Smart Tax Strategies, Return Tips and Mistakes to Avoid with Equity Compensation

InspireHer: Plancorp Women’s Initiative | Tax Strategy | Equity Compensation

 Susan Jones By: Susan Jones

One of the most powerful advantages of equity compensation is that equity awards typically offer ways to defer or minimize taxes. But making the most of stock options, restricted stock units and other types of equity compensation requires smart tax planning—otherwise, you could end up with a surprising tax bill and even end up paying more in taxes than needed.

Making matters trickier, companies often give packages that include multiple forms of equity awards, each with their own tax rules. That’s why it’s essential to develop an overall tax plan for your equity compensation, keep track of important information regarding your equity awards, and work with a professional who can assist you with tax planning and minimization strategies. To get started, consider these important strategies for managing your tax bill, filing your tax return properly, and avoiding common mistakes.

Smart Tax Strategies for Equity Compensation

Different types of equity compensation are subject to very different tax rules. You can see a complete rundown of these rules in our eBook, “How to Make the Most of Equity Compensation.” 

One of the first steps in maximizing the value of equity compensation is creating a tax strategy that’s aligned with the specific rules of your award. Here are examples for the most common types of equity compensation.

Incentive Stock Options (ISOs)

People often misunderstand the tax treatment of ISOs. The most important detail to note is that the taxation of ISOs depends on when you sell the shares after you’ve exercised your options.

If you sell your shares less than the later of two years from the grant date and one year from the exercise date, the sale is a “disqualifying disposition.” That means the spread between the stock’s fair market value on the exercise date and the strike price is taxed as compensation income. Any additional gain over this amount is taxed as capital gain, although stock sold within one year of exercise will be treated as short-term gain and subject to ordinary income tax rates.

On the other hand, if you hold the stock for the longer of two years from the grant date and one year from the exercise date, the sale is considered a “qualifying disposition.” With a qualifying disposition, you won’t owe regular income tax or payroll tax when you exercise your options. However, the spread between the fair market value of the stock on the date of exercise and the ISO’s strike price is considered income and subject to the alternative minimum tax (“AMT”). This means that you may owe AMT in the year of your ISO exercise, which can be challenging from a cash flow perspective since there will not be wage withholding to help offset those taxes.

If you do owe AMT at exercise, depending on your other income and deductions, you may receive an AMT credit that you can carry forward and use in a year in which your regular income tax is more than your AMT. Since your AMT cost basis for ISO shares is greater than your regular tax basis, this often occurs when the shares are sold.

As you can see, the taxation of ISOs is complex, so it’s important to work with an advisor who understands and can guide you through these rules.

Non-Qualified Stock Options (NSOs)

When you exercise NSOs, the difference between the strike price and stock’s current fair market value is treated as compensation income and you’ll owe income and payroll taxes on this amount. You might think you’re covered because employers automatically withhold those taxes for you. But many employers simply withhold the mandatory 22% federal minimum tax, even if you’re in a higher tax bracket. 

To avoid a surprise tax bill the year you exercise NSOs, work with a financial advisor to run a tax projection so you can prepare for any additional taxes you may owe and consider if additional tax planning may help ease your tax burden.

Restricted Stock and Restricted Stock Units (RSUs)

When RSUs vest their share value it's considered ordinary income, and you’re taxed as if you received the same amount of money in cash—even if you don’t sell them. So with RSUs, pay close attention to the vesting schedule and make sure you have a complete picture as to your potential income that year. For example, if you will be pushed into a higher marginal tax bracket, does it make sense to increase your pre-tax qualified plan contributions ?  Or does your employer offer nonqualified deferred compensation plans that let you postpone a portion of your compensation to reduce your income tax burden in the current year?

If you’re granted actual restricted stock (as opposed to RSUs), you also might look into a Section 83(b) election, which gives you the chance to pay income taxes on restricted stock when it is granted rather than when it vests. It involves a bit of risk, because you’re assuming your company stock will increase in value by the time your restricted stock vests (which may not be the case). And if you leave your job before vesting you will have paid taxes on compensation that you never receive. Keep in mind that the rules for Section 83(b) elections require strict compliance as to both the timeline for making the election and the reporting requirements, so it’s imperative to work with an advisor who understands these issues.

Employee Stock Purchase Plans (ESPPs)

Although you only incur taxes when you sell shares received through an ESPP, it’s still a little complicated. Similar to ISOs, one of the key issues to understand is whether you have qualifying or disqualifying disposition when you sell. 

Selling shares held for less than two years after the offering date or less than one year after the purchase date, if later, equates to a disqualifying disposition. Shares that are held for at least this long are qualifying dispositions and eligible for preferential tax treatment. 

Under both a qualifying or disqualifying disposition, you will have ordinary income on the discount you received when you purchased the shares (often 15%). In a disqualifying disposition you will also have ordinary income on the difference between the stock price on the purchase date and the price on the offering date. In both a qualifying and disqualifying disposition, any gain in excess of the compensation income will be treated as capital gains, with shares held for at least one year after purchase qualifying for the preferential long-term capital gain rate.

So before selling shares earned through an ESPP, you should determine whether there is a benefit to recognizing the income this year, or if it’s better to wait, and what the additional tax from a disqualifying disposition would be. It’s also important to recognize that tax shouldn’t be the only driver in determining your sell versus hold strategy. Asset concentration and risk issues associated with holding too much company stock should also factor into your decision.

Tax Return Tips for Reporting Equity Compensation

People with equity compensation who file their own tax returns often have questions about how to report what they’ve earned. These tips can help ensure you file correctly.

  1. If you exercised NSOs or had RSUs vest during the year, any compensation income will be reported on your Form W-2, so you will not need to report on a special place on your Form 1040, individual income tax return. That said, keep in mind that you’re ultimately responsible for reporting your income, so be sure to verify that the income is correctly included on your paystub for the period of exercise or vest, as well as on your Form W-2.

  2. If you’ve sold shares acquired through an NSO during the year, you need to report any gain or loss from that sale. This requires knowing your adjusted cost basis—which should be the market price on the day you exercise, not the exercise price. Prior to 2014, many brokerages and custodians reported the adjusted basis of shares acquired through nonqualified stock options on Form 1099. Since then, however, IRS rules have generally prevented custodians from tracking this information. It’s imperative that you maintain good records of NSO exercises and review the cost basis listed on Form 1099-B to avoid potentially paying more taxes that you really owe on any sales. 

  3. If you’ve exercised ISOs, you may owe Alternative Minimum Tax (AMT) on the difference between the fair market value and the strike price on the date of exercise.  The income subject to AMT will not be included on your Form W-2 and the reporting of this information on IRS Form 6251 is complex. So if you’re not a tax wiz it is important to work with a professional who can help guide you. 

  4. If you’ve sold shares acquired through the exercise of an ISO and were subject to AMT at that time, you may be able to utilize a minimum tax credit you have carried forward.  This credit will be calculated on Form 8801 but can only be calculated if you have the information, so be sure to review prior returns to determine any AMT credit carried forward.

No matter what kind of equity compensation you receive, selling shares without considering your complete financial picture can result in higher taxes and a tax bill you haven’t prepared to pay. The tax benefits of equity compensation are not guaranteed. To achieve them, you need to integrate the value of equity compensation in the context of your financial circumstances, plan and goals.

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This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.

Plancorp is a registered investment advisor with the Securities and Exchange Commission ("SEC") and only transacts business in states where it is properly registered or is excluded or exempted from registration requirements. SEC registration does not imply a certain level of skill or training. Please refer to our Form ADV Part 2A disclosure brochure and our Form CRS for additional information regarding the qualifications and business practices of Plancorp.

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For over twenty years, Susan has passionately provided wealth management services to individuals, families, fiduciaries, private foundations and their related entities with a focus on sophisticated income, gift and estate tax consulting and compliance, proactive executive compensation planning and succession planning. Susan understands the many facets involved in creating a successful multi-generational family legacy and uses a forward-looking approach to help clients grow and preserve assets, reduce taxes and realize both their financial and non-financial goals. Susan’s experience includes practicing law in the tax and estate planning. More »