Stock Compensation Taxation
As the tax filing deadline approaches us again this year, I thought I’d write a quick summary of taxation of Stock Compensation. Each of the three types of stock compensation discussed below are taxed differently so it is important to be informed as to how each is treated by the tax code in order to avoid expensive mistakes. (Please remember that these are general concepts and that for any specific tax questions you should always consult your licensed tax professional.)
Employee Stock Purchase Plans
Many larger employers offer these plans which allow their employees to buy company stock at a discount to the market price (usually 15% off) several times a year. Employees contribute post tax dollars to the ESPP and the company at some point(s), purchases the stock on your behalf. Upon purchase you have established your taxable basis in the stock. There is no taxable event during this point of the process.
In order to receive long term capital gains (LTCG) rate you cannot sell the stock until 2 years have passed from the offering date (this is when payroll deductions for the ESPP plan begin for that period or the deadline for enrolling into the ESPP plan for that time period) AND until 1 year has passed from the actual date of purchase. While this can be confusing, most plan administrators will have the ability to inform you as to when specific lots of stock have qualified to receive LTCG treatment.
If you sell prior to the 2 year anniversary of the offering date or before holding the stock for a year, it is considered a disqualifying disposition and while you may still be able to claim LTCG in some cases, most of the time the gains will be taxed at ordinary income rates. Obviously, the most preferable strategy is to hold the stock for the two time periods listed above.
All ESPP shares purchased are yours to take with you should you leave the company. Any funds remaining in your ESPP that have not yet been used for purchase should be returned to you upon your separation of service from the firm.
Restricted Stock Units (RSUs)
There is no taxable event when your company grants you RSUs. Generally speaking, they are granted on a 3 or 4 year vesting schedule. When you reach your first vesting period, you take ownership of the actual shares and are free to hold them or sell them as you please. The value of the stock at vesting will be reported on your W2 as ordinary income. Some firms will sell a portion of your vested stock to pre pay some or all taxes due on your behalf. After the taxes are paid, the IRS treats the stock as if you paid for it yourself. Thus, LTCG apply after the first anniversary of the vesting date. Any sales made prior are accounted for as ordinary income and subject to your marginal tax rates.
All vested RSU grants are owned by you and freely transferable should you leave the company. However, any unvested grants will be forfeited by you upon separation of service.
Incentive Stock Options (ISOs)
These are the trickiest of the three types of stock compensation listed in this post. ISOs are granted to the employee by the company. The employee generally is on a vesting schedule much like with RSUs.
Upon vesting the employee can choose to hold the option or exercise the option and buy the company stock. At this time there is no taxable event. However, once you decide to exercise the option, the clock is ticking. In order to receive LTCG, you must hold the stock until the 2 year anniversary of the grant date and 1 year anniversary of the exercise date. If you sell prior to that you will pay ordinary income taxes on the difference of the sale price and exercise price. If you sell after those two qualifications have been met, then you are eligible for LTCG treatment. Waiting to qualify for LTCG treatment can be dangerous especially if you work for a company whose stock is extremely volatile ( Tesla, Facebook, Twitter etc). as ISOs are an alternative minimum tax (AMT) preference item. The worst case scenario is worth describing. If you exercise ISOs at your grant price of $30/share when the stock is trading at $50/share you have established something called the bargain element. As you are waiting for your holding periods to be satisfied for LTCG treatment, the stock begins to fall due to various reasons and is now worth $35/share. In this scenario it is possible that you will be taxed at AMT rates (for persons with ISOs this rate will usually be 28%) on the difference between the grant and exercise price of $20/share even though the stock is now trading significantly lower than at the time of exercise. ISO and AMT are incredibly complicated topics and attempting to describe the different scenarios of taxation under their myriad of rules is beyond the scope of this communique. However, if you have ISOs and are considering exercising your options, I cannot emphasize enough how important it is to coordinate with your wealth manager and CPA.
Upon separation of service you have 90 days to execute any vested ISOs. After 90 days any ISOs that have not been exercised with be forfeited.
Please feel free to call us regarding any of the above or any matter related to wealth management.