Introduction

Corporate Executives typically receive a significant portion of their compensation in the form of equity. This equity compensation can take many forms, each with its own features, risks, benefits, requirements, and tax implications. It is critical for executives and their advisors to understand the structure of their particular equity compensation so they can make the best planning decisions and seek to minimize tax impacts. Some of the more common forms of equity compensation include:

Stock Options

A stock “option” is the right (not the obligation) to purchase shares at a specified exercise price at some future point(s) in time. A major benefit to employees granted options is that, at the time of exercise, there may be a significant difference in the price paid (exercise price) to acquire the shares and the current market value of those shares. The difference between the exercise price and the market value at the time of exercise is termed the “bargain element” (an important concept for tax planning that will be discussed later). For instance, if an employee was granted options to purchase 500 shares of stock at $10/share and the stock at the time of exercise was trading at $50/share, the bargain element would be $40/share.

While often just referred to as “options” generally, there are actually multiple types of options to become familiar with. We will discuss two common types here, Incentive (also called Qualified) Stock Options or ISOs and Non-Statutory (also called Non-Qualified) Stock Options or NSOs. Incentive Stock Options (ISOs) are stock options that meet statutory requirements for preferential tax treatment. NSOs are stock options that do NOT meet the statutory requirements for ISO taxation and therefore do not enjoy the same potential tax advantages. This distinction is important when creating an exercise strategy.

In the case of ISOs, no tax is due on the previously discussed bargain element in the year of exercise (however, the amount of the bargain element is included for the Alternative Minimum Tax (AMT) calculation). If the shares are then sold (at least 2 years after the grant date and 1 year after exercise), all capital gains will be treated as long-term in nature. This can be advantageous to the taxpayer as long-term capital gains rates are lower than ordinary income rates.

On the other hand, NSOs do not qualify for this tax treatment and the bargain element is taxable as ordinary income in the year of exercise. In the example above, this could result in the bargain element of the NSOs being taxed at the maximum federal tax rate (including the 3.8% Medicare surtax) of 40.8%.

The timing of when to exercise NSOs should be examined carefully to achieve the most optimal outcome. For example, if the holder of the NSOs anticipates being in a lower tax bracket in certain years, it may make sense to time the exercise of options in those years as opposed to higher-tax years. It may also make sense to exercise NSOs if it is anticipated that the stock will appreciate rapidly and/or significantly. Continuing the previous example, if the stock grew from $50/share to $100/share after exercise, then exercising when the stock was at $50 would have resulted in $40/share being taxable at ordinary income rates and the remaining $50/share of gain (if held for 1-year post-exercise) being subject to long-term capital gains treatment. Contrast this with waiting to exercise until the stock price was already at $100/share. At this point, the entire $90/share in gains would all be subject to ordinary income tax rates.