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Stock Options and Restricted Stock Simplified

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In the tech world, an employment agreement is often accompanies by a stock option or restricted stock grant. Issuing equity compensation as part of an employment package has basically become an industry standard for those who decide to take the leap into the startup/emerging growth world–and why not? For the risk you are taking, it only makes sense to get some of the upside if your startup turns into the next big thing.
While obtaining these instruments makes good sense, what they are and how they work often remains shrouded in mystery. With that in mind, the purpose of this article is to break down some of the basics of how stock options and restricted stock work and what you need to be thinking about when you receive equity-based compensation. And of course, this article is meant to provide a broad roadmap of the issues at a high level and is NEVER a replacement for tax advice from your accountant. So let’s start with the basics.

What is A Stock Option?

A stock option is an agreement between the employer and the employee that provides the employee the right to purchase stock of the Company at a fixed price (often called a “strike price”) at a future point in time. An option itself is not stock, or any kind of ownership in the company; it is merely a right to purchase stock. One important point that is often misunderstood is the receipt of an option is rarely a taxable event for the employee. The reason being that the “right” to purchase stock has virtually no measurable value given the fact that there is no guarantee that the right will ever be exercised. The fundamental value of an option is that your purchase price for the shares is locked in. The risk is that the actual value of those shares in the future is unknown, the proverbial “bag of magic beans.” To put it simply, if you are able to obtain options to purchase stock at a low strike price, they become significantly more valuable to the holder in the future if the Company’s stock value increases.

stock report

How Does Vesting Work?

Generally when one receives a stock option, there are restrictions placed on the employee’s ability to exercise the option (purchase stock). While several types of restrictions can exist, the most typical restriction is a “vesting period.” The Company generally wants to protect itself from having an employee purchase stock through option exercise too soon after he or she starts (just in case things don’t work out). In addition, the employer may want the employee to earn this valuable right by providing extended service and value to the Company. With that in mind, you will often not be allowed to exercise your right to purchase stock until a specific period of time passes. Thus, you “vest” in your right to exercise your option after you have served the Company for a certain amount of time (I often see three to four years, with portions vesting every year). It is also not uncommon to see vesting happen as a result of the achievement of a specific project goal or milestone, such as an IPO or strategic acquisition. The important matter here is that only after you have vested in your options will you have the right to purchase stock.

Are There Different Types of Stock Options?

Yes! While there are several types of options that exist, the vast majority of stock options that are issued fall into one of two buckets: incentive stock options (ISOs) or non-qualified stock options (NQOs). Both options have a significantly different treatment and tax impact. As previously noted, the receipt of an option itself is not a taxable event; however, the way the transaction is taxed after the option is exercised can be vastly different.

While there are several types of options that exist, the vast majority of stock options that are issued fall into one of two buckets: incentive stock options (ISOs) or non-qualified stock options (NQOs). Both options have a significantly different treatment and tax impact.

Non-Qualified Stock Options (NQO)

When someone exercises an NQO, at the time of exercise the employee is taxed on the difference between the fair market value of the stock purchased (on the purchase date) and the price paid for the stock based on the option agreement (strike price). For example, if you exercised your option to purchase 1,000 shares of stock where your strike price was $.05 and the fair value of the stock was $1.00, your taxable gain is $950 ($.95 X 1,000). This gain is considered to be “ordinary income” and is taxed at your regular income tax rate (rather than a capital gain rate which is generally lower and preferred). Your employer should include this income on your W-2 as compensation to you. On the date that you purchase the shares, your “holding period” in that stock begins. If you hold on to the shares for at least one year, when you sell them, any gain will be taxed at capital gains rates (generally 20%). It is important to remember that your gain on the sale at that time will be the difference between the sales price on the date of sale and your “basis” in the shares (the amount you paid for them plus the income recognized upon exercise). In our scenario, if you sold the stock for $1,500, your taxable gain would be $500 ($1,500-$1000), and that gain would generally be taxed at a preferential capital gains rate.

Incentive Stock Options (ISO)

Incentive stock options are generally considered to be more advantageous for an employee from a tax perspective as it can often result in a more favorable tax treatment upon exercise. There are several requirements that must be met for an option to be deemed an ISO (this is managed by your employer). One example is at the time the option was issued to the employee, the strike price cannot be less then the fair market value of the stock (in an NQO this is not required). When an employee exercises his/her right to purchase stock through an ISO, unlike an NQO, there is no taxable income recognized by the employee at the time of the exercise. Instead, the employee will have a taxable event only at the time that the employee sells the stock to someone else. In addition, the entire gain is taxed at a capital gains rate as opposed to an NQO, where as previously discussed, a portion is taxed at ordinary income rates upon exercise.
On the surface it seems that ISOs are significantly more tax efficient than NQOs, and on some level that is true. However, there are some pitfalls that come with an ISO that, if ignored, can diminish or eliminate the tax benefits all together. First, in order to get the preferential tax treatment when you exercise your ISO, you MUST hold the stock for at least a year after the exercise and at least two years after the grant of the ISO. If you do not satisfy this holding period, the ISO will be “disqualified” and therefore taxed as an NQO. The second is “AMT” (the Alternative Minimum Tax). AMT is a relatively complex matter that I will not attempt to delve into in this article; however, the basic issue is that the IRS may tax you under two methods: a regular method and an alternative method. Under the regular method, the “spread” in an ISO between the strike price and the fair value of the stock is not taxed upon exercise (as opposed to an NQO). Under the alternative method, that spread is deemed to be taxable upon exercise. A taxpayer is required to always pay the higher tax between the regular and alternative method; therefore, depending on your personal tax situation, you may be required to pay the tax immediately regardless of the type of option (ISO or NQO). Generally, even if the ISO is taxed under the AMT, it is a more favorable tax rate than the regular ordinary income rates and consequently still beats out an NQO.

When Should I Exercise My Options?

Knowing when to exercise your options is often decided on a case-by-case basis. Here are some general thoughts and guidelines that might be helpful when making that decision:

  • A vast majority of option holders choose to exercise their options when a major event happens, such as a sale of the Company or IPO. The reason for this is because one can pay for the option and sell it on the same day with no out-of-pocket cost. This is usually the easiest path to take, however under both option types above, will result in ordinary income treatment on the entire difference between the strike price of the option and the fair value of the stock (sale price).
  • If your goal is to have as much of your gain taxed at preferential rates (capital gains rates), you want to exercise your option at least one year before you intend to sell the shares. Unfortunately, sometimes you can predict this; sometimes you can’t. The obvious risk in exercising well before a sale event happens is that you pay for stock and then may not have any prospect of selling it. As we all know, companies may never sell for a multitude of reasons.
  • If you feel VERY confident that the stock will one day sell at a significant price, you want to exercise as soon as you can while the fair market value is still low and your gain upon exercise will therefore be lower (for an NQO). For an ISO, you can start your holding period in order to ensure you will not disqualify your ISO.

Long story short —if you don’t want to come out of pocket to pay for shares and are not confident on if/when a sale event will ever happen, wait until the company actually sells. If you are confident that the value of the shares will increase substantially over the foreseeable future and are also confident the company will either sell its stock or go public, exercise as soon as you can in order to be sure to lock in capital gains treatment and mitigate the taxable gain upon exercise (assuming you are not subject to AMT or are exercising an NQO).

Restricted Stock and 83B Elections

A less frequent alternative to stock options is the issuance of actual stock that is coupled with restrictions (typically timebased). In this scenario, the recipient actually receives an equity award rather than an option to purchase equity at some future point in time. IRS code section 83 generally states that when restricted stock is issued in exchange for services (and without cash consideration), the recipient is required to recognize the fair value of the stock received as income and pay tax at ordinary rates. A key provision, however, is that the recognition of that income will not take place until such time that all restrictions have lapsed. In this scenario, if you receive a stock today worth $1,000 with a three-year vesting schedule, you do not have to pay tax on the receipt of that stock until three years have passed.
One important matter to note is that when you do pay the tax, it is based on the fair value of the stock on the date the restrictions have lapsed, not the original grant date. If three years from now, the value of the stock appreciated to $30,000, you would have an additional $29,000 of taxable gain beyond what you originally received. This is where the well-known “83(b) election” comes in. Code section 83(b) allows the recipient of restricted stock to elect to have the value of the stock taxed on the date of receipt rather than the date that all restrictions lapse. This acceleration of tax is an effective election in the context of a startup because the restricted shares are received when they are worth the least. In our scenario above, had the recipient elected to be taxed on the date of receipt rather than the date the restrictions lapsed, he would have saved at least $10,000 of actual taxes. One important key to the election is that it must be made within 30 days of the grant of the restricted stock.

Conclusion

Stock options and restricted stock awards can be a complex and daunting matter to deal with. The key is to work closely with your tax advisor to make sure you fully understand the impact of receiving your option/equity compensation and choose the right strategy to effectively manage the potential current future associated tax.

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