Understanding the Tax Implications of Company Stock Based Compensation

If you are an executive at a large company, you may receive stock in your company at some point as a form of compensation.

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If you are an executive at a large company, you may receive stock in your company at some point as a form of compensation. In general, this can be a great way to build wealth, but it also comes with its share of risks and tax implications to consider. Below are three common forms of equity compensation and what you need to know about the potential tax implications.

Stock Options

A stock option grants you the right to purchase a set number of shares at an established price after a certain amount of time has passed (called vesting). Options can be seen as a retention tool because the hope is that the stock will appreciate by the time the options vest, creating a ‘low’ purchase price relative to the prevailing stock price.

With Non-Qualified Stock Options, (NQSOs) this difference in prices (called the bargain element) is taxable as ordinary income in the year of exercise. Ordinary income (just like income from a bonus or salary) is typically subject to Social Security, Medicare and payroll taxes. You can elect a ‘cashless’ exercise, where you essentially buy and sell the stock at the same time. If you buy (at exercise) and hold the stock for less than a year, you will have a short-term gain or loss upon the sale. Holding more than a year creates a long-term gain or loss.

Incentive Stock Options (ISOs) have a tax advantage in that you report income only when you sell the stock, not at exercise. Your tax rate depends how long you hold the stock. Generally, if you can wait a year from purchase (exercise date) and two years from when they were granted, any profit on the sale is treated as a long-term capital gain. This could mean significant savings over being taxed at ordinary income tax rates. Also, you do have to report the bargain element in the year of exercise for purposes of the Alternative Minimum Tax (AMT) unless you sell the stock in the same year. Later when the stock is sold an AMT adjustment is made. This should be done with the help of a qualified tax preparer.

Restricted Stock

Restricted stock is another common form of equity compensation where a certain number of shares are granted to an employee, and they become vested once some period of time has elapsed.

Restricted Stock Units (RSUs) are a promise by the company to grant shares and are not actual voting stock until they vest. In some cases, cash can be elected to be received at vesting instead of stock. RSUs are taxed as ordinary income on the date they vest based on the market value of the shares. If they are held beyond that point, short or long-term capital gains would be realized upon the final sale in addition to the tax due at vesting.

Restricted Stock Awards (RSAs) are owned by the employee once granted. Unlike RSUs, they do not have the option of being redeemed for cash. The other key difference is the potential tax treatment. If a Section 83(b) election is made by the company, the employee will have the option to pay the tax (ordinary income) at the grant date, instead of at the vesting date. This gives significant control over the timing of the tax payment and can be very helpful in coordinating bonuses or other income sources. If no Section 83(b) election was made then the tax is due at vesting, just like RSUs.

Stock Appreciation Rights

Stock Appreciation Rights (SARs) are similar to NQSOs in many ways. There is no income tax due until exercise, which hopefully allows them to be exercised at an opportune time. The value of SARs is determined by calculating the difference between the grant price and the exercise price, multiplied by the number of shares. They are also comparable to RSUs and RSAs in the fact that the taxes can be paid either in cash or by withholding shares. If you elect to withhold shares, you just end up with a reduced number of shares after the initial exercise.

Investing in your company stock obviously has the potential to increase your net worth, but beware of letting it become too large a portion of your overall investment portfolio. A good rule of thumb is to limit your exposure in any single company to 10% of your portfolio. This is especially true if your job, insurance, and livelihood are hanging in the balance over the overall performance of your place of employment.

Do you have further questions about tax implications for your investment portfolio? Learn more about how we help investors plan and implement tax-efficient strategies.

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