Many companies offer their employees equity-based compensation in the form of company stock, primarily through the issuance of NQSOs and RSUs. Both NQSOs and RSUs align the interests of the employee and company by giving employees the opportunity to benefit from a company’s rising stock price over time. Before we get into the details on how they differ, here are some common mistakes we have seen over the years.
1. Becoming over concentrated in a single stock.
2. Not understanding the taxation rules and incurring unfavorable income tax treatment (especially on RSUs).
3. “In the money” NQSOs that go unexercised and expire are worthless. For example, an option grant with a $5 strike price and $10 current market value if not exercised before expiration is literally leaving money on the table.
4. Not having context or a roadmap on how these benefits fit into a long-term financial plan.
NQSOs and RSUs are different in nature and require proper planning to optimize their use in financial plan. Next we’ll review some of the key terminology you should become familiar with and then we’ll review how they are impacted by income taxation.
Grant Date: The date when the NQSO or RSU is awarded to the employee.
Vesting schedule: The requirements to be eligible to exercise NQSOs or receive shares of stocks from RSUs. This is usually met by maintaining employment for a specific time frame.
Strike Price (NQSOs only): The pre-set price at which an employee can purchase shares of stock per the terms of the grant.
Market price (both NQSOs and RSUs): The current value of the stock.
Bargain element (NQSOs only): The difference between the current market value of the stock and the strike price. g. a strike price of $10/share and a market price of $20/share has a bargain element of $10/share. Said another way, the employee would be “in the money” at $10/share.
Exercise (NQSOs only): The purchase of shares at a pre-determined price per the terms of their grant. Once a stock option is vested the employee has discretion on when to exercise (i.e. if the strike price was $10/share and the market value was $5/share the employee would be “out of the money” and would not exercise).
Expiration Date (NQSOs only): The date an employee’s grant expires, and they are no longer able to purchase the stock. Typical terms are 10 years.
Upon vesting the market value is taxed as ordinary income. For example, 1000 shares of ABC company stock vests on 3/15/20 at $100/share the employee would report ordinary income of $100,000. It is important to note that when RSUs vest your cost basis and holding period are established.
If we continue from our previous example but change the fact pattern slightly, we will see how they differ. Assume that an employee received a grant of 1000 shares of ABC company stock on 3/15/2019 which vested on 3/15/2020 at a strike price of $50/share. Upon vesting the client is “in the money” $50/share. The key difference in this scenario is that there is no tax triggered at vesting with NQSOs, but tax is triggered at exercise. If the client decides to exercise these 1000 shares, they will pay ordinary income taxes on the bargain element of the option (the difference between current market price and exercise price or $50,000 in this case). Upon exercise the employees holding period begins and cost basis is established. In our example the employee would have a cost basis of $100/share and if held long enough could have the potential for long term capital gains tax treatment.
NQSOs and RSUs are powerful tools to build wealth and can be optimized with proper planning. Over the years we have demonstrated a strategic process to educate clients on the nuances of their equity-based compensation with goals of growing wealth, reducing single stock risk, and creating tax efficiencies.
We work with clients from both publicly traded and private companies. If you find yourself in a position where you want to better understand how these types of benefits fit into your financial plan, please contact us at email@example.com.
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