Adam Frank

Managing Director, Head of Wealth Planning and Advice, J.P. Morgan Wealth Management

If you are an employee of a private company, part of your compensation may be paid in stock, restricted stock units, stock options or other company securities. Since your company is private there often is no good way to convert that stock or option into cash until there is a liquidity event (usually a recapitalization, a sale of the company or going public).

However, that doesn’t mean that there’s nothing you can do to maximize the value of your stock-based compensation. No matter what strategy you consider, it is important to make sure to be compliant with SEC rules and your company’s policies.

Planning with restricted stock subject to vesting – the 83(b) election

If your stock is subject to vesting requirements (which means that the stock isn’t yours to take with you when you leave the company until a certain amount of time has passed or certain milestones are met), you may be able to make a so-called “83(b)” election within 30 days of the grant of stock.

Normally, the value of stock is included in your ordinary income (and is subject to income and payroll taxes – Social Security, Medicare, etc.) when it vests in the future. If you make an 83(b) election, however, you proactively agree to be taxed on the value of the stock when you receive it (i.e., upon grant), even though it is not yet vested, in order to reap potential future tax benefits. This means that you are agreeing to pay tax earlier than you would have otherwise had to. However, in many early-stage companies, the value of stock received as compensation is quite low at the time of grant relative to what it could be in the future (and can sometimes even be close to nothing); if you make the election, are taxed on the grant amount when received, and hold the stock for the applicable holding period from the date of the election (often at least one year), any further growth in the stock’s value will be taxed as long-term capital gains at preferential tax rates (versus ordinary income and payroll taxes) upon sale. Note: regardless of whether you've filed an 83(b) election or not, if you leave the company before the restricted stock has vested, you may lose the stock (and the tax you had already paid).

For a more in-depth analysis of the 83(b) election, please see our WealthFocus on stock-based compensation and the Section 83(b) election.

Planning with stock options

There are two kinds of options: nonqualified stock options, which are known as NQSOs, and qualified stock options, which are also known as incentive stock options or ISOs.

An option gives you the right to buy your company’s stock at a set price, called the exercise price or strike price. When you exercise your options, you pay the strike price (the cost of exercising your options) to the company in exchange for stock. Options generally have a vesting schedule, before which they can’t be exercised, and an expiration date, after which they can’t be exercised.

Neither kind of option is subject to tax when granted.

Nonqualified stock options (NQSOs)

The taxation of nonqualified stock options is fairly straightforward.

Assume you are granted 10,000 NQSOs with a strike price of, say, $1/option. The stock price when the options are granted is $1/share.

If you exercise the NQSOs when the stock price is $5/share (assuming the options are vested), you would pay the company $1 for each option you want to exercise (the strike price); the $4 difference between the strike price and the stock price is included in your taxable income as compensation income and thus subject to ordinary income tax and payroll taxes. If you want to exercise your NQSOs, you can either pay the company the strike price plus tax and receive the shares, or, if your company allows, surrender shares in payment of the strike price and taxes and receive a net number of shares.

However, you choose to exercise your NQSOs, you may decide to sell your shares immediately (assuming there is a market to do so) in order to diversify since there should be no additional tax due upon an immediate sale.

Incentive stock options

Incentive stock options (ISOs) are more complicated than NQSOs, but potentially more remunerative. In the previous example, if the options were ISOs rather than NQSOs (10,000 options with a strike price of $1/option), the mechanics are the same, but exercising the ISOs would not subject you to immediate ordinary income tax. Instead, the $4 gain per share may subject you to alternative minimum tax (AMT). (A detailed exploration of AMT is beyond the scope of this WealthFocus; please see our WealthFocus on Incentive Stock Options and the AMT.) If you hold the resulting stock for at least one year from exercise (and two years from the option’s grant), the difference between the strike price and the eventual sale price is taxable as long-term capital gain rather than ordinary income.

Early exercise of options

Some companies allow you to exercise your options before they vest (meaning before you own them). If your company’s option agreement allows pre-vesting exercise, you may be able to make an 83(b) election on your options; this means that you would pay the strike price to the company and pay tax on any difference between the market value of the stock and the strike price as previously described depending on whether the options non-qualified or incentive. If you exercise your options early, don’t forget to file your 83(b) election within 30 days of the exercise (different from restricted stock, where the 30 day clock starts running from the grant date). Note: if you leave the company before the options vest, you may lose the resulting stock (and the tax you had already paid) even if you’ve filed an 83(b) election.

Often, the stock price is the same as (or close to) the strike price at the time that options are granted. If you are able to do so, exercising your options soon after you receive them (even if they are not yet vested) could save you money on ordinary income taxes or AMT since the difference between the strike price and the stock price would be small (if there is even a difference at all). Then, assuming you satisfy the relevant holding periods, future gains on the sale of the stock (i.e., the difference between the sales price and the stock price at the time of exercise) should be taxed at beneficial long-term capital gains tax rates.

Even if the stock price at the time of exercise is higher than the strike price and you have to pay some tax at that time, it may be worthwhile if you believe that a liquidity event is likely to take place at a significantly higher value.

However, you should discuss risks associated with an 83(b) election with your tax professional. For a more in-depth discussion of the 83(b) election and its ramifications, please see our Wealth Focus on stock-based compensation and the 83(b) election.

Early exercise of ISOs specifically can be risky, however, in the event of a so-called “disqualifying disposition”. This would occur if the stock was not held for the required holding period discussed above (1 year from exercise and 2 years from grant of the option). This is because an 83(b) election filed for an early exercise ISO is effective only for AMT purposes and not for ordinary income tax purposes. If there is a disqualifying disposition of an early exercise ISO, the difference between fair market value of the stock on the date of vesting minus the exercise price paid would be considered compensation income and the capital gains period would only begin when the underlying stock vested. Because you may not always be able to control when a disqualifying disposition may occur (e.g., the company is acquired and the shares are sold), you should carefully weigh your risks prior to early exercise of ISOs.

Considerations when exercising stock options

Even if the strike price on your options or the stock price at the time of a planned exercise are low, consider the following when deciding whether and to what extent to exercise your options:

  • Cost: Do you have the liquidity to pay the strike and make the necessary tax payments, considering that you may not be able to get liquid once again until the private company sells or goes public, which could be several years later? Exercise costs could be substantial, depending on the number of options you exercise and the difference between the strike price and the stock price. For example, if you have 100,000 options and a $2/option strike, you would have to pay $200,000 to exercise your options (without accounting for any ordinary income tax or AMT liabilities).
  • Diversification: Are you comfortable making an additional investment in a private company? You already receive your salary from the company; does it make sense for you to expose your liquidity to the company as well?

Talk to a J.P. Morgan representative to review these and other issues and decide how best to incorporate your stock and options into your wealth management plan.

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