The following is a chapter from Employee Benefits: How to Make the Most of Your Stock, Insurance, Retirement, and Executive Benefits by Josh Mungavin CFP®, CRC® and Edited by Chris Boren & Tristan Whittingham.

 

Stock Benefits

 

Employee Stock Purchase Plan

Optimal Use: Strategies and Analysis

Employee stock benefit plans are generally beneficial for one of two reasons or a combination of both reasons. The most common benefit of an employee stock purchase plan is that your employer allows you to buy stock at a discount, (usually somewhere in the range of 5–15%) to the fair market value. The other primary way employee stock purchase plans can add value is that some plans provide a look-back period, allowing you to use a historical closing price of the stock. This price may be either the price of the stock offering date or the purchase date, whichever is lower.

This means that, if your employer offers a 15% discount to the share price and a look-back period benefit and the price of your stock has gone up by 10% over the period, you will get a 15% discount to the price at the beginning of the period. Then you can sell it for an immediate return on your investment.

It is usually best to maximize your employer stock purchase plan to the extent that your financial plan allows. The employer will generally allow you to use up to a certain percentage of income towards your stock purchase plan, but you will always need to keep the contributions below the IRS-dictated $25,000 per year for qualified employer stock purchase programs.7 If you buy and sell the stock on the same day with the discount, you receive the percentage discount as additional compensation with little risk, even without a look-back period, so there is at least a locked-in benefit of additional income. If there is a look-back period, the stock has gone down over the period, and you buy the stock at its current price with only a discount, which again provides you the benefit of buying a stock more cheaply, you still make money if you immediately turn around and sell the stock. If there is a look-back period and the stock has gone up, you stand to gain significantly with the combination of the look-back period and the discount along with selling the stock immediately and just thinking about the gains as additional income or additional salary rather than a long-term investment in the company. In other words, it’s a win–win situation as long as the shares are bought and sold on the same day regardless of whether there’s a look-back period.

Special Considerations

While there may be some tax benefits to holding on to the stock you have purchased for a certain period, it’s generally best to sell the shares as soon as possible to diversify your investments. The discount to the stock price you must pay versus what the stock is worth will always be taxed at ordinary income rates. Shares held for at least two years from the first day of the offering period and at least one year from the purchase date are generally taxed at the lower long-term capital gains rates. It’s important to remember that while the tax benefits may seem appealing, the stock can easily decline enough to justify the diversification of the holdings over that time. Holding the stock past the first day on which you can sell it is essentially the same as buying the stock on the open market for its present value. As investments in individual companies, stocks come with unsystematic risk (i.e., risk that can’t be diversified), and so much of an employee’s net worth is tied up in the company based on their personal earning power through their job, incentive stock options, restricted stock options, deferred compensation, and employee stock purchase plan. It is generally best to sell employee purchase-plan stock as soon as you can because there’s no benefit above and beyond what one would get from going out into the open market to buy the stock for the employee who keeps the stock. There is a significant downside to the employee if the company suffers significantly or goes out of business.

General IRS Rules and Eligibility

• Employee stock purchase plans usually have an upfront enrollment period during which you need to decide what percentage of your paycheck you would like to have deducted and used to buy employer stock at a discount. Depending on the company, this is generally done with after-tax money, and the qualified plans are limited to $25,000 in stock purchases per year.
• The employer will generally have you sign up for a certain period, e.g., 12 or 18 months, and give a certain number of purchase periods (i.e., two or three six-month periods) during which your money will be put into an account. At the end of the period, the money you’ve saved will be used to buy employee stock at the discount offered by your employer’s plan.

Restricted Stock Units

Restricted stock units (RSUs) are issued to an employee through a vesting plan and distribution schedule after achieving required performance milestones or remaining with their employer for a particular amount of time.8 RSUs are different than incentive stock options in that the employer gives you units that represent stock for free, but you can’t touch the RSUs until you’ve met your company’s vesting. The RSUs are taxed when they vest. Some companies give you the ability to take the proceeds from a RSU in kind (meaning you receive shares either before taxes so you receive more shares but pay taxes out of pocket from outside money or after taxes have been withheld by the employer) or in cash (meaning the employer gives you the net value of the shares the units represent after taxes have been withheld). In either case, you may have the option to receive the proceeds before or after taxes. The employer may withhold taxes by selling enough shares to cover your tax liability and sending the proceeds of the shares to the government.

You may see private companies, such as Facebook, offer RSUs. This allows employees of a privately held company to participate in the stock valuation of the company during its pre-IPO days without having to meet some of the requirements of public companies or companies with more than a certain number of owners. It also ensures that shareholder rights, such as voting, don’t end up in the hands of people that the founders of the company don’t want to have an outsized say in the happenings of the company before it goes public.

Optimal Use: Strategies and Analysis

It is generally best to sell RSUs as soon as they’ve vested; otherwise, it’s the same thing as buying the stock on that day. Any gains that occur between vesting and the time of sale will be taxed as if the shares were purchased on the open market on the day they vested. Any time shares are held for less than 12 months, gains will be taxed at ordinary income rates. If they are held for over 12 months, the gains will be taxed at long-term gain rates. To vest in an RSU and keep the shares, you need to hold on to the shares for 12 months to get the long-term capital gains rate (only on any gains after the date they vest) potentially leaving you overexposed to your employer’s stock because your livelihood and the RSU portion of your portfolio are both in a single company. Selling shares immediately upon vesting means you pay only the ordinary income taxes that would be due anyway, you don’t pay any other taxes than you would otherwise have to, and you can properly diversify the money so you’re not overexposed to a single company for your work income and your investments. It’s generally a good idea to think of RSUs that become vested as a bonus paid out in cash.

The strategy may be different when dealing with private company RSUs than with public company RSUs because you may want to have some exposure to company stock before it goes public that you couldn’t otherwise buy on the open markets. So, you may decide to keep the shares. In such a case, you may decide to instruct your employer not to sell any of the shares to cover your tax liability but instead come up with the tax money out of pocket. You will still need to pay the taxes on the RSUs immediately, so you need to have enough cash on hand to do so. In doing so, you take on a significant risk in terms of the number of shares owned, the amount of cash spent paying for the taxes on the shares, and your time spent working for the company.

General Considerations

Keep in mind that there’s a difference between a restricted stock plan, in which you own the shares and your employer repurchases any vested shares upon termination, and RSUs, in which you do not own any shares until the units vest and you are given stock or the value of the stock at the time of vesting. The settlement can occur in either cash or company stock at the time of vesting for RSUs. As an owner of an RSU, you are not a shareholder in the company, you generally do not have shareholder rights, and you may be given cash rather than stock.

RSUs are generally more valuable than options because there is likely to be some value to the shares at the end of the vesting period. The shares can be sold for something, whereas incentive stock options may be at a strike price lower than the current stock price; this means it doesn’t make sense to exercise the stock option at the end of vesting, leading to a complete lack of value. This means that, if you’re given the choice between incentive stock options and an equivalent amount of RSUs, it’s generally best to choose RSUs because there’s likely to be some residual value unless the company goes completely out of business. If choosing between the two, you want to see a large amount of incentive stock options in comparison to the RSUs to make the incentive stock options a justifiable bet not only because you need to buy the stock option (so you only get the difference between the price you can exercise the stock option at and the current price) but also due to the volatility of the nature of the option itself. Keep in mind that if you can fill out a beneficiary form, it’s always worthwhile to do so just in case something happens before you have handled your vested RSUs.

Special Considerations

Because the stocks can’t be touched until you vest, it’s important to know your vesting schedule and what shares are on the line if you plan on changing jobs. That way, you don’t quit a job right before a large vesting period. In addition, you can bring up how many shares you’re leaving on the table and what level of compensation that relates to when negotiating a new job to give you a better angle for negotiating the salary that is comparable to your previous employer’s compensation package. It may be possible to negotiate a one-time upfront restricted stock offer from a new employer with a vesting schedule similar to or possibly longer than your existing employer’s RSUs but with a similar value so you are no worse off for leaving your current employer and joining a new employer.

If you receive restricted stock rather than RSUs, you can make what’s known as an 83(b) election with the IRS. The election tells the IRS to lock down the fair market value at the time the stock is granted so you owe income tax on the grant date between the fair market value of the grant and the amount paid for the grant. The election starts the clock earlier for capital gains purposes, so when you eventually sell your stock, the second round of taxes is paid on any gains in the stock price after the election but before the vest. This introduces a new, potentially huge risk. You have paid taxes on the pre-vested shares, which were granted, that you can’t get back if you leave the company, pass away, or get fired before they vest. If the stock declines in value after the taxes are paid at ordinary income tax rates, you can deduct the losses, but that may mean you have paid taxes at a higher rate than you can deduct the losses at.

General IRS Rules and Eligibility

Vesting can generally be either time or performance driven; for example, you may find a yearly vest of 25% of your grant for four years, once the company hits a predefined goal, or once you as an individual hit a preset goal. This can also be tied to the IPO of the company, which means the company can specify a period after the IPO during which employees cannot sell shares so the market is not flooded with shares of the stock. Some companies allow you to defer the settlement of RSUs for income tax purposes so you can choose to vest the RSUs in years with low earnings to be in a lower tax bracket when your shares vest. A change in timing on the vesting of your stock requires two conditions to be met:

• The initial deferral election is made prior to the year in which the compensation is earned; and
• Payments are made according to a fixed schedule or tied to an event, such as end of employment, disability, or death.

Stock Options

Incentive stock options and non-qualified stock options are relatively complex instruments that led me to debate whether to include them in this book. I believe this topic requires professional modeling and opinions along with a comprehensive knowledge of all the workings of an individual’s finances. I fear that as simple as I have tried to make this book read and as overly simplified as I have made the topic, I run the highest risk of giving the reader enough information to be dangerous but not enough to make a truly educated decision in this section; however, I would be remiss in excluding it. At the same time, I am concerned that not enough information can be given about stock options in such a brief book when the topic of stock option analysis could comprise an entire book and still be inconclusive. Bill Gates said,

When you win [with options], you win the lottery. And when you don’t win, you still want it. The fact is that the variation in the value of an option is just too great. I can imagine an employee going home at night and considering two wildly different possibilities with his compensation program. Either he can buy six summer homes or no summer homes. Either he can send his kids to college 50 times, or no times. The variation is huge; much greater than most employees have an appetite for. And so as soon as they saw that options could go both ways, we proposed an economic equivalent. So, what we do now is give shares, not options.

With this in mind, I will try to provide the easiest, most simplistic routes in which to judge incentive stock options with the caveat that you should not make decisions concerning these instruments without consulting a professional. This is all to say that including any of this information gives the reader a sense that they have enough information to decide, when in fact I believe the only reason to include this information is so the book doesn’t feel incomplete. Stock options are very complex and volatile, but they have a lot of value if used correctly with discretion and the best luck. While the upside is substantial, the downside is likewise substantial, and both should be considered when making any decisions concerning stock options.

Fundamentals

Before we begin discussing stock option strategies and analysis, a grounding in some fundamentals on the topic is in order.

A stock option is the right to buy a specific number of shares at a preset price (i.e., the exercise or strike price) during a certain period. There is generally more upside potential in stock options than in restricted stock because of the inherent investment leverage in options contracts.

The strike price is what it costs you to exercise an option (i.e., to buy a share). It is commonly called an exercise price since you’re exercising the option to buy the share at a specified price.

The value of your options (i.e., the options value) is the market price minus the strike/exercise price along with an adjustment for time value that decreases as you get closer to the end of the option time period.

The option is in-the-money when the value of the option is greater than zero (i.e., when the strike price is less than its per share value). The option is out-of-the-money when its intrinsic value is zero (i.e., the price you can buy each share for with your option is higher than its current cost on the open market).

The time value is the premium paid over the current exercise value of an option because of the possibility that the option will increase in value before its expiration date. The time value of an option naturally decays as you get closer to the expiration date, reaching zero on the expiration date, but the option will almost always be worth more than its current exercise value prior to the expiration date.

Optimal Use: Strategies and Analysis

While a host of insights and variables should be considered, this section includes some of the most common ones and provides a framework you can use to conduct a preliminary analysis and determine how to begin pursuing a stock option strategy.

It is always very important to know when your options will vest so you can exercise and/or sell the options because missing that date can be very costly. The expiration date on the stock options are critically important because the time value of the option decreases as you get closer to the expiration date and the value of the options more closely approaches the value of the stock. Keeping this in mind, any time you exercise employee stock options before their expiration, you lose the remaining time value.

Any change in the market price of your stock can have a very large impact on your option value. Any time you have leverage on investments, not only your gains but also your losses are potentially magnified. So, while options have more potential upside than RSUs, they also have more downside, and they may expire worthless since the price you can buy the shares at may be higher than the market price. In addition, if you exercise your options and the price decreases, the money you spent to purchase the shares and the taxes you had to pay are already money out of pocket that you may not ever get back.

It almost never makes sense to allow an in-the-money stock option to expire without exercising it. As mentioned above, a stock option is considered in-the-money when the stock is trading above the original strike price (i.e., you can buy the stock through your option cheaper than you can buy it on the open market). It makes much more sense to exercise the in-the-money stock option and immediately sell the stocks acquired (in turn realizing the short-term gains) than it does to allow that money to slip through your hands by letting the options expire.

Keep in mind that while it’s easy to think of incentive stock options as stock, they are not stock since there is inherent upside and downside leverage in your incentive stock options; and so an analysis of the stock options and their value is essential before making any decisions. The analysis should include the in-the-money value, the cash-out value, and a Black-Scholes value at the very minimum. There are many other ways of looking at stock options, but these are the bare-bones minimum when looking at any stock options and determining which options would be primary candidates for exercise and diversification.

•  The in-the-money value calculation is the difference between the current fair market value per share (i.e., the current stock price) and your exercise price multiplied by the number of options you have. This only applies to the number of shares you have vested; it does not count the number of unvested shares you have options in. You can calculate the cash-out value by subtracting the amount of taxes you would have to pay on your vested grants from the value of your vested grants so you get an after-tax value equal to your cash-out value on the grants.
• The Black-Scholes method of evaluating the value of an option should be a section unto itself in this book. It allows a deconstruction of the in-the-money value and the time value. You must know the expiration date (i.e., the time until the option expires), the strike price (i.e., the price you can buy the stock at), an estimate for the volatility of the stock, and the risk-free rate of return. Note that an option with a high volatility is an option where the stock fluctuates substantially; it will have a greater time value than an option for a stock that does not fluctuate substantially or that has low volatility because the volatility of the stock reflects both the potential upside and downside of the stock. The option value is enhanced by the theoretical ability to earn above the risk-free rate of return without investing anything (i.e., the higher the risk-free rate of return, the higher the time value of the option). Almost the entire value of the Black-Scholes model lies in finding the time value of the option. The time value is important in determining when to exercise options because as the time value decreases the value of holding the options also drops. In-the-money options with low time values are generally good candidates to diversify. The Black-Scholes value is equal to the in-the-money value plus the time value. The time value of vested options is important because it measures the company-specific risk or general market-specific risk associated with continuing to hold the options.
• The cash-out value is the amount of money you would receive by selling your stock options at their current value. This allows you to see how much money is put at risk by not exercising your currently vested stock options.

Once you compute the above values, it’s helpful to look at them in aggregate to see how leverage plays out in your stock options. This modeling does not give you a clear decision as to which stock options to exercise or provide a judgement with regard to exercising, but it at least lets you see the breakdown of where the value is coming from, how much is at risk due to time-value decay if the stock should remain flat, whether the market value of the options illustrates more or less volatility in the stock than you anticipate, and what the consequences of the stock going down might be so you can make a better informed decision.

General Considerations

There are two general ways to exercise stock options: pay cash or net shares. With the pay-cash exercise, you pay for the entire value of the stock options to be exercised out of pocket. With the net shares approach, some of the shares you can buy are sold immediately to pay the taxes on the exercise for the remainder of the options. You own less shares after the exercise, but your tax has been paid based on the benefit of having the stock options.

Any time you elect to have all stock options purchased rather than a certain number exercised and sold and then the remainder purchased, you do have to pay out of pocket to buy the number of stocks you are allowed to buy at the specified rate.

It’s important not to delay exercising your stock options until the last-minute, waiting for your stock price to go up. If you miss the deadline, your options will expire worthless. These options are not stock; they are options to buy stock, and if you let the option lapse, you no longer have the benefit of buying the stock at your option at a cheaper cost than the list price. In addition, remember that if you retire, leave your company for a new job, or are laid off or fired, you may have no more than 90 days to exercise any stock options; therefore, it’s incredibly important to clarify what you can do with your stock options and what you need to do with your stock options before you leave a company or as soon as possible after you are let go.

As illustrated in the above chart, it’s also important to understand that incentive stock options have a leveraged nature. This means your incentive stock options are inherently more volatile or risky than the value of your employer stock, which can be a significant factor when you want to potentially decrease a single company-specific risk. The chart below shows that as the value of the stock increases, the value of the options dramatically increases; however, the value of the options is near zero below a certain point.

Special Considerations

Incentive stock options are usually granted to employees, and they are not taxed at the grant date or the exercise date but only when the shares are sold. To qualify for favorable tax treatment, you must hold the shares two years from the grant date and one year from the exercise date. That means, if you exercise after one year from the grant date, you need to hold the shares for an additional year to qualify for long-term capital gains rates; otherwise, you are taxed at ordinary income tax rates. This can lead to people “letting the tax tail wag the dog.”

For some, this is a worthwhile gamble, but it would have devastating life consequences for others. It is important to know which position you are in and not take risks that would devastate your lifestyle for the hope of a little extra gain that may not have much of a meaningful effect on the rest of your life. Even though incentive stock options are generally not taxed when you exercise the option, the value of the discount your employer provides and the embedded gain may be subject to the Alternative Minimum Tax in any given year. So, it’s important to talk to your accountant to know the potential tax ramifications for exercising any incentive stock option.

General IRS Rules and Eligibility

If your company is acquired or if it merges, your vesting could be accelerated; this means, in some cases you might have the opportunity to immediately exercise your options, so it’s important for you to know your exercise options. It’s also important to check the terms of the merger or acquisition before acting so you know if the options you currently own in your company stock will be converted to options to acquire shares of the new company.

Unlike RSUs, stock options are not taxed until they are exercised, and if you exercise your option before the value of the options has increased and file an 83(b) election, you will not owe any taxes until the stocks are sold. If you exercise your options after the value increases but before they are liquid, then it is possible for you to owe an alternative minimum tax. So, it’s crucial to consult a tax advisor before making that decision. Usually, you can’t sell or exercise your stock options before vesting unless your stock option plan allows early exercise. If you can exercise your options before vesting, you can make an 83(b) election. The 83(b) election starts the clock early for capital gains by notifying the IRS to lock down the fair market value at the time of exercise rather than vesting. You have 30 days from the early exercise date to file an 83(b) election.

Non-Qualified Stock Options

Non-qualified stock options require that taxes be paid upon exercise, whereas qualified incentive stock options are generally not taxed until the stock is sold. However, there may be an alternative minimum tax at the time of exercise, so it’s important to speak to your CPA to fully understand the tax implications. All options are taxed at the difference between the fair market value at sale and the fair market value of the purchase. Non-qualified stock options are taxed at ordinary income tax rates, which are substantially higher than the capital gains tax rates on which incentive stock options can be charged tax depending on the holding period of the stock purchased and sold.

Non-qualified stock options can be granted to employees and non-employees, and there are no restrictions on what the strike price can be; however, any strike price less than the current fair market value of the stock would be considered ordinary compensation and not capital gains. For example:

 

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