By Matt Wheeler
Equity compensation is a popular tool for attracting the brightest and best talent in innovation hot spots like the Silicon Valley, Austin, Denver, and Boston, to name a few. It is also increasingly used in smaller companies as a retention tool for high quality employees. Tax principles require a taxpayer to recognize into income the value of any property received in exchange for services performed, including equity awards, and for US income tax purposes, the type and structure of equity compensation will dictate how the employee is taxed upon grant, exercise, vest, and sale of the option or award. Equity awards are generally taxed partially as compensation income (ordinary) and partially as portfolio income (capital gain). The key goal of the employee taxpayer is to maximize the amount of income recognized that is taxed at capital gain rates and minimize the amount taxed at ordinary income rates.
There are many types of equity compensation, and equally as many strategies for maximizing tax efficiency for each. We will briefly touch on the rules for incentive stock options, but this article will more specifically focus on non-qualified stock options.
INCENTIVE STOCK OPTION RULES
Incentive stock options (ISOs) have specifically defined qualities in the tax code. Some of the more common requirement are
- They may only be issued to employees, not non-employees or contractors
- They are non-transferrable
- An award of ISOs is limited to an annual vesting value amount of no more than $100,000 per year based on the grant price (the $100,000 rule), and
- The options must be exercisable while the taxpayer is still employed by the employer or not more than 90 days thereafter.
Non-qualified stock options are anything other than incentive stock options. The easiest way to identify your equity award option types is to review the grant document or check with your HR department.
BASIC NQSO RULES
Non-qualified stock options (NQSOs) have the most straightforward tax-treatment: upon exercise of an NQSO the entire “spread”, or difference between the fair value on exercise date and the strike price, is considered compensation income for tax purposes. At the time of exercise, the employer is required to collect the strike price per share from the employee and impose statutory withholdings for income taxes and payroll taxes on the spread amount. The entire gain is taxed at ordinary income rates. NQSOs may have more limited planning opportunities, but there are a few key considerations which can greatly impact the tax efficiency of this form of income. It is important to understand the following:
- Timing Considerations for Sale of Shares
- Estimated Tax Requirements
- Marginal Tax Rate Arbitrage, and
- Stock Price Risk Considerations
TIMING CONSIDERATIONS FOR SALE OF SHARES
The best time to sell your shares depends on a few factors, like employment status and type of employer.
Due to the significant cash layout required by the employee, the most tax advantageous and practical move for NQSO of publicly traded companies is generally to execute a same-day-sale or cashless exercise. The employee walks away with cash for the sale of the shares less required withholdings. For non-employee option holders, there are more tax strategies available, which we will discuss later in more detail.
For privately held NQSO shares where the current spread may be significantly less than the expected future value of the shares, the risk of exercising and holding the NQSOs, even at the cost of paying the required tax withholdings and strike price out of pocket, may be worth consideration.
In all scenarios, the key is to be aware of withholding shortfalls and the estimated tax requirements for individuals, understand how an income spike from the exercise and sale will affect your tax bracket compared to surrounding tax years, and remain conscious of the upcoming expiration dates of remaining options.
ESTIMATED TAX REQUIREMENTS
Non-qualified stock option holders must understand the estimated tax requirements for individual taxpayers and the statutory withholding rates for supplemental wage payments such as for income from stock option exercises.
Employers are required to withhold both social security and medicare taxes (social security up to the maximum wage cap in effect for the year) as well as income taxes on the gain portion of an exercise of non-qualified stock options. The tax code requires withholding on these supplemental wage payments at statutory rates—currently 22% for federal income taxes and 10.23% for California state income taxes. Other states may have other flat withholding rates required. The federal 22% rate applies to the first $1 million in supplemental wage payments made for the year. After the $1 million threshold has been reached, the statutory rate raises to 37%. Current maximum federal and California ordinary income tax rates are 37% and 13.3% respectively. This creates a potential withholding shortfall for taxpayers exercising NQSOs, which often results in additional taxes owed at the time of filing.
The timing requirements for estimated payments play an important role in your tax efficiency. Underpayment penalties are imposed on taxpayers that do not meet either the prior year or current year safe harbor requirements. While the IRS refers to them as penalties, leaving open the potential for abatement in certain circumstances, the underpayment penalty is essentially a form of interest charged to the taxpayer by the government for use of the funds throughout the year. Current underpayment penalty rates are at historical lows of 3% on an annualized basis.
The prior year safe harbor states that a taxpayer is required to pay in at least 100% or 110% of their prior year tax liability during the current year to avoid underpayment penalties. The payments can be in the form of any combination of withholding or estimated tax payments. The current year safe harbor states that a taxpayer is required to pay in at least 90% of the estimated current year tax during the year to avoid underpayment penalties, again via any combination of withholding or quarterly tax payments. In the case of an income spike from the exercise of non-qualified stock options, most taxpayers will find themselves relying on the prior year safe harbor. Due to the required withholdings on exercise, there is often sufficient tax paid in based on the exercises that no additional payments are required during the year.
One way taxpayers can maximize their tax efficiency here is by reducing future regular salary withholdings or eliminating future quarterly tax payments for the rest of the year and investing that money instead to earn a return before the money must be paid to the government. However, for taxpayers experiencing a sideways or down income year compared to the prior year, more care must be taken to ensure the proper amount of taxes have been paid in to avoid being penalized.
MARGINAL TAX RATE ARBITRAGE
Non-qualified stock option holders triggering income from the exercise and sale of options must also understand the impact it will have on their expected marginal tax rate compared to their expected tax rate for the following tax year. Utilizing the principals of tax rate arbitrage, you want to be strategic about triggering additional income or incurring deductions such that you are maximizing tax efficiency.
Additional income recognition should be deferred to the subsequent year, when possible, assuming a similar or lower marginal tax rate than the current year. Deductions should generally be accelerated into the current year rather than postponing them or waiting until the following year. Being strategic here can result in permanent tax savings on the rate differential.
While taxpayers may not have control over the timing of all income or deduction items, there are a few common strategies that may be available.
On the income side:
- Cashing out PTO or vacation pay
- Sale of assets at gains
- Invoicing of customers for self-employed taxpayers
- Roth conversions
On the deduction side:
- Prepayment of January mortgage payments in the current year
- Charitable contributions
- Business expenses for self-employed taxpayers
- Recognition of losses on the sale of assets or bad debts
- The freeing up of suspended passive losses on disposition of assets
There may be more tools at your disposal, depending on your specific situation, but this touches on some of the most common scenarios.
STOCK PRICE RISK CONSIDERATIONS
The last strategy available to employee NQSO holders relates to stock price risk. Non-qualified options have a maximum term of 10 years from the grant date, sometimes less. The specifics of your equity grant document should be reviewed.
As the expiration date looms closer for unexercised non-qualified stock options, the window of time in which the taxpayer can exercise and sell the option narrows. As this period approaches, the taxpayer runs increasing risk that a black swan style event, events outside the control of the underlying company, or perhaps poor execution on events within its control, could dramatically reduce the stock price. Even if the reduction is temporary, a narrowing exercise window means the taxpayer may be forced to cash out these options at a depressed price.
Medium term time horizon planning of multiple years can ensure that taxpayers are being smart about executing NQSO exercise and sale transactions at opportune times, minimizing pricing risk as execution windows narrow, and reserving equity awards with longer expiration time horizons for future years. While we always strive to maintain tax efficiency on our equity award transactions, paying more tax on higher income due to a high sale price is always preferable to paying less tax on lower income due to sale at a much lower price.
NON-EMPLOYEE OPTION HOLDERS
Non-employee NQSO holders have access to additional strategic options since any income recognized is considered income from self-employment. This is most commonly the case for directors of businesses who receive equity awards as compensation for director services.
Directors may utilize business expenses to reduce income, including
- Home office deductions (even carried over from prior years where no income was recognized but director services were still being performed)
- Communication expenses, such as cell phone and internet
- Travel and vehicle expenses
- And, perhaps most significantly, retirement plan expenses for the self-employed business. Certain retirement plans permit deductions well into five and even six figures, depending on the circumstances, which can result in significant tax savings.
SUMMARY
While non-qualified stock option holders may often feel there are limited tax planning and strategic tools available, there are still important considerations to keep in mind which can lead to significant four, five or six figure tax savings. Understanding estimated tax requirements and statutory withholding rates to take advantage of time value of money principles, utilizing tax rate arbitrage concepts to generate permanent tax savings, being aware of pricing risk in relation to upcoming option expirations, and maximizing business deductions for non-employee option holders can result in material savings.
Working with an advisor that understands the intricacies of these strategies should more than pay for itself in comparison to less experienced and expensive advisors or a DIY approach. If you have significant equity compensation awards, there is no time like the present to develop your tax minimization strategy.
Reach out to us at email@wheelercpa.com if you have questions or would like to know more about our tax planning and preparation services.
Matt Wheeler, CPA is the Managing Partner of Wheeler Accountants LLP, a full service accounting firm located in the heart of Silicon Valley. Matt works primarily with individuals on comprehensive tax strategies, specializing in equity compensation, serial entrepreneurs, venture capitalists and ultra high net worth individuals. He is also the co-host of the Avocado Toast Podcast – a Podcast targeting HENRYs (high earner not rich yet) and millennials helping them make smart financial decisions.