Stock awards provide corporations a way to pay their executives based on company performance so their compensation aligns with the expectations of the shareholders. Companies may also grant stock awards to lower-level employees to incentivize them to take ownership of the company's performance and retain their loyalty.
Broadly, there are four types of stock awards:
Stock awards can prove to be a valuable form of compensation. But employees whose wealth is heavily concentrated in stock awards must proceed carefully. Given the various risks and tax consequences associated with stock awards, and the added complexity brought by a crossborder financial situation, global executives will need to be even more cautious about how they leverage their stock awards.
Stock options are essentially a contract between the company and the employee that grants the option’s holder (the employee) the right (or ‘option’) to buy or sell a share of the company’s stock for a set price under certain conditions. This set price is known as the exercise price and is typically equal to the market price of the stock at the date the option is granted.
In most cases, companies implement a vesting schedule that specifies the amount of time that must pass before the employee can purchase the stock at the exercise price. Once an employee is vested, they can exercise their stock option, which they typically have to do before the expiration date. Vesting schedules and expiration dates vary by company but commonly we see vesting schedules of four years and expiration periods of 10 years.
To purchase stock at the exercise price, an employee has several options to make the purchase. They can raise the cash themselves, obtain a loan, or use company stock they already own, which is also known as a ‘cashless exercise.’ (Not all companies allow employees to use the third option.)
Ideally, the market price of the stock will be higher than the exercise price when the option’s holder is ready to sell the stock. (The spread between the exercise price and the market price of the stock is known as intrinsic value.) Although this doesn’t always happen due to company performance and market fluctuation, a positive intrinsic value can mean profits for the employee.
In the U.S. a stock option is either an incentive stock option (ISO) or a nonqualified stock option (NSO/NQSO). An ISO meets certain tax requirements that allow the options holder to benefit from favorable tax treatment. The options holder will not have to pay regular tax on the date of grant or the date of exercise. Additionally, the profit on the ISO will qualify as a long-term capital gain if certain holding periods are met.
NSOs/NQSOs, on the other hand, do not meet the IRS criteria necessary to benefit from favorable tax treatment. Upon exercise of an NSO, options holders are subject to withholding of federal income tax, Social Security, Medicare, and, if applicable, state income tax.
Here’s a hypothetical example to illustrate how stock options work: a technology company in Silicon Valley offers ISO-type stock options to their employees with an exercise price of $25 a share on a four-year vesting schedule with ten years until expiration. Imagine that within four years, the share price has risen to $80 a share.
One employee, Rob, exercises his stock options upon vesting and sells the stocks at the market price of $80 a share. He makes a profit of $55 (minus transaction fees). Assuming it was a qualified disposition of his ISOs, Rob will have to pay Long Term Capital Gains rate taxes on his gain—and the profit is still significant.
Michelle, on the other hand, is confident that the market price will continue to rise. She continues waiting until 10 years have passed since her options were granted. On the expiration date, the company shares have tanked to only $10 a share. Unfortunately, Michelle will never be able to profit from her options as they have now expired and had an exercise price higher than the market price, meaning that they have no intrinsic value.
This example illustrates one inherent risk of stock options. Stock options can provide tremendous leverage, or they can expire worthless. Specific outcomes depend on a multitude of factors. In the past decade, stock options have become more commonplace with senior executives in particular, given their greater ability to influence the share price of their company’s stock.
Stock options give employees the option to purchase the stock at the exercise price once they become vested. As mentioned already, this creates a payoff situation where the option is worth something, often providing a significant gain—or nothing at all. To mitigate against this risk, restricted stock units (RSUs) became a more popular alternative.
Instead of employees having to purchase the stock themselves, employers grant their employees shares of stock (or a cash equivalent) upon vesting or other requirements being met (e.g., meeting certain performance standards).
Depending on the value of the stock at the time it’s granted to the employee, the company may decide whether to grant the value as shares or as a cash equivalent. Sometimes, the employee may be able to make this decision. Either way, RSUs are taxed as ordinary income in the year of vesting even if the employee does not sell the RSUs that year (see more on taxation below).
Stock appreciation rights (SARs) are different once more. Like RSUs, SARs do not require employees to actually purchase stock options. Instead, SARs are (typically) cash payments to employees based on the company’s stock price from a predetermined period to the time the SARs are exercised.
Both the employee and the employer can benefit from this arrangement. Employees don’t have to purchase stock with the risk that the stock value will decrease, and employers don’t have to dilute the share price of company stock by distributing stock to employees as RSUs. In some cases, employers will distribute both SARs and stock options—employees can then use the SAR payments to purchase their stock options at the exercise price.
Like other types of stock awards, SARs are typically subject to a vesting schedule set by the employer. They are also subject to the same taxes as NSOs: The value of the SARs are not taxed as ordinary income on the grant date or when the employee becomes vested. Instead, the spread at the time of exercise is treated as ordinary income.
Employee stock purchase plans (ESPPs) are the last basic type of stock award we will cover in this article. ESPPs are programs in which employees can purchase company stock, often using a discount formula.
Employees typically participate in the program by making contributions through payroll deductions between the time they become eligible to participate and the time they become eligible to purchase the discounted stock.
A common discount formula used for purchasing the employer stock is the lower of the beginning period stock price or ending period price with a 15% discount applied. Employee Stock Purchase Programs are limited to $25,000 USD in stock purchases per year.
Taxation of ESPP shares can be quite complex, and taxation depends on whether or not the ESPP is qualified or nonqualified. (Non-qualified plans are subject to fewer restrictions, but do not have as many tax advantages for employees as qualified plans.)
As deferred compensation, all stock awards are taxed differently than wages and bonuses. Even for U.S.-based employees working for U.S. corporations, the tax effects of stock awards can be confusing and depend on a number of factors.
For instance, in the case of stock options, taxation will differ depending on whether the option is qualified or nonqualified, the difference between the exercise price and the current market price (aka ‘the bargain element’), and then ultimately the final selling price.
Additionally, different types of stock awards are taxed differently. For example, the entire value of an employee’s RSUs is taxed as ordinary income in the year of vesting, unlike traditional stock options. Any income gained from a subsequent sale of RSUs in a later year would be taxed as a capital gain.
Stock options, on the other hand, may be subject to capital gains tax, income tax, and payroll tax, but typically only in the year the options are exercised. Taxation also depends on the type of stock option granted—ISOs vs. NSOs. For example, ISOs are not subject to payroll taxes but are considered a preference item for the alternative minimum tax calculation, which can be complicated to figure out.
Taking a loss on stock awards often results in tax consequences that can be quite expensive. In a worst-case outcome, the awards may expire out-of-the-money (i.e., when the exercise price is higher than the market price), meaning the awards are worthless. Meanwhile, the employee may still have to pay income taxes on the value of the stock awards compensation.
In the case of stock options, there may be loss carry-forward provisions to mitigate the tax consequences of a stock options loss. Stock option losses can be generated by:
In the case of scenario one, the options holder can claim their loss on any unexercised stock options that have expired on Form 8949, which feeds into Schedule D. The loss will be classified as short-term or long-term depending on how long the employee held the option before it expired. Similarly, individuals experiencing scenario two will include losses on Schedule D to determine their combined gains and losses for the year.
In the case of scenario three, option holders who buy and sell back their options at gains or losses may be taxed on either a short-term basis or long-term basis, depending on the holding period. In all three cases, capital losses are subject to the $3,000 annual capital loss carryover limit. The remainder of the loss will be carried forward.
For global executives and employees, the tax implications can be even more complex. Tax credits, income exclusions, and tax treaties all come into play. Additionally, deferred compensation may not be realized in a single tax year, and tax years between nations might not align. For individuals who are not U.S. citizens or permanent residents, this is problematic.
Such individuals whose stock options are not granted by a U.S. company, but who spent a certain number of days working in the U.S., must determine how much of their deferred compensation is subject to U.S. tax depending on how many days they lived and/or worked in the U.S. each tax year. Taxes on this type of income are typically assessed on a time basis for the applicable period between which the individual is granted the option and the vesting date.
For U.S. citizens and permanent residents who earn stock options from non-U.S. companies, they will have to strategize how their deferred compensation will be taxed after taking advantage of Foreign Tax Credits or the Foreign Earned Income Exclusion (if applicable).
As with any investment, stock awards can be risky—especially since they are considered a form of compensation. One only need look back at the dot-com bubble burst of the early 2000s to realize the devastating effects that can result for employees whose wealth is too heavily invested in their employers’ stock awards.
Market volatility and the inherent instability of start-up companies can result in stock prices that fluctuate significantly. If market prices fall below the exercise price, the investor may lose money.
However, risk brings the potential of greater rewards. Stock awards continue to provide executives and other high-level employees with enough leverage potential that they are only increasing as a desirable form of deferred compensation.
Many high-earning global executives receive stock awards as part of their compensation package. As their financial advisor or tax professional, you must be prepared to incorporate appropriate tax planning strategies regarding their deferred compensation—but we realize you may have a lot of questions. At the Global Financial Planning Institute, we support fiduciary financial advisors and other professionals who serve cross-border citizens all over the globe.
We provide education, resources, and a network of professionals in this niche to help you better support your clients. To learn more about stock awards and their implications for global executives, make sure to check out our other post on stock options complete with a hypothetical case study and stay tuned for our upcoming whitepaper on this topic!
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Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual.
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