Employee equity & stock options are a major part of the modern compensation plan. That’s certainly the case for my financial planning clients. Unfortunately, a search for the best approach to managing your equity opens the door to an alphabet soup full of jargon and tax strategies that can give you a headache.
If you don’t have the time or brain space to do a deep dive into employment equity strategies, this post just might be for you. It’s meant to be a bird’s-eye view into the world of equity compensation for non-finance experts (looking at you, Wes & Jack).
Who should read this?
- You personally have equity compensation (congrats, btw!)
- You have friends or family with equity compensation
- You have clients with equity compensation
Bottom line? Making the most of your employee equity is well worth your time.
How to make the most of this guide
- Pull out those agreements and verify your type(s) of employee equity. (You may have more than one.)
- Review the basic terms & definitions below.
- Learn when to exercise & how to keep your taxes low from the strategy table.
- Connect with a financial planner to ask about your specific situation.
Terms to Know
- ALTERNATIVE MINIMUM TAX (AMT):
- A parallel tax to standard income tax that allows fewer deductions and recognizes certain types of income such as exercising Incentive Stock Options.
- Taking action on your right — not obligation — to buy or sell company stock at a specified price.
- The right to buy a certain amount of company shares at a predetermined price for a specific period of time.
- STRIKE PRICE:
- The price at which the owner of an option can execute the contract.
- STOCK PRICE:
- The last price a share of stock was bought or sold for in the market — or, a fair market value (FMV) of company shares based on recent transactions in private markets.
- The conveyance to an employee of unconditional entitlement to a share — in other words, the right to keep your shares even if you leave a company’s employment.
|Type||What is it?||Tax Implications||Best Time to Exercise|
|Nonqualified Stock Options(NSQOs)||You get the option, but are not required to buy stock. Your price is set on the date the option is granted. You can exercise the option over several years or need to when you leave the company.||Taxes are reported as ordinary income at exercise. Report the difference between the strike price and the stock price on exercise date.||Exercise your options close to expiration date OR if your employee equity is more than 10-20% of your portfolio, have valid need for cash, or don’t think stock has upside.|
|Incentive Stock Options (ISOs)||The right, but not the obligation, to buy company shares at a given price. The ISO comes with an added tax benefit compared to the NQSO.||No taxes owed when options are granted or exercised and if you sell more than 2 years past the grant date and more than one year after exercise you only pay long term capital gains.Depending on your specific situation, you may have to pay the Alternative Minimum Tax (AMT).||Exercise strategy depends on specifics, but possibilities include the following:Exercise and sell enough shares to buy options and pay your taxes. Keep the rest as ISOs.You may exercise early if you have high confidence stock will increase over time.Exercise gradually if you want to minimize AMT and start clock for long term capital gains treatment.Exercise if your employee equity is more than 10-20% of your portfolio, have valid need for cash, or don’t think the stock has upside.|
|Restricted Stock Units (RSUs)||Compensation in the form of a commitment of units of company stock (may be other than 1:1) that vests over time.||Pay ordinary income tax on stock when vested.Once you own stock, then tax treatment of the sale is the same as any other stock you own.||Think of this as getting a cash bonus and buying company stock — you’re taxed on the bonus itself.Sell if your RSUs are more than 10-20% of your portfolio, have valid need for cash, or don’t think stock has upside.|
|Restricted Stock||An equity vehicle transferring stock to a recipient on the date of grant, subject to certain restrictions.||Pay ordinary income tax on stock when vested.Once you own stock, then tax treatment of the sale is the same as any other stock you own.||Ditto to RSUs, but consider 83(b) election to pay tax before vesting & accelerate capital gains clock.|
|Employee Stock Purchase Plan (ESPP)||A way to buy company stock at up to a 15% discount using funds withheld from pay without reporting the income until you sell the stock||Typically pay ordinary income taxes on the discount and capital gains on any gains. Specific taxes depend on how long ESPP shares are held.||Sell when you hold too much company stock (exceeds 10-20% of total assets),you need cash for larger purchases, or don’t think stock has upside.|
Are you too concentrated?
Readers of Alpha Architect are likely to be quite familiar with the basics of diversification (see here, here, and here for different takes on the subject); nonetheless, a refresher is in order.
- A single-stock portfolio presents investors with an inferior risk/reward tradeoff. Less bang for your buck.
- The high uncertainty of an individual company stock diminishes its expected return.
- There is pronounced skew to single-stock returns. While the additional return potential for holding the right stock is substantial, significant underperformance has been four times as likely.
When 10% to over 50% of your compensation is comprised of options & restricted stock it’s easy to get really concentrated, really quickly!
The takeaway here is that concentration can happen faster than you think. For example, I recently spoke with a startup employee with 119% of their net worth tied up in NQSOs & RSUs of their employer. Absolute madness, but that’s the reality of the equity-compensated millennial professional — serious student loans, plenty of equity that may or may not be liquid, and an aggressively (perhaps accidentally) leveraged personal balance sheet.
Think like an outsider
There’s a significant psychological element to employee equity. Many employees feel a sense of obligation to their employer above and beyond what’s outlined in their employment contracts or performance reports — am I a bad team player if I sell my stock? Should I buy more through the stock purchase program to demonstrate that I believe in myself, my team, and the company as a whole?
These are valid questions, but I encourage every employee who’s also a shareholder to think of the mindset of an independent shareholder of a random company. Save billionaires and funds with huge positions, most of us are not harming the outlook of a company’s equity by reducing our position. Moreover, would you put 10-20% of your assets into a single biotech company, or even a blue-chip mega cap stock? Most investors understand intuitively that this is a suboptimal portfolio choice, yet we see it all the time with employees. (See here for a piece by Lauren Cohen called “Loyalty Based Portfolio Choice”).
You, Me, and Section Eighty-Three (§ 83)
I tried to find some cultural references to the number 83 as it has particular relevance to this conversation. The best I could come up with is that French electro-pop band M83, and that 83 is a prime number as well as a “safe prime”.
Anyhow, U.S. Code § 83 relates to property transferred in connection with performance of services. Think of situations like: “hey come work for me, I’ll give you company stock!”
There are two tools relating to this § 83 knowledge that are worthwhile for us today. I’ll approach each component in alphabetical order.
This one’s been around a while. You may have heard it used as a verb — “I’m going to 83(b) this option grant that I just got.”
To paraphrase Robert Wood & John Flora: with an 83(b) election, you set aside the income deferral rules that apply when stock is not yet vested. You pay some extra tax early in order to, hopefully, avoid more tax later.
Functionally, to take advantage of this means to write a letter to the IRS stating your preference to accelerate your tax liability on your equity or option grant from the time of vesting to the present.
This starts the clock for capital gains purposes. It also means our 83(b) letter-writer will not pay any additional tax upon vesting.
New kid on block 83. This is a TCJA change for employees of private companies only, allowing them to defer income tax on NQSOs and RSUs for up to five years.
Deferral ends on the employee’s revocation, an IPO, a liquidity event, a change in the 83(i) program compliance status of the equity, or five years from the date when the stock vests/becomes transferable.
Lots of restrictions to keep in mind, more on that below.
Table of Applicability for 83
|Company Type||Equity Type||83(b) accelerate?||83(i)defer?|
|NQSO||yes(but only applicable if you exercise early)||yes(but mutually exclusive with 83(b) election)|
|ISO||yes (but only applicable if you exercise early)||yes, but you’ll lose ISO treatment, so unlikely to apply|
|NQSO||yes (but only applicable if you exercise early)||no|
|ISO||yes (but only applicable if you exercise early)||no|
83(i) has a long list of restrictions.
- Must be
- Private C-Corp
- Qualified Stock (NQSO is fine — different idea of “qualified”)
- Qualified Employee
- Qualified Equity Grant — essentially, your company needs to play along with a program to ensure 83(i) compliance.
- Cannot be
- CEO, CFO, or their relatives
- Otherwise top 4 highest compensated individuals with 10-year look-back period
- 1%+ owners (with 10-year look-back period)
- Stock that employee can sell back to company, or receive cash in lieu of stock compensation
Also, good to note that while you do get to defer recognition of income when you 83(i) defer, you & your company will still pay payroll taxes on the full notional amount. See Box 12 of your W-2 for details.
It’s critical that potential utilizers of these strategies make timely and accurate filings with the IRS.
The big surprise for people new to this is that 83(b) and 83(i) do not have IRS forms. They are free-form letters that you write, sign, and mail to the IRS. More info and a sample from IRS.gov is here.
Both require their respective letter written to the IRS within 30 days of the key dates, which depend on the type of equity. Generally, the trigger is Exercise on options, and Grant on stock, starting the 30-day clock.
This is one of those places where maximum documentation is your friend, and you’ll absolutely want to pay for tracking when you mail these letters in.
For 83(b), since you are accelerating your tax liability, the 83(b) letter plus your tax return reflecting the election have a sense of finality about them — you’ve made the election, and that’s over.
For 83(i), life is a bit trickier, since the letter to the IRS only starts the clock for deferral purposes. The initial letter transforms your illiquid, vested private stock into what the IRS calls “deferral stock”. Your company helps you keep track of this deferral stock in escrow as they have significant reporting requirements. One thing to keep in mind here is that technically you are allowed to revoke your 83(i) election and pay your tax before a liquidity event (see page 2 of this IRS notice). More guidance to come on that from the Treasury Department.
Applying the 83’s
83(b) shines early, and loses luster later in a company’s life. We might call it 83(bullish) because it’s functionally a bullish tax bet on your company’s valuation. 83(b) is ideal for early employees with cash on hand, ready & willing to exercise options at affordable strike prices, and a positive, bullish outlook for their company’s equity.
As outlined nicely on Wealthfront’s blog, it’s always a good idea to file 83(b) when you are doing an “early exercise” (AKA exercising before vesting) on your stock options.
83(i), sorry to break this to you, is just not that good of a deal! It seems built to address the inherent unfairness of being taxed on illiquid income, and that’s a nice thought. But as it stands today, it’s not all that helpful.
Pro tip: thus far, the IRS hasn’t indicated that they care if you have a lockup restriction — you still owe tax in the year of IPO if you have done an 83(i) deferral. Annoying.
The ideal 83(i) application would be on a big chunk of vesting RSUs for a highly compensated (and therefore highly taxed) employee, perhaps neutral or bearish on her company’s equity, and who has an upcoming tax differential event. That could be something like realizing a large capital loss, moving to a lower income-tax state, taking a sabbatical, or changing to a lower-paying career just before IPO (big assumption there that you keep your RSUs when you leave).
Narrow, I know. You really need to expect a liquidity event — IPO, company sale, or the emergence of a robust private shares market — within 5 years for 83(i) to be useful, otherwise it’s just a forced 5-year deferral and you’re stuck with whatever the 409(a) preparer hands you for valuation of your shares.
Conclusions & Considerations
As I conclude this enormous post, I’m having a bit of a laugh: there are people and companies built just to address the complexities that I’ve just glazed over. These topics are highly complex and I don’t claim to have all the answers. Nonetheless, some concluding thoughts are in order.
As a financial planner, the aspect of equity compensation that is most concerning is that of Concentration. This overarching theme guides many of my recommendations regarding employee equity. My person opinion is that having 20% of your wealth tied into one stock is a maximum for most people. Some will say 25%, others may say 10%. That said, I acknowledge that you’ll likely never become a billionaire by capping your personal balance sheet allocation to one company at 25%. (This guy did it though.)
I tend towards conservative balance sheets. I think it’s a personal preference. That tendency makes me prioritize diversification over the potential tax & upside benefits of patiently holding a big chunk of employee equity. I couldn’t (and wouldn’t) convince anyone to make a 25% of balance-sheet bet on a single public stock — so what makes people comfortable doing it as part of their employment arrangement? (Don’t answer that.)
The second key theme here is Liquidity, and its sister that I’ll call “affordability”. In her excellent Early Exercise blog post, Meg Bartelt asks us to ponder, “Can I afford to front and eventually lose this money?” That is the real elephant in the room that every employee should be facing, taming, and hopefully domesticating, to take that metaphor way too far. But really — the possibility of illiquid equity actually being worthless is the contingency I most worry about when advising on employee equity.
There are a million and one Tax considerations, each of which will be critical in its own context. My advice is to identify the big, broad tax themes that will affect you (e.g. please identify all the equity you have and how it ought to be taxed), and then write them down, and then share what you have written with a tax or financial professional so that they might check on your understanding and hopefully grab a tax toolbox and get to work for you.
I’ll summarize as such: don’t get surprised by the breadth of possibilities & outcomes for your employee equity. Know what you own!
Resources & Further Reading
- IRS — 83(i) in Notice 2018-97
- Bruce Brumberg & the team at MyStockOptions.com— if you want to really nerd out on this, you should come to their conference in San Francisco on June 18th.
- Meg Bartelt, CFP® at Flow FP
- PNW Startup Lawyer on 83(b)
- White & Williams, LLP on 83(i)
- KPMG on how companies– not individual taxpayers — have messed up tax calculations on equity compensation
- A legal nightmare on 83(b) street