Financial Planning for Equity Compensation in 2023
With tech and startup companies expanding rapidly into the Pittsburgh region, equity compensation packages (stock options) are one way that these companies are attracting and retaining talent to help build and grow without draining their operating accounts. Incentive Stock Options (ISOs) are a common offering to these early tech employees in order for them to have the option for equity in the firm. Interests align in that the company doesn’t have to pay a hefty salary, the employee has the option to own “stock” in the company, and both parties are going to do their best for the value of that stock to grow. A win win!
Maximizing the dollar value of these options requires some planning, timing, and discussion around the financial and tax implications of such compensation which differs significantly from W2 income. Here are 6 factors to consider when you engage with your financial professional regarding your ISOs:
1 - Define Goals
This step is number one on the list because each client has different financial priorities with different needs, wants, and wishes. Are you looking to maximize the value of your options? Absolutely, but determining how these options fit into your overall financial plan needs to lead the conversation.
How are you going to pay for these options when it comes time to exercise? What role do the options play in your plan (income, short term goal, long term goal, pay off debt, hold for equity appreciation)? What is your exit strategy and how are you going to protect the value of the stock? Starting with these questions will help you determine what actions to take and how a financial plan can actually benefit you and your take home value of the equity compensation.
2 - Long-Term vs. Short-Term Capital Gain Tax
One of the main components of tax planning for ISOs is the tax status of the stock after it is exercised and sold. There are details and jargon in the tax law to “qualify” for long-term capital gains tax rate (0-20%) as opposed to a short-term capital gains rate (22-37%), but for simplicity:
The stock sale date is at least 2 years from the grant date
The stock sale date is at least 1 year from the exercise date
This tax savings is the driver behind the urgency and timing for a plan because the savings can be significant. For example, if you have stock options that are worth $50,000 when granted to you and they are valued at $150,000 when it comes time to exercise and sell, that will leave you with $100,000 gain. Assuming you are in the 24% income tax bracket, you could save 9% or $9,000 in federal taxes if you properly plan for a qualifying disposition.
3 - Alternative Minimum Tax (AMT)
Alternative Minimum Tax (AMT) is another variable in the tax plan puzzle that needs to be considered and weighed since it can have a major impact on your tax liability. Consult your CFP® or licensed tax professional to run an AMT tax projection for you which can be variable based on a few different factors (income, filing status, strike/exercise price, FMV (409a) valuations, AMT credits, holding period).
To get a general idea of how AMT should be considered without mastering tax code:
If your stock option plan is to exercise and sell in the same tax year, then AMT likely won’t apply to you
If your stock option plan includes exercising and holding for more than 1 year and 1 day in order to capture the long-term capital gain rate, then you have to consider the AMT impact
If the amount of AMT you will pay exceeds the tax savings gained from the long-term capital gain holding period, then it might not make sense to exercise and hold all of your shares. Other factors to consider are timing of future exercises, AMT credits, and the potential gain/loss of the stock value.
4 - State and Local Tax Withholding
Although every state has their own tax laws, in Pennsylvania, be prepared to prepay (withhold) your state and local tax when you exercise. The difference in the strike (exercise) price and the fair market value (409a or price of publicly traded stock) on the date of exercise is called the “bargain” element or economic gain on the stock which is the value used for AMT calculations as well as state/local income tax.
Since state and local income tax authorities often have a more simple form of taxation (flat or graduated tax schedule), they can assess their tax in the year that an option is exercised, no matter if the stock is sold or not. There aren’t many ways to get around the state income tax liability but the timing of taxation can come in to play if you are exercising and holding because you could have to pay the tax without actually having the cash available from a stock sale.
For example, if you plan to exercise 1,000 options with a grant price of $10 per share and a FMV of $100 per share, there is $90 in “economic gain” x 1,000 shares = $90,000 in economic gain that is subject to state and local tax withholding. If the City of Pittsburgh imposes its 3% flat income tax and the state of PA imposes its 3.07% flat tax, you can expect to pay 6.07% x $90,000 = $5,463 in state and local tax at the time of exercise.
5 - Expiration and Vesting of Options
Incorporating the expiration and vesting of your options into your plan is another variable that should be addressed in order to reach your goals and help to avoid large tax bills. Employee stock options often carry a “vesting” schedule that releases shares to you at certain intervals over a period of years in order to keep you at the company during periods of growth. As your shares “vest”, you then have the ability to exercise them. Once you exercise, you can either hold the stock or sell it to collect your cash.
One mistake that people often make is to let all of their shares vest before they exercise any of them. This can become a problem for those who plan to hold their stock, which can create a large AMT bill in the year of exercise.
A stock or option holder must also take into consideration the expiration of the options. With options of a publicly traded company, an employee would be leaving money on the table if they failed to exercise due to their ability to perform a “cashless exercise” which allows them to simultaneously exercise and sell enough shares to pay for the shares. With a private company, an employee has to consider the potential for the company value to decline post exercise, as well as coming up with the cash out of pocket to buy the shares which are two reasons why someone might let an option lapse.
6 - Initial Public Offering (IPO)
An exciting reason that you might decide to engage with a financial planner or tax advisor is due to your company becoming publicly traded via an initial public offering (IPO). In this scenario, the value of your stock options may be dramatically affected (usually for the better) and additionally, a new list of restrictions are added to the mix.
During a company IPO, there are trading restrictions (called a “lockup” or “blackout” period) around when an employee can sell their company stock in order to prevent a fire sale from employees looking to cash in on their options. If an employee is forced to hold their shares for a period of time through an IPO, it is important to consider the implications of exercising and holding through the end of a calendar year which could potentially trigger AMT.
Communication is key to a well-executed financial plan, so it is important to let your financial advisor who specializes in stock options know about the options that might seem insignificant when granted to you. Planning early for these events in life can help you take home more of what you earned and/or have the peace of mind that you are doing all that you can to maximize your hard work and time! To learn more about how we help clients manage equity, schedule some time to meet with us.
