RUEDI: Weighing Your Equity Options | Business
Tesla CEO Elon Musk recently made headlines regarding the sale of part of his shares in the company he founded in 2003. The amount of taxes he will pay as a result of those sales It also gets a lot of attention.
The value of Tesla shares has skyrocketed this year, so it’s understandable that Mr. Musk wants to capitalize on some of his profits. However, it appears that the sales may be motivated more by a deadline to act on the company’s stock options that Musk received as compensation instead of a traditional salary.
Options allow Tesla shares to be bought at a fraction of their current market price, but as the owner of those options, Musk had a limited window to act on them or risk letting them expire unused. Stock options and other stock awards are often included in compensation programs to attract talent and align interest with company shareholders.
While most individuals won’t have the nine-figure product or the tax bills like Elon Musk, the process of exercising stock awards effectively is an important consideration for anyone who may own them.
Stock options are granted in three common ways: unqualified options, incentive stock options and restricted stock units. Each style has unique practice requirements and tax implications.
Unqualified stock options (NSO)
A company can grant NSOs to employees, directors, outside consultants or anyone who provides services to a company. Grants are issued with a “strike” price closely tied to the current market value of the company’s shares.
Typically, these awards also come with a vesting schedule, a period of time before the owner can exercise the options and purchase shares of the company. Nothing is taxable when stock options are granted, but once they are exercised, things get complicated.
Once the options have vested, the owner can choose to buy shares in the company for the price stated in his options. The difference between the purchase price of the shares and their current market value becomes ordinary taxable income for the owner. Any subsequent sale of these shares is processed at the capital gain rates in force according to the length of the holding after exercise.
Incentive Stock Options (ISO)
ISOs are more restrictive as to who they can be assigned. Like NSOs, ISOs are not taxable when granted. However, ISOs are also not taxable when exercised by the owner.
In the case of ISOs, the difference between the strike price and the current market value is included as income for the purposes of calculating any alternative minimum tax that may be payable. To benefit from preferential tax treatment on sale, an owner must hold the shares for one year after exercise and at least two years after the date of their grant.
It should also be noted that ISOs must be exercised no later than three months after termination or they expire.
Restricted stock units (RSUs)
RSUs are issued as an unsecured benefit to their owners. Often, acquisition metrics are tied to certain business performance metrics and / or a time period an employee must stay with the business to gain benefits. Once an employee meets all vesting parameters, RSUs are exchanged for a set number of company shares.
The current market value of the share on the date of acquisition is considered ordinary taxable income for the owner. Unlike options, RSU holders are not required to find funds to purchase shares. Keep in mind that RSUs are only of value after all requirements have been met and could be lost if an employee leaves the company prior to the acquisition.
There are many tax considerations and claims strategies that can be implemented by employees who hold options or restricted stock units. Please consult your financial advisor and tax preparer before making any transaction with your compensation awards.
Ruedi is a financial advisor at Savant Wealth Management, Bloomington.