Since we are located in the San Francisco Bay Area, quite a few questions have come up from clients working in the technology sector in the Silicon Valley. Compensation comes in the form of cash (such as wages or salaries), stock compensation, and employees benefits, such as free lunches, medical insurances or other fringe benefits. They are all tools to attract, retain and incentivize great talents.
Today we demystify stock compensation specifically.
What are the types of stock compensation?
- Restricted Shares Units (RSU) - The company grants stock to you outright with certain limits. The incentive is for you to stay and contribute to company’s stock price growth, and therefore increase your financial gain in holding the company stock. RSUs have a vesting plan, in which certain milestones must be reached before the stocks can be sold and cash distributed.
- Stock Options - The company gives you the “option” to purchase company stock at a predetermined price at a given time. Usually that predetermined price is lower than the current trading price, so that a gain is already built-in and acts as the incentive. However, if you leave the employer before vesting, you will lose this benefit.
Below are two types of stock options in use, one more common than the other.
· Nonqualified Stock Options (NSO) - This can be used to incentivize numerous people that support an organization, including outside consultants and board directors. NSOs are more of a perk offered to all employees and receive no special tax treatment.
· Incentive stock options (ISO) - This generally is given to incentivize team members to greater job performance. These are most often used with C-suite executives or key team leaders. ISOs tend to receive preferential tax treatment, as the thinking behind ISO is that such incentives strengthen businesses performance, and by extension the overall economy.
How do they work and how do they impact my taxes?
- Restricted Shares Units (RSU) - RSU has no value until the vesting terms have been satisfied. For example, certain company or individual performance goals are achieved, or months or years of service are reached. At the point of vesting, you are given shares of the company stock and you can sell the shares if you choose to do so. You’ll be taxed on the market value of these shares at this time, and that tax will be withheld from the amount your employer pays you.
You can ask your employer to defer settling the shares for a short time frame after vesting, therefore delaying paying income tax on it a little longer. Your employer has to make sure all tax laws are carefully followed.
Even within RSU, there are a couple of things to be aware of.
· Single Trigger RSU - A single-trigger RSU taxes you as it vests. That means with each vesting date, you’ll have taxes taken out based on the market value at the time of vesting. This will be taxed as ordinary income unless you hold the stock for a year or longer after vesting, at which point it becomes capital gains.
· Double-trigger RSU - Double trigger only applies if you join a company and take an RSU before it has gone public, i.e. Initial Public Offering (IPO). In this case, generally the tax will be due at the date the IPO is made, and that your RSU has vested at that point.
When an IPO is taking place, your employer will likely give you a deadline at which time you’ll need to exercise your options. You don’t have to wait until the last day of that deadline, but you may want to. This will give you extra time to research what the tax repercussions will be and make the best decision for your own bank account. - Stock Options - With stock options, once the predetermined period ends, these options can become common stocks if you choose to exercise them.
With stock options, you have more flexibility when it comes to taxation. You’ll pay taxes if you choose to exercise and sell the shares. If your stock option is of the nonqualified variety (NSO), when you sell the shares, you’ll pay income taxes on it. For ISO, the taxes you’re charged will be paid at the going capital gains rate at the time of selling the shares.
If the stock share prices drop to the point where they’re below the option price, your options will lose their value. This means your “investment” won’t have any worth. Obviously, there would be no tax consequences.
What other implications are there?
For the benefit of your overall financial health, please remember a few things related to your stock compensation.
Reinvestment
Reinvesting any proceeds you’ve made from your stock compensation doesn’t mean you have to abandon your employer altogether. If you still work there, you may want to put some money back into shares in the business you’re helping build. The key is to keep your portfolio diverse even as you’re holding shares in your workplace.
Diversification
Although stock compensation is a great job perk, they shouldn’t be your only financial plan. It is dangerous to only rely on shares in any one company when preparing for your future, even if you believe in your employer and the work they’re doing. If something happens along the way, you could stand to lose your entire investment.
Build a diverse portfolio with companies that are in completely different industries. If you work for a tech firm, for instance, investing only in other tech firms won’t serve as a protection if the entire industry takes a nosedive.
It may also help to seek out the assistance of a financial adviser if you’re interested in building a portfolio. Whether you should take a chance on some riskier investments while also putting money into low-risk options depends on your age and your current financial standing.
Feel free to reach out to us to see how we can be of assistance to you in this regard.
Source used - “Stock Options Vs. RSUs” By: Stephanie Faris | Reviewed by: Ashley Donohoe, MBA