Tax planning when exercising your stock options and selling your company stock

Tax planning when exercising your stock options

Tax planning when exercising your stock options is essential to manage your tax risk, maximize your gains and avoid any unpleasant surprises with the IRS. If you are sitting on a pile of ISOs and NSOs, now is the time to consider exercising some of these grants.

The tax impact of exercising your stock options can be complex. There are many moving parts, and everyone’s circumstances are different. I am sharing some ideas with you on how to plan for exercising your stock options. Whether you aim to exercise at year-end or throughout the year, there is no one-size-fits-all strategy.

Feel free to make an appointment if you have any questions.

Exercise your ISOs up to the AMT breakeven limit

Exercising ISOs are not subject to Federal and state income taxes, but you may pay Alternative Minimum Tax. The AMT is a parallel tax system that adds certain income, such as the ISO bargain element and the interest from certain types of Municipal bonds, to your regular income. Furthermore, the AMT system uses two tax brackets – 26% and 28%, respectively- with its own standard deductions. The AMT typically impacts just 0.1 percent of US households overall.

Most people receive an AMT exemption every year. The annual exemption is the difference between what you owe on your regular tax income and the AMT calculation. You may know it as AMT breakeven.

You can exercise enough ISOs annually to keep you under the AMT breakeven level. However, this annual AMT breakeven benefit is “use it or lose it.” You cannot roll it over for next year.

Suppose the FMV of your ISO is higher than your exercise price. This strategy could help you stay within a reasonable budget and start the one-year holding period on shares for favorable long-term capital gains tax treatment.

Exercise ISOs during high-income years

The AMT breakeven point will likely be much higher if you have a significant windfall year. Let’s say you received a large bonus, sold your startup, or hit the jackpot. You will most likely be able to exercise a higher number of ISOs before you reach the AMT exemption.

Exercise NSOs to fill in your tax bracket

Unlike ISOs, non-qualified stock options (NSOs) are subject to Federal, payroll, and state income taxes. Exercising a big chunk of non-qualified stock options can easily throw you in a higher tax bracket. In high-income tax states like California, your total payable tax can exceed 50%. You will end up keeping only half of your gains.

Depending on your tax situation, you can consider exercising just enough NSOs to keep you within your desirable tax bracket.

Use AMT credit by exercising NSOs or receiving RSUs

Once you pay AMT, you receive a tax credit, which will be payable to you in future tax years. Most people recoup their AMT taxes, but the exact timing depends on your specific circumstances.

You may have the entire suite of grants ISOs, NSOs, and RSU through your current employer or previous startups. If you have exercised ISOs in the past, you may have an outstanding AMT credit.

In that scenario, your AMT credits can offset the taxes you must pay for exercising NSOs or receiving RSU grants.

Exercise ISOs and NSOs with a low bargain element

If you have recently received ISO and NSO grants, there is a good chance that the fair market value of your unexercised grants will be equal to or closer to the original exercise price. By exercising these specific lots with a small spread between FMV and exercise price, you may have a low to no bargain element. In that scenario, you may not owe any taxes. The downside of this strategy is that for more mature startups with appreciated FMV, exercising newer grants may require a higher cash expense.

Spread an exercise window across two tax years

If your exercise window stretches between two calendar years, you can decide how much to exercise each year. Again, depending on your specific tax situation in the current and the following year, you can exercise a portion of ISOs and NSOs in December and then another lot in January.

83b election

83b election allows startup employees to exercise their stock options and other equity grants early and pay income taxes based on the Fair Market Value at the time of the election. You must file a one-page form to the IRS declaring your early exercise decision. The election entails that you exercise your ISOs and NSOs before they start vesting. Your primary benefit would be to avoid paying taxes on the growing spread between fair market value and exercise. If your exercise cost and FMV match at the time of your 83b election, you will avoid paying AMT on ISOs and income taxes on your NSOs. The downside is that you will be fully invested in your startup and need to put in upfront capital.

Prioritize long-term capital over short-term capital gains

Long-term capital gains receive favorable tax treatment. They are subject to a 15% or 20% tax rate. On the other hand, short-term capital gains trigger ordinary income tax, which is generally higher. You could pay over 50% in taxes in high-income states like California.

All else equal, prioritizing long-term capital gains can significantly impact your final outcome.

The moment when you exercise your NSOs and ISOs or receive your RSUs, and ESPP shares sets the clock on your holding period.

Each grant has different rules that make them eligible for long-term capital gains

  • ISOs – 1 year from the exercise date and two years from the grant date
  • NSOs – 1 year from the exercise date
  • RSUs – 1 year from the vesting date
  • ESPP shares – 1 year from the purchase date and two years from the grant (offering) date

Tax-loss harvesting

Tax-loss harvesting is a strategy that aims to realize a loss on a position in your investment portfolio. You can use the proceeds to invest in similar security. However, when it comes time to pay your taxes, you can offset any gains from selling your company shares with realized losses from your tax-loss harvesting strategy. In addition, if your losses are bigger than your gains, you can use the remaining amount to offset up to $3,000 of your ordinary taxable income.

Let’s take an example:

You own 1,000 shares of company XYZ, which you acquired for $100 per share. The total cost basis is $100,000.

In addition to that, you own 10,000 shares from your employer ABC. The cost basis per share is $5

One year later, the price of XYZ dropped from $100 to $75, while the price of your employer shares is $20. You want to sell 2,000 of your company shares but you want to avoid paying large taxes. If you sell your shares, your capital gain will be $30,000. You noticed that your XYX shares have dropped and if you sell them you will realize a loss of $25,000. Instead of paying capital gain taxes on $30k, you will only pay taxes on a 5k gain.

ABC capital gain

2,000 shares x ($20 – $5) = $30,000

XYZ capital loss

1,000 shares x ($75 – $100) = -$25,000

Total gain = $30,000 – 25,000 = $5,000

Don’t ignore the tax man

April 15 is the conventional deadline for tax filing. However, the IRS expects you to pay at least 90 percent of your estimated tax liability upfront. If you exercise your shares throughout the year are responsible for paying your taxes, including your AMT. There are four quarterly deadlines for making estimated payments in four equal amounts.

  • 1st payment …………….. April 15
  • 2nd payment ……………. June 15
  • 3rd payment …………….. September 15
  • 4th payment …………….. January 15

You might be subject to penalties if you owe a sizable amount and wait to pay it during the tax season.

Have a comprehensive plan

The tax implications of exercising stock options can be complex. And there is little room for error. Through my years of experience helping my clients, I can share that the best strategy for you is to have a comprehensive plan. Before exercising your ISOs and NSOs, you must have a holistic view. There are many moving parts with any strategy. The most challenging part is predicting the future fair market value or exit price. Some of our clients have multiple grants from different companies,  various sources of income, or a high-earning spouse. Any additional layer of complexity can dramatically change your assumptions.

Choosing between RSUs and stock options in your job offer

RSUs and stock options

RSUs and stock options are the most popular equity compensation forms by both early-stage start-ups and established companies. If you receive equity compensation from your employer, there is a good chance that you own a combination of different equity grants. RSUs and stock options have some similarities as wells as many differences in tax treatment and potential upside. Sometimes your new employer may offer you the opportunity to choose between having RSUs or stock options. Or you already own a mix of them. The purpose of this article is to describe how each compensation works. You will learn how they affect your taxes and how to plan for future upside.

What are RSUs?

RSUs (Restricted Stock Units) are a type of equity compensation in the form of company stock. Typically, your employer will grant you a specific number of shares that will vest over a particular period. The classic vesting schedule is four years with a first-anniversary cliff equal to 25%.  The remaining shares will vest gradually on either a monthly, quarterly, or annual basis.

Taxes on RSUs

RSUs are taxable as ordinary income. Every time your RSUs vest, the fair market value of your shares will be added to your W2 earnings. The employer must withhold Federal and State income tax. In most cases, public companies will sell a portion of your shares to cover all taxes. In the end, you will own a smaller number of shares than your original grant.

Example. You have 1,000 RSUs of company XYZ, which get vested tomorrow.  The fair market value is $10. Therefore $10,000  [1,000 x 10) will be added to your payroll. To cover all Federal income, FICA, and state taxes, the company will sell 300 shares from the total. The proceeds of $3,000 will be used to cover your tax obligations. You can keep 700 shares which you can either sell immediately or keep long term.

If you hold and sell your RSUs before the 1st anniversary of their vesting, all potential gains will be taxable as short-term capital gains.

If you hold and sell your RSUs for longer than one year after vesting, all potential gain will be taxable as long-term capital gains

Double Trigger RSUs

Many private Pre-IPO companies would offer double-trigger RSUs. These types of RSUs are taxable under two conditions:

  1. Your RSUs are vested
  2. You experience a liquidity event such as an IPO, tender offer, or acquisition.

You will not owe taxes on any double-trigger RSUs at your vesting date. However, you will pay taxes on ALL your vested shares on the day of your liquidity event.

What are stock options?

Employee stock options are another type of equity compensation that gives you the right but not obligation to purchase a specific number of company’s shares at a pre-determined price.

Incentive stock options (ISOs)

ISOs are a type of employee stock option with preferential tax treatment. They can only be granted to current employees. You can receive up to $100,000 of ISOs every year. If your total grant exceeds $100,000, you will receive the difference as Non-qualified stock options (NSOs). Most ISOs and NSOs grants will have a 4-year vesting schedule with a one-year cliff. For more information about ISOs, check out this article.

Taxes on ISOs

The vesting and exercise of ISOs do not trigger income taxes.

If you hold your ISOs for two years from the grant date and one year from the exercise date, you will owe long-term capital gains of the difference between the sale and exercise price.

AMT

The exercise of ISOs may cause paying Alternative Minimum Tax (AMT). The AMT is an alternative tax system that is calculated in parallel with your regular taxes. The bargain element or economic benefit of your exercise equals the difference between the Fair Market Value (FMV) and the exercise price of your shares. The AMT formula adds the bargain element to your regular income and calculates a minimum tax rate. If the AMT value is higher than your regular income, you will have to pay the difference to the IRS.

The probability of paying AMT increases as the gap between your shares’ Fair Market Value (FMV) and exercise price widens.

It is crucial to remember that the AMT is a future tax credit. You can potentially recoup all of it. Every year when your AMT dues are lower than your regular taxes, you will receive a tax rebate until you deplete the entire credit.

Non-qualified stock options (NSOs)

NSOs are another type of employee stock option. However, they lack the preferential tax treatment of ISOs. Furthermore, NSOs can be granted to a broader group of stakeholders. For more information about NSOs check out this article.

Taxes on NSOs

The exercise of ISOs triggers Federal and state income taxes. The difference between your shares’ Fair Market Value (FMV) and the exercise cost is taxable as compensation income. Whether your employer is a public company or a startup, you will be responsible for paying the taxes due from the option exercise.

How to choose between RSUs and stock options in your job offer

There is a rule of thumb that 1 RSU is equal to 3 or 4 stock options. Most companies that give you a choice between RSUs and stock options will likely offer you a similar ratio. Let’s discuss some of the key factors that can help you choose between the different grant types.

Public versus private company

Private companies and startups tend to gravitate towards offering ISOs and double-trigger RSUs. These two equity compensation types require the lowest financial commitment from the employees before any liquidity event or an IPO.

Public companies tend to offer traditional RSUs and employee stock purchase plans (ESPPs). You can read more about ESPPs here. Many recent public companies will maintain legacy stock options from their startup stage but will not issue new grants.

Early-stage vs. established startups

Early-stage startups with fewer employees usually give generous ISO grants at below a dollar per shares valuations. The shares are often worth a few cents. These grants offer the biggest upside if the venture becomes successful down the road. Exercising your shares early will allow you to avoid or minimize AMT and pay long-term capital gains when selling your shares in the future. The biggest downside of an early startup is that your first liquidity event might be years away. You may not see a windfall for a long time.

More mature or pre-IPO startups might offer a wider range of equity compensation types. If you join those companies, you may end up owning a mix of ISOs, NSOs, and RSUs. Working for a more established startup, you will be closer to a liquidity event. But the cost of your stock options will be a lot higher. You may have a chance to sell your share through a tender offer or a pending IPO.

Sometimes your company may get acquired by a larger firm. When that happens, your stock options and RSUs will be converted to the acquiring company’s stock.

Liquidity and cash

Owning RSUs generally requires spending less upfront cash. Your company will pay your taxes by selling a portion of your shares on the open market. You don’t have to dip in your checking account.

Both ISOs and NSOs require paying your exercise cost out of pocket. You also may owe taxes or AMT on the transaction.

Cashless exercise

In some cases, employers offer a cashless exercise either through a tender offer or post-IPO.  If you are opt-in for a cashless exercise of your ISOs, they will lose their preferential tax treatment and automatically turn into NSOs.

With a cashless exercise, you exercise your shares and immediately sell them to the buyer. If your firm is private, the buyer can be the company itself or an external investor. If your company is public, you will sell your shares on the stock market.

The exercise cost of your shares will be subtracted from the total value of the proceeds after the sale. Sometimes your payroll department will withhold taxes automatically. Otherwise, you will be responsible for paying taxes on your gains.

The upside potential of RSUs and stock options

From a risk-reward perspective, traditional RSUs offer a lower risk relative to stock options. You can get more predictable payouts if you choose to receive RSUs or NSOs from a public company.

In contrast, owning stock options of an early-stage startup offer a higher risk/reward upside potential. At the same time, your financial outcome is a lot more uncertain. Your windfall will depend on your company’s success in addition to your strategy to exercise your shares early, well in advance of any liquidity events.

Waiting to exercise your ISOs after receiving a tender offer or going public can create issues with paying extremely high AMT and reducing your financial upside by paying higher taxes.

Final words

In closing, the benefits of owning RSUs and stock options will depend on the odds of your company running a successful business model, getting acquired, or going public. There is a massive range of financial outcomes depending on when you exercise your shares, your investment horizon, risk tolerance, cash savings, tax situation, and a little bit of luck. If you want to get the most out of your ISOs, NSOs and RSUs, you need to plan proactively. The decisions that you take today will impact what you keep in your pocket years down the road.

All you need to know about Restricted Stock Units (RSUs)

Restricted Stock Units (RSU)

Restricted Stock Units are a popular equity compensation for both start-up and public companies. Employers, especially many startups, use a variety of compensation options to attract and keep top-performing employees. Receiving RSUs allows employees to share in the ownership and the profits of the company. Equity compensation takes different forms such as stock options, restricted stock units, and deferred compensation. If you are fortunate to receive RSU from your employer, you should understand the basics of this corporate perk. Here are some essential tips on how to manage them.

What are RSUs?

A restricted stock unit is a type of equity compensation by companies to employees in the form of company stock. Employees receive RSUs through a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with their employer for a particular length of time. RSUs give an employee interest in company stock but they have no tangible value until vesting is complete.

Vesting Schedule

Companies issue restricted stock units according to a vesting schedule.
The vesting schedule outlines the rules by which employees receive full ownership of their company stock. The restricted stock units are assigned a fair market value when they vest. Upon vesting, they are considered income, and often a portion of the shares is withheld to pay income taxes. The employees receive the remaining shares and can sell them at their discretion.

As an employee, you should keep track of these essential dates and figures.

Grant Date

The grant date is the date when the company pledges the shares to you. You will be able to see them in your corporate account.

Vesting Date

You only own the shares when the granted RSUs are fully ‘vested’.  On the vesting date, your employer will transfer the full ownership of the shares to you. Upon vesting, you will become the owner of the shares.

Fair Market Value

When vesting is complete, the restricted stock units are valued according to the fair market value (FMV)  at that time. Your employer will provide you with the FMV based on public price or private assessment.

Selling your RSU

Once the RSUs are converted to company stock, you become a shareholder in your firm. You will be able to sell all or some of these shares subject to companies’ holding period restrictions. Many firms impose trading windows and limits for employees and senior executives.

How are RSUs taxed?

You do not pay taxes on your restricted stock units when you first receive them.  Typically you will owe ordinary income tax on the fair market value of your shares as soon as they vest.

The fair market value of your vested RSUs is taxable as personal income in the year of vesting. This is a compensation income and will be subject to federal and local taxes as well as Social Security and Medicare charges.

Typically, companies withhold part of the shares to cover all taxes. They will give employees the remaining shares. At this point, you can decide to keep or sell them at your wish. If your employer doesn’t withhold taxes for your vested shares, you will be responsible for paying these taxes during the tax season.

Double Trigger RSUs

Many private Pre-IPO companies would offer double-trigger RSUs. These types of RSUs become taxable under two conditions:
1. Your RSU are vested
2. You experience a liquidity event such as an IPO, tender offer, or acquisition.

You will not owe taxes on any double-trigger RSUs at your vesting date. However, you will all taxes on ALL your vested shares in the day of your liquidity event.

Capital gain taxes

When you decide to sell your shares, you will pay capital gain taxes on the difference between the current market price and the original purchase price.

You will need to pay short-term capital gain taxes for shares held less than a year from the vesting date.  Short-term capital gains are taxable as ordinary income.

You will owe long-term capital gains taxes for shares that you held for longer than one year. Long-term capital gains have a preferential tax treatment with rates between 0%, 15%, and 20% depending on your income.

Investment risk with RSUs

Being a shareholder in your firm could be very exciting. If your company is in great health and growing solidly, this could be an enormous boost to your personal finances.

However, here is the other side of the story. Owning too much of your company stock could impose significant risks to your investment portfolio and retirement goals. You are already earning a salary from your employer. Concentrating your entire wealth and income from the same source could jeopardize your financial health if your employer fails to succeed in its business ventures. Many of you remember the fall of Enron and Lehman Brothers. Many of their employees lost not only their jobs but a significant portion of their retirement savings.

As a fiduciary advisor, I always recommend diversification and caution. Try to limit your exposure to your employer and sell your shares periodically. Sometimes paying taxes is worth the peace of mind and safety.

Key takeaways

Receiving RSUs is an excellent way to acquire company stock and become part of your company’s future. While risky owning RSUs often comes with a huge financial upside. Realizing some of these gains could help you build a strong foundation for retirement and financial freedom. When managed properly, they can help you achieve your financial goals, whether they are buying a home, taking your kids to college, or early retirement.