In this volatile stock market, the legions of MOPs (millionaires on paper) and ex-MOPs are growing by the day. In this climate, executives who hold stock options and other forms of equity compensation need to develop at least a basic awareness of the key tax issues. The only thing worse than a huge tax bill on the exercise of a highly appreciated option position is any tax bill at all on a paper fortune that has evaporated.
In any market, equity compensation makes good sense for companies. It allows companies to reward employees without spending precious cash (or having a substantial effect on earnings), aligns employees' economic interests with those of the company and, under a vesting schedule, provides "golden handcuffs" to keep key employees on board. It also can generate a big cash-free income tax deduction for the company even allowing some major corporations to avoid corporate tax altogether. However, in this market where overnight multimillionaires have seen their fortunes dry up before their "lock-ups" expire employee enthusiasm for non-cash compensation may be on the wane. The more traditional view that equity is merely a "kicker" to an executive's cash compensation package appears to be making a comeback.
For those executives who are negotiating a new compensation package or renegotiating an old deal after a market "correction," the basic tax goals relating to the equity component are: deferring the accumulation of taxable income for as long as possible, minimizing capital gains taxes on the sale of the equity stake, preserving flexibility for future estate planning and minimizing the economic risk from undertaking any tax-planning strategies.
Often, there are tradeoffs in pursuing these goals. However, as with most things, the stronger your bargaining power, the better your chance of obtaining a custom compensation package that can achieve most of these goals. At the very least, a well-designed package can preserve your ability to choose among these goals, based on your needs at a particular time.
There are five basic types of equity compensation: restricted stock, non-qualified options (non-ISOs), incentive stock options (ISOs), phantom stock or stock appreciation rights (SARs), and non-stock equity, such as LLC or partnership interests. Each is taxed differently. We highlight only the most basic rules below, but recommend that advisers be consulted for sophisticated tax strategies.
- Restricted Stock. The difference or "spread" between the value of the stock and its purchase price, if any, is considered compensation income not capital gains when the stock "vests." It is advisable when dealing with this kind of stock to file a special "election" document known as an "83(b)" election with the IRS at the time of the award of unvested stock in order to lock in capital gains on future appreciation or avoid income tax entirely if the stock is held for life.
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