pride, and proximity to the company’s success. This feeling of ownership in the company, and the prospect of increased income, often improves employee retention, morale, and employee satisfaction. Your efforts to help the company succeed are rewarded tangibly through the value of incentive stock options.

Advantage 8: Managing Cash Flow Required to Cover the Cost of the Alternative Minimum Tax

As we discussed, exercising your incentive stock options may trigger an AMT liability, which can cause a cash flow shortage at tax time. A way to manage this issue is to focus on your cash flow by exercising your options and strategically holding the shares, selling them when cash is needed to pay the additional AMT costs.  This approach is called AMT balancing.

AMT balancing may help insulate you from having to come up with a large amount of cash to pay your tax bill but also allows you to spread out the sale of your stock shares. There are a few reasons why this approach might be advantageous. For example, it can enable you to hold onto a portion of the shares beyond a 12-month window so that the profits on the shares will be treated as a qualifying disposition. This approach may allow you to manage the costs of the AMT liability while maximizing the long-term growth of the company’s stock.

As you can see, there are several important strategic decisions to make to maximize your incentive stock option profits. An investment professional can help you map out your strategy to take full advantage of this powerful compensation vehicle.

The content herein is for illustrative purposes only and does not attempt to predict the actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

What Are Some of The Advantages of Employee Stock Options

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Employee stock options are a powerful tool for businesses to provide an incentive for key employees and those who contribute to a company’s success. Stock options give you the right to purchase shares of stock at a predetermined price within a certain period of time through a vehicle called a stock option grant.  

 

If the stock price increases above the exercise price of the stock options, the price you can buy your shares, you can profit when you exercise your option and sell your shares. 

 

This optionality has the potential to be a lucrative source of compensation and an important topic to understand more fully.

 

What are the Two Types of Stock Options?

 

There are two types of stock options– incentive stock options (ISOs) and non-qualified stock options (NQSOs). Both types can help create a sense of ownership and commitment to the company, which can help both the company and the recipient. While similar, there are some notable differences between the two. 

 

Incentive stock options can only be awarded to employees and only up to certain limits. They have the advantage of potentially preferential tax treatment should you meet certain holding period requirements.

 

Non-qualified stock options have the unique advantage of being able to be awarded to both employees and non-employees. This allows a company to compensate directors, contractors, suppliers, consultants, lawyers, and others for services rendered or as recognition for their dedication to the company.

 

There are several key terms of incentive and non-qualified stock option that are helpful to know:

  •  Grant date: the date when you are given the option to buy the stock.
  • Exercise price: the price at which you can exercise your option and buy the stock.
  • Expiration date: the latest date when you can exercise your options from the option grant. If you don’t exercise the options by that date, they “expire” and are no longer valid.
  • Vesting Schedule: this schedule details when you obtain the right to sell your shares and how fast you can do so. In most cases, until the shares are vested, you cannot exercise your right to buy them.
  • Bargain element:  sometimes called the “compensation element”, this is the profit you make on the exercise of the options, determined by the difference between the option’s exercise price and the current market price of the stock when you exercise the stock options. 

The type of employee stock option you have determines how the bargain element may be taxed when you exercise your stock options. If you have non-qualified stock options, the bargain element is typically taxed as ordinary income, similar to your regular wage income. 

 

If you have incentive stock options, the bargain element may be taxed several ways depending on the timing of when you exercise your option and when you sell your shares. If you have incentive stock options, you may also need to address the Alternative Minimum Tax (AMT). 

 

The potential tax benefit of an incentive stock option can be seen as an advantage ISOs have over non-qualified stock options. However, both types have several common advantages over other equity types that show how powerful and lucrative they may be as a compensation tool.

 

Advantage 1. You Have Control Regarding When to Exercise Your Stock Options

 

As mentioned, you receive employee stock options through a stock option grant that gives you the right to purchase a certain number of shares at a predetermined price. In some cases, you cannot immediately exercise the stock option once you receive it. 

 

The timing of when you can exercise and sell or exercise and hold your options is typically based on what’s called the “vesting schedule.” 

 

Until your shares vest, you cannot sell your shares. Once they do vest, however, you can act upon your ability to exercise and sell the shares, if you wish. If you want to sell your shares, you’ll want to be aware that you are not in a “blackout period” that may limit your ability to sell your shares. If you are subject to a blackout period, you’ll likely need to wait until an “open-window” to sell your shares.

 

Alternatively, if you believe the company’s stock will continue to rise, you can hold the options and exercise them at a later date. As long as the current stock price is higher than the option price, there is a potential to profit. 

 

Either way, an advantage of a stock option over some other types of equity compensation is that you have control regarding the exercise of your option shares. Control may help you manage income tax, investment risk, and other financial planning goals and objectives.

 

Advantage 2. You May Not Need Any Cash to Exercise Your Shares

 

When you exercise your stock options, you have to purchase the stock at the exercise price of the option. Once exercised, you can either keep the shares or sell them and benefit from the proceeds of the transaction.

 

An attractive feature of employee stock options is that there may be a way to exercise your options that do not require any out-of-pocket expenses. Some of these no out of pocket exercise strategies are a sell-to-cover and a same-day sale. 

 

Let’s explore these and other methods for exercise your options:

  • First, you may consider a cash exercise. With a cash exercise, you use your cash to buy the shares at the exercise price, then recoup your cash outlay when you sell your shares (assuming you sell the shares for a price that exceeds your exercise price).
  • If you aren’t in a position to use cash, you can use a sell-to-cover, method. Most times, this process is conducted through a brokerage firm. With a sell-to-cover, the firm covers the cost of exercising the stock options by immediately selling the set number of shares required to cover the cost of purchase (and possibly income tax). After completing the sell to cover, you are left owning a share amount equal to the full amount exercised less the shares sold to cover the expenses.
  • Share withholding looks and feels similar to a sell-to-cover. The difference is that in lieu of using a brokerage firm to sell shares, your company will withhold the requisite shares to cover the cost, depositing the remainder into your investment account.
  • A same day sale is one that exercises the option and sells all the shares on the same day. The difference between the exercise price of the option and the final sales price is the profit and is commonly deposited into your brokerage account. 
  • Finally, there is the stock swap method, for use if you already own shares of the company stock. You can transfer enough stock to the brokerage firm to cover the cost of the options, and they will use the value of those shares to exercise the option.

 If you implement a sell-to-cover, share withholding, a same day sale, or a stock swap to exercise your employee stock options, it’s possible that you will not need to bring any cash to the table. This flexibility is attractive for someone who may not have adequate cash on hand or may not want to use that cash to buy shares of stock.  

 

Advantage 3. You Get to Participate in the Potential Upside of the Company

 

Employee stock options can provide a quality source of income in addition to cash compensation. If a company prospers and the stock price rises, you share in the company’s success, and your hard work is rewarded in a tangible way. For both employees and non-employees, this is a particularly powerful compensation tool.

 

One main advantage of employee stock options is the potential for upside on an appreciating stock price with no added cost. As a recipient of options, you have not paid for the shares. You were given them as part of a compensation package. 

 

Because you did not pay for options and you can benefit from an appreciating stock price, there is an argument that there is no risk to you from a financial standpoint. The higher the growth of the stock price, the more your ability to leverage the stock option for a more significant wealth generation.

 

However, this upside potential should continue to be managed as part of a financial plan. As the stock price increases above the exercise price, you’ll likely want to review your stock options planning and decide if and when it may make sense to exercise and sell some of your shares. Just as a stock price can increase and generate wealth, the stock price can also go down and decrease wealth too. 

 

Advantage 4. Some or All of the Taxes May Be Taken Care of For You

 

If you have non-qualified stock options, the bargain element is typically reported on your form W-2 at year-end (for employees). In many cases, income tax is withheld when you exercise your options via a sell-to-cover or a same day sale. This withholding feature is a convenient way to process a tax payment to the US government. However, it’s important to know that the amount withheld at exercise may or may not be enough to cover your entire tax liability, and you might want to consider additional tax planning.

 

If you have incentive stock options, income tax is not withheld when you exercise your option nor when you sell your shares. This non-withholding puts more of the onus on the taxpayer to plan for a pending tax bill. Therefore, prior to acting on your incentive stock options, you may want to plan for what type of tax you may owe, how big you expect that tax bill to be, and where that money will come from.  

 

There are many advantages to incentive and non-qualified stock options for both individuals and companies. Because of the complexities of managing employee stock option programs, as well as the various tax implications for option recipients, it’s important to work with a professional to maximize your return and take full advantage of this powerful compensation tool. 

 

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

5 Advantages of Restricted Stock – and What That May Mean For You

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There are many types of equity compensation that an employer can include in an employee’s compensation package to attract and retain the best talent. Each kind has its own set of rules that apply to how that equity is managed, granted, and taxed. It’s important to understand these nuances if you have access to benefits like employee stock options or grants of company stock.

Restricted stock units and restricted stock awards (commonly referred to as restricted stock in this article) are common types of equity compensation granted to employees. They offer a future promise of uncertain value; the value based on the stock price of the company when the restricted stock vests.

Vesting is usually dependent on a specific vesting schedule, which generally requires you to stay employed with the company for a certain period of time before the restricted stock will vest. Once they do vest, however, the restricted stock goes from a promise to value you actually receive.

It’s essential to take the time to develop a clear understanding of how your restricted stock works and how it can benefit you. Once you do so, you can develop a better strategy for how to best manage restricted stock in your financial plan.

Here are the main benefits to be aware of for your restricted stock.

1. The Timeline of Restricted Stock Is Easy to Understand

One of the more attractive features of restricted stock is their relative simplicity compared to other forms of equity compensation. With restricted stock, the timeline of events is straightforward and easy to follow.

It often looks a little something like this:

  • Your employer grants restricted stock to you. Being granted restricted stock is not a taxable event.
  • Your restricted stock vest after you meet the vesting requirements, and you are taxed on the value of the units that day.
  • Some (or all) of the income tax due is withheld for you.

You receive shares of stock in a brokerage investment account (or cash if that’s an option and you select it; check your plan document to see what applies in your specific situation) equal to the value of these shares at vesting, less the amount withheld for taxes.

Once the shares are deposited into your brokerage account, you own them just like you went out and bought them yourself that same day. You can keep them, sell them, or do anything else that your ownership rights allow you to do.

2. Restricted Stock is Easy to Value

Restricted stock is one of the easier types of equity compensation to value. You can calculate the value of your restricted stock by multiplying the number of restricted stock awarded by the current fair market value of the stock:

Restricted Stock x Stock Price = Current Value

This calculation can be done at any time to value your restricted stock. Keep in mind that the value, as calculated above, is only a future promise. It remains this way until your award vests.

While everything could remain the same between today and your vesting date, it’s more likely that the value will change between now and then. Keep this in mind when planning a strategy around how you’ll use your restricted stock; the value today may be different than the value when the award vests.

3. Knowing When You’ll Receive Shares Is Clear, Thanks to the Vesting Schedule

When you receive restricted stock, they are, in fact, restricted. This means that you need to meet specific criteria for the restriction to lapse. Only after the restrictions are met or lifted can you claim the value of the shares.

Most restrictions are tied to the vesting schedule. For example, your company may award you 2,000 restricted stock units/awards — but they only vest if you remain employed with the company three years from the grant date. Vesting schedules can vary from one company to another, and you’ll want to confirm your specific schedule.

When the restricted stock does vest, you receive shares of company stock (or the value paid as cash; again, that’s subject to specific rules laid out in your plan document). Prior to meeting the restriction set by your employer during which time you have a substantial-risk-of-forfeiture, restricted stock is deemed unvested. The value of the unvested restricted stock is not taxed.

From a financial planning standpoint, vesting, and more specifically, the vesting schedule can help you to plan a strategy for the value of your restricted stock because you know when to expect them. This should allow you to make better decisions around tax planning, investment planning, and strategizing what to do when you have the option to act.

4. When Restricted Stock Vests, Taxes Are Often Withheld for You

When your restricted stock vests, it creates a taxable event. You will be taxed on the full value of the restricted stock as of the date of vesting.

For income tax purposes, the full value of vested restricted stock is taxed as ordinary income, subject to both Medicare and Social Security wages, as if it were the same as your typical wage income.

One advantage of restricted stock is that when the award vests, your employer commonly withholds income tax on the vested value. Employers will often also include the value of your vested restricted stock units in your W2 at year end.

Typically, employers withhold at a statutory rate of 22% on the vested value, plus the appropriate Medicare (1.45%) and Social Security (6.2%) rates if those apply, for a total potential withholding of 29.65%. (This does not include potential state and local tax.)

Using an example to illustrate how much tax may be withheld, let’s assume that you have the following:

  • Vested Restricted Stock: 2,000
  • Fair Market Value at Vesting: $50.00
  • Total Value of Your RSUs: $100,000

If we assume that a company withholds at the total 29.65% rate discussed above, we can calculate that $29,650 will be withheld when the shares vest. This means that you will receive the remaining value, or $70,350, in either stock shares or in cash.

It’s nice to know that at least some of your tax bill is being covered via the withholding. However, it may or may not be enough to cover your total tax liability, and you may still owe more.

If you are not sure how you may be impacted and whether or not you withheld enough, you may want to speak with your CPA about how this may impact your personal situation.

5. Restricted Stock Generally Requires Fewer Decisions for You to Make

Overall, restricted stock is easier to deal with than other types of equity compensation. That includes non-qualified and incentive stock options. One main reason is that several of the critical decisions are driven for you, not by you.

This is different than equity compensation types like employee stock options. With employee stock options, you must choose when (and if) to act on your options. That decision may be complicated by a number of items, including income tax, valuation, cash flow needs, and market timing.

All of these factors can leave even the most educated of investors confused and uncertain of what to do—possibly leading to no action at all because the onus is on them to act. That may be a potential problem because those options do expire.

For that reason, the forced decision-making tree of restricted stock can be seen as an advantage. The vesting schedule, the fair market value you receive, and some tax withholding happen without you needing to make any decisions or take actions. That automation can make it easier to actually take advantage of your equity compensation.

But while many of the decisions are made for you, you still need to remain engaged in the process. This is your restricted stock, after all — and you’ll likely still need to address some income tax planning questions during the year of vesting. You also need to make the decision of what to do with your newly owned shares once they vest.

There Are Many Advantages to Restricted Stock — Be Sure to Make the Most of Them

The overall simplicity of restricted stock, as compared to other forms of equity compensation, make them an attractive company offering. Restricted stock can also generally result in something of value for you as the employee (assuming the vesting periods are met) without requiring you to make a lot of decisions along the way to get to that outcome.

To make the most of this opportunity, take the time to understand how much value you have in restricted stock, how you plan to address income tax and cash flow post vesting, and how you plan to incorporate that value into your financial plan.

Even though some of the advantages of restricted stock make them easy to understand, making consistently good decisions with the value is vital to achieving a positive outcome.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

 

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