"Opportunities are like sunrises. If you wait too long, you miss them." – William Arthur Ward
Stock-based compensation is an excellent tool in building personal wealth. In particular, executives in public companies often enjoy being compensated based on their company's stock price. Having worked with public corporation executives over the past three decades, I have had the opportunity to see incredible levels of wealth be built. Unfortunately, I have also seen an amazing amount of money get left on the table.
Here are three mistakes people often make with their stock-based compensation:
1. Forgetting to exercise options before they expire.
"North of 10% of valuable options expire unexercised every year," says Bruce Brumberg, editor of myStockOptions.com, a site devoted to options, restricted stock and other forms of equity-based compensation. Too often, you get busy, and your focus on other business and personal items causes you to forget that you need to deal with an option. All options should be placed into a management system to avoid this unfortunate, but all too easy, mistake.
2. Not having an exit strategy.
This mistake is also quite common and sometimes leads to waiting until the last minute to exercise. In some cases, this is due to not having a strategy to determine when the optimum price and time to maximize the value of the option is. There are tools that can assist you in determining an appropriate time to exercise. For example, Black-Scholes modeling uses the current price, the stock's volatility and expiration, or expiry, date to assist in coming up with an estimated fair value. While not perfect, it is far better than holding up your finger to see which way the wind is blowing. If you have stock-based compensation, you will benefit greatly from having advisers with expertise in these strategies.
3. Misunderstanding the tax consequences.
This issue is critical to achieving optimal results. Executive stock options fall into three general types: Incentive Stock Options, Non-Qualified Stock Options and Stock Grants. All have their own unique and special tax features.
Incentive Stock Options (ISOs)
ISOs have been waning in popularity at very large organizations, but are still popular with many start-up companies. ISOs have a special feature: When you exercise, the tax event is deferred until the stock is actually sold. For example, let's say XYZ Company issues a stock option for $10 per share, and the current value is $20. When you exercise the $10 gain, it is not recognized until the XYZ Company stock is sold and converted to cash. If you hold for one year and one day, the exercised stock's gain then qualifies for long-term capital gains treatment, at a maximum of 20%, instead of ordinary income tax treatment at a maximum of 39.6% plus any state taxes. This is a huge difference. In many cases, executives are not aware of this point, exercise the stock and sell immediately, losing the long-term capital gains treatment.
Non-Qualified Stock Options (NSOs)
The popularity of NSOs has been increasing as ISOs decline. The overall costs for the issuing company are lower due to the tax treatment at exercise. Let's look at an example using the same scenario as before. XYZ issues an NSO at $10 per share, and you pay no tax at the time of issue. The stock appreciates to $20 and is vested. If you decide to sell at $20, the gain is $10. The stock is either purchased with cash, or (most frequently) a zero-cost strategy is exercised that in effect sells and provides you with the same $10. Either way, the entire $10 is taxed as ordinary income.
However, while for IRS purposes the gain is taxed as compensation, in most cases, your withholding would not be based on the combination of your salary and the NSO sale, which would result in the tax day surprise that no one wants. Proper consultation with your financial and tax advisers when exercising is critical to understand what will be required.
Stock grants are gaining more and more traction in corporate America, in part, because of the increased pressure from shareholders to keep executive compensation reasonable. This type of stock option lacks the leverage that ISOs and NSOs enjoy, and in many ways, are like a deferred bonus with upside and downside potential. For example, let's say XYZ Company issues you 1,000 shares of stock at a price of $10 per share. No taxes are due at the time of the grant since the stock typically has a vesting schedule. The taxable event occurs when the stock is fully available to sell. Whether or not the stock is sold, the shares would be taxed when they become vested, either partially or fully.
The challenge may be in having the cash to pay the tax on the vesting date. Let's assume the stock doubles to $20 and vests. The taxable income would be the full value of the stock, or $20,000. If, on the other hand, the stock drops to $5, the taxable income would be $5,000. The only way the stock can have long-term capital gains treatment is to hold it for one year and one day past the vesting date.
There is one exception called an 83(b) election. By filing an 83(b) election, you are declaring the value of the stock at the time of the grant rather than waiting. If in the example above, thestock doubles to $20, and an 83(b) election was properly filed within 30 days of the initial grant, $10,000 would be taxed as ordinary income in the year of the grant, and $10,000 would be taxed as long-term capital gains when the stock is ultimately sold.
Of course, there are disadvantages to this strategy: You could end up forfeiting the stock pre-vesting, if you wind up leaving the company, for example. Also, the stock may not appreciate, and the tax treatment would be worse than it would have been had you waited. If, however, you are very confident in your long-term role at the company, and the confidence is very high for the stock, then an 83(b) election is something to seriously consider.
The landscape for stock-based compensation continues to change significantly, and the continuous evolution is almost certainly assured. Attention must be paid to the management of these tools and the timeliness and techniques that are most appropriate. By paying attention to the expiry dates, types of grants and the tax treatment, you can maximize the impact of stock-based compensation on your personal financial security.
Robert Klosterman, CFP® is the CEO and Chief Investment Officer of White Oaks Investment Management, Inc., a fee-only investment management and wealth advisory firm. Bob is the author of the book, "The Four Horsemen of the Investor's Apocalypse. White Oaks has been recognized by CNBC.com as one of the "Top 100 Fee-Only Wealth Management firms in the country.
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