Employer stock has long been a popular way for employees, not just executives, to accumulate wealth. This article explores different ways to navigate employer stock when considering your overall financial picture.
Many companies offer employee stock options and restricted stock grants to select employees and executives as part of their overall compensation. Often, these options and grants gradually vest over a period of several years—providing an added financial incentive for the individual to remain with the company.
There are, however, a number of strategies and considerations when it comes to accumulating wealth through employer stock—all with differing tax implications as well as risks you’ll want to factor into your investment decision. Please consult with your plan documents for specific details on the following strategies regarding the impact of leaving your employer.
Qualified Retirement Plans
Employer stock can be added to your tax-deferred qualified retirement plan in several different ways. Some 401(k) plans may offer employer stock as one of many investment choices. In other instances, employers may provide 401(k) matching contributions (where applicable) in shares of company stock. Certain select employees may also be granted participation in an Employee Stock Ownership Plan (ESOP) which involves the sale of a portion of the company for the benefit of ESOP participants, followed by annual allocations to the account of each individual employee. Check your employer’s plan for details concerning withdrawal from the program, refunds, and re-enrollment.
For private companies, you may be required to liquidate your company stock if you leave employment or choose to transfer your qualified retirement account assets to an Individual Retirement Account (IRA), since the employer is technically the ‘owner’ of the plan. Public companies, on the other hand, will often allow you to retain shares even if you transfer your retirement account to an IRA.
Employee Stock Purchase Plans
Employee Stock Purchase Plans (ESPPs) are another employer-provided benefit that can help you acquire shares of company stock. You can either hold shares as part of your overall portfolio or sell them at your discretion (subject to any holding period as required by your employer). In an ESPP, stock is offered to employee plan participants at a discount, which can be as high as 15% in a qualified plan. However, when calculating any price appreciation when you eventually sell shares, your basis is the amount paid for the stock. The discount you received is not reported as taxable income, providing you with potentially valuable tax savings. Eligibility is typically based on assumed full time employment. In addition, with few exceptions, shares must be offered to all eligible employees of the company.
Stock options1 often comprise a significant part of executive compensation packages. A stock option is a contractual right to acquire company stock at a predetermined price—typically the price of the stock on the date of the option grant—for a fixed period (up to 10 years from the grant). The right to exercise the option may occur all at once or over a period of several years, according to a “vesting” schedule.
These programs provide companies with a great way to attract, motivate, and retain key executive talent, without requiring any significant cash outlays to fund the program. There are two primary types of compensatory stock option programs: options are granted to employees as either Non-Qualified Stock Options (NQSOs) or Incentive Stock Options (ISOs).
For tax and financial planning purposes, the difference between the two is very important. The documentation you receive with the option grant will usually specify which type of option is being granted. But most frequently, NQSO will be the default if an option type isn’t specified. Note that this option is only possible if the company is publicly traded or if there is a secondary market for company stock.
Non-Qualified Stock Options
The acquisition price (or ‘strike price’) of an NQSO is typically the fair market value of the stock when the option is granted. Any difference between the strike price and the fair market value of the stock when the option is exercised is taxed as ordinary income. Payroll tax withholding is required, although this requirement can be satisfied in several different ways. If the stock is sold immediately, essentially no capital gains will result. Sometimes this is referred to as a cashless exercise, allowing you to immediately receive the net value of the stock. But if the stock is held, any future appreciation will be treated as capital gains when you sell those shares.
NQSOs, however, have several specific requirements which must be met or else the option will be treated as an ISO. For example, stock acquired by the exercise of an NQSO must be held for at least one year following the exercise of the option. If the stock is sold before that, it’s called a ‘disqualifying disposition’ and effectively converts the NQSO to an ISO.
Incentive Stock Options
Incentive Stock Options are issued on a ‘grant date’ at a ‘strike price,’ which is determined by your employer (generally the market value of the shares at the time they’re granted). You then can exercise your right to buy the corresponding stock shares on the ‘exercise date,’ and either sell or hold the stock. The advantage offered by an ISO is that when the stock is ultimately sold, all the appreciation is taxed as capital gains income (rather than earned income) as long as the shares are held for at least a year from the exercise date and two years from the grant date. Also, the income from ISO exercise is not subject to FICA or FUTA tax.
But exercising an ISO may result in an Alternative Minimum Tax (AMT) liability, as there’s the potential of realizing a substantial enough profit to trigger AMT—which not only sets a minimum tax threshold, but can limit the tax advantages for certain deductions.2
Important Tax & Planning Considerations
Net Unrealized Appreciation (NUA)
If you hold company stock in your employer retirement plan, you’ll want to explore whether you’re eligible to make a Net Unrealized Appreciation (NUA) election for taxes. If an NUA election is made, the cost basis of the shares distributed is immediately taxed as ordinary income.
Any unrealized gain above that cost basis is then taxed as long-term capital gains (but not until the stock is sold). If the stock has appreciated significantly, this can create a large tax savings when compared to being taxed as ordinary income. If you transfer the stock to an IRA, the tax continues to be deferred, but any appreciation would be taxed as ordinary income when ultimately distributed. It should also be noted that any stock included in an NUA election won’t receive a step-up in basis when you die.3 Your estate would include the value of the stock at its full fair market value.
Eligibility to make an NUA election depends on meeting several strictly enforced requirements:
- Your entire vested balance in the employer-sponsored plan (including all assets from any accounts sponsored by that same employer) must be distributed within one calendar year;
- The company stock must be distributed in-kind; and
- The transfer must happen after you leave the company, reach age 59½, or following your death or disability.
You can learn more about NUA at www.irs.www.irs.gov/taxtopics/tc412.
Concentrated Stock Risk
Over time, key executives frequently find that they’ve accumulated an over-concentration of their employer’s stock. This can place both your wealth and your career at significant risk if the business ever suffers a major downturn. Even if investment diversification isn’t possible (due to restrictions on selling shares), it may be possible to mitigate some of the risk by using a collar on the stock to act as insurance against significant price fluctuations.
You can work with your Janney Financial Advisor to determine if this may be an appropriate risk mitigation strategy that fits your needs.
Restricted Stock & RSUs
If you are granted shares of company stock, the arrangement frequently will vest over a period of years, as long as you remain employed with the company. Under IRS Section 83,4 your continued employment is therefore considered a ‘substantial risk of forfeiture’ and special rules apply.
In these instances, you’re allowed to wait until shares vest (and the corresponding risk lapses) before you recognize income at the then-fair market value of the stock (a taxable event). Alternatively, you can elect to disregard the risk and pay the tax immediately. This is referred to as an ‘83(b) election.’ It can be an advantageous approach if you strongly believe the stock will appreciate greatly and would rather pay tax on a smaller amount of income now than a larger amount later. You must, however, declare an 83(b) election within 30 days of the stock grant.
Recent years have seen the popularity of restricted stock waning in favor of Restricted Stock Units (RSUs). These RSUs differ from restricted stock in that until vesting occurs, no actual transfer of stock is made—you simply receive a promise of future shares. Therefore, because no actual stock transfer occurs prior to vesting, no 83(b) election is permitted.4
Qualified Small Business Stock (QSBS)
This highly favorable tax treatment (IRS Section 1202)5 applies to the stock of smaller companies, and means that you could potentially owe no tax on as much as $10 million in gains from the sale of your company stock. Not surprisingly, rules to qualify as QSBS are therefore very intricate, and the IRS is likely to audit these transactions aggressively, so strict compliance with the law is critical. Two of the principal requirements for QSBS treatment are that:
You must satisfy a minimum holding period for the stock of at least five years; and
The total market value of the issuing company must be less than $50 million
But vetting to determine whether your shares are eligible for QSBS treatment should be left to qualified specialists. So make sure to discuss this opportunity with your attorney or other tax advisors before taking any action.
Navigating The Details
The various strategies, implications and tax considerations outlined in this article are complex. It’s important to discuss these matters with your accountant and other tax advisors to determine how these considerations relate to your individual situation, and the implications of each strategy for your unique preferences and financial picture.
Working With Janney
Depending on your financial needs and personal preferences, you may opt to engage in a brokerage relationship, an advisory relationship or a combination of both. Each time you open an account, we will make recommendations on which type of relationship is in your best interest based on the information you provide when you complete or update your client profile.
When you engage in an advisory relationship, you will pay an asset-based fee which encompasses, among other things, a defined investment strategy, ongoing monitoring, and performance reporting. Your Financial Advisor will serve in a fiduciary capacity for your advisory accounts.
For more information about Janney, please see Janney’s Relationship Summary (Form CRS) on www.janney.com/crs which details all material facts about the scope and terms of our relationship with you and any potential conflicts of interest.
By establishing a relationship with us, we can build a tailored financial plan and make recommendations about solutions that are aligned with your best interest and unique needs, goals, and preferences.
Contact us today to discuss how we can put a plan in place designed to help you reach your financial goals.
1. Options: For more information on options, please click here. For additional information on the characteristics and risks of options please refer to the OCC website found here.
2. AMT: https://www.irs.gov/taxtopics/tc556
3.Rev. Rul. 75-125: https://www.irs.gov/retirement-plans/revenue-rulings
4. IRS Section 83: https://www.irs.gov/pub/irs-drop/rp-12-29.pdf
5. IRS Section 1202: https://www.irs.gov/pub/irs-regs/ia2694.txt
For additional information on the topics covered herein, please refer to IRS.gov and the following pages:
- Employee Stock Ownership Plans: https://www.irs.gov/retirement-plans/employee-stock-ownership-plans-esops
- NUA: https://www.irs.gov/taxtopics/tc412
- Stock Options: https://www.irs.gov/taxtopics/tc427#:~:text=You%20have%20taxable%20income%20or,the%20sale%20as%20ordinary%20income
- Restricted Stock: https://www.irs.gov/pub/irs-drop/rp-12-29.pdf
This is intended for use with sophisticated investors who are capable of understanding the risks associated with the investments described herein and may not be appropriate for you. If you believe you have received this document in error, please contact your Financial Advisor.
Please note, this is not a complete analysis. The tax rules discussed in this material are complex and nuanced. You should consult with your accountant and/or tax attorney for additional guidance on the possible risks and advantages of the strategies mentioned herein.
Janney Montgomery Scott LLC, its affiliates, and its employees are not in the business of providing tax, regulatory, accounting, or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.
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