Receiving a grant of company stock or options to purchase company stock can be a great way to build wealth. The trick is understanding the risks, rewards and nuances of your particular situation.
Timing is so important when dealing with company stock compensation decisions.
Equity compensation comes in multiple forms, each with its own rules, tax implications and strategies for maximizing the upsides and minimizing the downsides. Whether you work for a pre IPO startup or an established public company, a grant of stock compensation requires some careful planning and attention to detail.
Here are five common mistakes to avoid when handling your own stock compensation decisions:
Neglecting to accept a grant of shares.
Believe it or not, this happens. Some companies require you to officially accept a grant of Restricted Stock Units. This acceptance indicates your willingness to receive the shares and be taxed on them as income at each vesting date.
Similarly, company stock options come with expiration dates. If you fail to exercise these options before they expire, you could end up leaving money on the table. It is important to keep track of your vesting schedule, option expiration dates, current share prices and your strike price in order to exercise your “in the money” options before they expire. In the language of options, “in the money” simply means that the strike price or price you will have to pay to purchase the shares is lower than the current market price, allowing you to make money on the sale of the shares.
Not holding shares the appropriate length of time to receive beneficial tax treatment.
Understanding the tax implications of your particular type of equity compensation can get complicated, and, strangely enough, there can sometimes be more than one right answer.
Here are a couple of examples:
1 ) Restricted Stock Units are taxed at ordinary income rates upon vesting. At that point, you own the shares and your cost basis is the vesting price. If you hold the shares for more than one year from the vesting dates, you can receive preferential long term capital gains treatment on the difference between the price at vest and the sale price. On the other hand, you may want to skip the wait for long term gain treatment and sell the shares sooner if you are concerned about the stock price dropping over the course of the year and you need the money for something else.
2 ) Incentive Stock Options (ISOs) can qualify for special tax treatment if you hold onto them for at least two years after the grant date and one year from the exercise date. The tricky part comes in the form of the Alternative Minimum Tax that can rear up as you hold onto those shares across a calendar year in order to keep it qualifying. This is an area that may require some careful tax planning in order to make the best decision based on your particular circumstances.
Under withholding for taxes when shares are vested, exercised or sold.
If you are used to completing a form w-4 when you first get hired for a job and then letting your company payroll department handle your tax withholding from that point forward, you may be in for a surprise when you receive the great perk of equity compensation. Not all taxable moments in the cycle of stock compensation require companies to withhold taxes on your behalf and those that do often do not withhold at a high enough rate to cover the tax owed on a particular transaction. Get comfortable reading your paystubs and keep track of your equity compensation vest, exercise and sale information so that you can avoid an unpleasant surprise at tax time!
Not properly tracking your cost basis for tax reporting.
Some forms of stock compensation come with incredibly preferential tax treatment, as long as you know how to properly track and report your cost basis to the IRS. Employee Stock Purchase Plans (ESPP), for example, often provide an opportunity to purchase company stock at a discount and, if proper holding periods are adhered to, enjoy long term capital gains tax rates on all but the purchase price discount or the gain on the sale, whichever is lower.
Unfortunately, the tax form 1099 that reports the sale of these shares does not usually report the taxable gain properly and must be adjusted, using IRS form 3922 or other documentation provided by the employer designed to help you “track your basis” for tax purposes. So hold onto all that paperwork and share everything with your tax preparer to get the most out of this fantastic company perk!
Holding on to too much company stock for too long.
In the world of investment management we call this concentration risk. Understanding the role company stock plays in your overall portfolio asset allocation is an important part of your comprehensive financial plan. Diversification is a powerful tool in mitigating investment risk and it may require selling some shares of your beloved company stock to achieve. Finding the balance between what to hold and when to sell can be a challenge often helped by enlisting a neutral advisor to help you see the big picture.
Jennipher Lommen is a Certified Financial Planner TM and Enrolled Agent who offers comprehensive financial planning and tax advice to clients in Santa Cruz, CA and beyond.
