Building Wealth with Nonqualified Stock Options
The Scenario
Your client was granted nonqualified stock options by their employer. A typical client question might be, “How do I get the most from my options?” Savvy advisors position themselves to respond to that question. We will address vital guidance-driven considerations, including:
- Understanding Nonstatutory Stock Options,
- Keeping Your Eyes on the Calendar, and
- Cutting taxes by up to 20%.
Understanding Nonstatutory Stock Options
Nonstatutory Stock Options (NSOs) are “nonstatutory” because there are no statutes (laws) that exclude the value of the options from compensation-related taxes. An advisor needs to understand the basic terms of employer-granted options on publicly traded employer stock. We will begin with key dates and periods in the option’s life cycle.
Next are key terms, including:
- Grantor—the employer who grants the options on its securities,
- Grantee—the employee who receives the options,
- Exercise price—the amount paid by the grantee to purchase shares under the NSO, and
- Bargain element—the excess of the stock’s fair market value (trading price) over the exercise price when the NSO is exercised.
We’ll use these important dates and terms to illustrate the next wealth-building factor.
Keep Your Eyes On The Calendar
Question: With respect to NSOs, is there anything worse than not receiving them?
Answer: Yes! Allowing the NSO’s value to evaporate is worse.
There are at least three critical dates and provisions to keep in mind to avoid losing an NSO’s value.
- The expiration date: NSOs become worthless after this date.
- The termination provision: The terms of the NSO may require the grantee to exercise any vested options within a specified number of days (frequently 90 days) of terminating employment.
- Merger or acquisition: Be sure to understand any restrictions, choices, and due dates relating to:
- Termination of any unvested options,
- Accelerated vesting of any unvested options,
- A payout in lieu of exercise, or
- Conversion of the NSOs to NSOs of the acquiring company.
Next up, how does your client keep more of the gains and send less to the IRS?
Cutting Taxes By Up To 20%
There are at least two approaches to paying taxes on NSOs, the traditional and the alternative approach.
The traditional approach is to wait until the NSOs vest before exercising. For example, assume your client Jane Dough could exercise 1,000 NSOs at the vesting date by paying an exercise price of $20/share when the stock traded at $50/share. Here’s how the bargain element per share is calculated:
The total bargain element would be $30,000, calculated as 1,000 shares x $30/share. The bargain element would be taxed as compensation income, the estimated combined tax rate would be 37%1, and the total tax cost would be approximately $11,100. The alternative approach can help your client slash taxes by (in effect) converting compensation income into long-term capital gain. Using Jane Dough’s information as an example, let’s add one data point to the mix. Now assume that the trading price of the employer stock was $25/share at the grant date. Here’s how the bargain element would be calculated using the alternative approach.
The total bargain element at the grant date would be $5,000, calculated as 1,000 shares x $5/share. Using an IRS provision referred to as the 83(b) election, your client could recognize compensation income at the grant date, even though the NSO would not have vested. Compensation income at the grant date is based upon a bargain element approach. The bargain element would be taxed as compensation income, and the appreciation from the grant date to the exercise date could be taxed at capital gain rates. The blended average tax rate would be about 19%.2 The total tax cost would drop almost by half, from $11,100 to approximately $5,600. The tax savings will vary based upon your client’s marginal income tax rates and other factors.
What just happened? Your client chose to use the 83(b) election to recognize the bargain element (compensation income) at its lowest value, i.e., at the grant date. The appreciation after the grant date could now be taxed at those lovely long-term capital gains rates when the shares are ultimately sold by your client.3 Noteworthy—the alternative approach can also apply to restricted stock awards.
Caveat—The success of the alternative approach depends on the stock appreciating after the grant date. If the stock falls in value after the grant date, your client will have paid unnecessary taxes on the bargain element at the grant date. Put another way; the alternative approach is not generally appropriate unless the stock is expected to appreciate. Here’s another date to remember—the grantee has only 30 days from the grant date to make the 83(b) election and send the appropriate form to the IRS.
Summary
This blog provides a brief summary overview of NSOs alone – but there is a range of other equity-based compensation programs that are used to compensate and retain executives. Compensatory Stock Options such as NSOs can be a significant part of any executive’s compensation. This means that advisors working with corporate executive clients should be well-versed in the different types of equity-based compensation strategies corporations use and how to provide guidance to those clients to maximize the after-tax value of this form of compensation.
If you want to develop a niche in working with corporate executives or simply want to refine your understanding of the planning techniques related to equity-based compensation plans, look at what Greene Consulting offers here.
Coming attractions: A different type of employer-granted option is the Statutory Stock Option, popularly known as an Incentive Stock Option. ISOs are granted to employees less frequently than NSOs but have powerful income tax advantages. We will address ISOs in our next article.
Disclaimer
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide investment, income tax, or financial planning advice of any kind. An experienced and credentialed expert should be consulted before making decisions relating to the topics covered herein. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.
1 The assumed rate includes federal (24%) and estimated combined state income tax, Social Security tax, and Medicare tax of 13%.
2 The blended rate is about 19% assuming the bargain element is taxed at a compensation tax rate of 37%, and the $25,000 in appreciation is taxed at a long-term capital gain rate of 15%. The NSOs are assumed to be sold after the exercise date at or above $50/share.
3 Assumes holding periods are met.
