9/10/2018

The latest episode of the "They Don't Teach You This Podcast" is brought to you by oXYGen Financial, serving the X & Y Generation and millennials since 2008. oXYGen provides financial planning and investment advice and allows you, the listener, to book a consultation with Tyler or Kurt for FREE with no obligation to move forward. Just go to www.oxygenfinancial.net today to get your own personal financial advice!

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In this episode we chat about employee stock options. Many people receive different types of stock options through work and we want you know which each one is. Whether it is a non-qualified stock option, incentive stock, or restricted stock, it can be a nice perk at work. Come find out what the differences are between them so you can make the right decisions at work!

 

What is an employee stock option?

• Grants the employees of a company the right to buy a certain amount of company shares at a predetermined price for a specific period. Often times this predetermined price is at a discount to what the shares were worth on the market at the time they were granted.
• Stock options come in two different types: non-qualified stock options and incentive stock options. The main difference is how they are treated when it comes time to pay taxes. We will get into the differences later.
• Ex: Home Depot grants an employee stock options, and the option agreement allows that Home Depot employee to purchase 1,000 shares of company stock at an exercise price, or strike price, of $50 per share - 500 shares of the total vest after two years and 500 more shares vest at the end of three years. This is called the “grant date”
• • We talked about vesting in a previous podcast but this refers to the employee gaining ownership over the options. It’s a way for the employer to get the employee to stay at the company.
• Using this example, let’s say that Home Depot stock increases to $70 after two years, which is above that exercise price of $50. That Home Depot employee can exercise their options by purchasing the 500 vested shares at $50 and immediately selling those shares at the market price of $70. The transaction generates a $20/share gain, or $10,000 in total. Keep in mind that $10,000 is taxable.
• You don’t have to immediately sell the shares but that $10,000 spread (called the bargain element) is still taxed because it is considered compensation by the IRS - ONLY if you hold them for less than 1 year..
• Then when you sell the stock, you are taxed at a capital gains rate, dependent on how long you’ve held the stock.
• Most companies grant these options with no cash outlay requirement from the employee meaning the employee doesn’t actually have to come out of pocket to buy those 500 shares at $50, the employer just pays the employee the difference. This is an expense for the employer which is why they tie these things to vesting schedules so they can have the ability to retain that key employee and get value of the the employee too.
• Let’s say the stock did not increase over that two year period and is at $40, the employee wouldn’t exercise their options but they would still retain them and have the option to exercise them in the future, even he or she left Home Depot.
• Most options do have an expiration date so you can’t hold them forever.

 

Types of employee stock options

 

Non-qualified stock options

Most commonly offered type of stock option by companies.

Typically offered to non-executive employees and outside directors or consultants

• Called “non-qualified” because they do not qualify for tax advantages.
• You pay taxes two times when you exercise these:
• • 1st: You pay ordinary income tax on the difference between the exercise price and market price as the IRS considers this compensation even if you havent actually sold the shares!
  • 2nd: When you ultimately sell the stock, you will pay capital gains taxes. If you have held the stock for less than a year, you will pay ordinary income tax and if you have held the stock for more than a year, it is subject to long term capital gains rates.
  • Non qualified options: 3-4 years vest 10 years to exercise or will become worthless
  • If vested in non qualified and fired then have 90 days to exercise.

 

Incentive Stock options

Strictly reserved for employees, and more specifically executives, of the company.

Given more favorable tax treatment bc they meet specific rules laid out in the tax code

• When you exercise ISOs, you do not pay ordinary income taxes on the difference between the market value and the exercise price. You ONLY pay capital gains taxes when you ultimately sell your stock.
• The bargain element (that spread between market value and exercise price) can trigger alternative minimum taxes, though. We won’t get into that right now but its something to know if you are in that type of tax bracket.
• If you are receiving any types of ISOs, there are some special tax requirements that have to be followed so you can reach out to us for those or a CPA. They have holding periods you have to meet before you can sell them and they can be pretty complicated.

Restricted stock options

Became more popular in the mid-2000s as companies were required to expense stock option grants.

Often used as a form of employee compensation

Different from stock options in that there is usually no purchasing involved.

• Predetermined amount of stock that belongs to an employee after certain restrictions are met.
• • Usually tied to some vesting schedule but can be tied to financial targets or goals for the company as well

 

• Restricted stock units (RSUs) are a promise made to an employee by an employer to grant a given number of shares of the company’s stock to the employee at a predetermined time in the future.

 

• No voting rights with RSUs
• An RSU must be exercised in order to receive the stock. You don’t buy the shares, rather you are awarded them outright.
• The employees in some cases can elect to receive the cash value of the RSUs in lieu of the stock.

 

• Restricted stock awards are similar to RSUs but they do have voting rights because the employee owns the stock immediately once its awarded.

 

• Restricted stock holders pay tax on the capital gain (if there is one) on the difference between the stock’s price on the date it vests and the date it is sold. In addition, restricted stock is taxable as ordinary income in the year it vests.

 

Employee Stock Purchase Plan

A form of equity compensation that some companies offer their employees, with the intention of making it easier for workers to purchase company stock, often times at a discounted price. Up to 15%.

• Allow employees to use after-tax payroll deductions to buy company shares
• Usually the employer will hold the contributions in an account and will have specified purchase dates throughout the year that will use the contributions to buy company shares.
• Either qualified or non-qualified plans

 

The 83(b) election is a provision under the Internal Revenue Code (IRC) which gives an employee, or startup founder, the option to pay taxes on the total fair market value of restricted stock at the time of granting.

The 83(b) election applies to equity that is subject to vesting, and it alerts the Internal Revenue Service (IRS) to tax the elector for the ownership at the time it of granting, rather than at the time of stock vesting.

In effect, an 83(b) election means that you pre-pay your tax liability on a low valuation, assuming the equity value increases in the following years. However, if the value of the company instead declines consistently and continuously, this tax strategy would ultimately mean that you overpaid in taxes by pre-paying on higher equity valuation.

 

What is a 'Phantom Stock Plan'

A phantom stock plan is an employee benefit plan that gives selected employees (senior management) many of the benefits of stock ownership without actually giving them any company stock. This is sometimes referred to as shadow stock.

Rather than getting physical stock, the employee receives pretend stock. Even though it's not real, the phantom stock follows the price movement of the company's actual stock, paying out any resulting profits.

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