Timing is everything. If you’re a sports fan, you know that literally one second can be the difference between winning and losing a big game. When everything else is equal, the small decisions here and there add up to make that difference of a win or a loss.
As an executive, you have likely seen the implications of small, timely decisions in the financial sector as well. When it comes to your equity compensation, it’s no different. Particularly in terms of your non-qualified stock options, you have decisions to make—and those decisions have tax implications. Due to ever-shifting rules and regulations set forth by the IRS, it is important to understand how non-qualified stock options tax treatment works today, as well as to seek the guidance of an experienced executive financial advisor who can keep you abreast of equity compensation taxation changes in the future.
Understanding Non-Qualified Stock Options Tax Treatment
One of the nice things about non-qualified stock options is that there is no taxable incident when the stock options are first granted to you. However, you do face taxation when you exercise the options. To illustrate, consider this scenario:
- Let’s say that you are granted 1,000 shares of your employer’s stock in the form of non-qualified stock options.
- Your exercise price is set at $50 a share, and you have a vesting schedule of five years.
- Over the course of the five-year vesting schedule, you watch the stock price move up to $75 per share.
- If you decide to exercise your non-qualified stock options after you become fully vested, you would create what is called a bargain element, which is essentially the difference between the market value and the exercise price when you exercise the stock option. In this case, the $75 market value would be $25 more per share than your original exercise price of $50 per share.
- The overall bargain element can be found by multiplying the bargain element price per share ($25) by the overall number of total shares you are exercising (1,000). So for our example, the total bargain element would be $25,000.
- This bargain element is an important number to know because this will be the first point of taxation regarding your non-qualified stock options. You will be taxed at your ordinary income tax rate on the total amount of the bargain element because it is considered employee compensation by the IRS.
Paying income tax on the bargain element upon exercising your non-qualified stock options is an unavoidable taxable incident, meaning there is really no way around it. However, once you have exercised the stock options and paid the taxation on the bargain element, there are some strategies to consider before proceeding further.
Non-Qualified Stock Options Tax Strategies
Once you have exercised your non-qualified stock options, and of course paid the ordinary income tax on the bargain element, you have a couple different ways you can proceed. The next taxable incident you face is when you sell the stock. This is where planning and strategy come into play, and where those small decisions can add up to make a big difference in your financial portfolio.
If you choose to sell your employee stock a year or less after you exercise your non-qualified stock options, then you would face a short-term capital gains tax rate on the sale of that stock. If, however, you choose to hold the stock a year or more after the exercise of the options, and then sell, you would be subject to a long-term capital gains tax rate on the sale of the stock holdings. This is important to note due to the difference in the tax rates.
For example, suppose you and your spouse have a household income over $479,000 a year. You would be subject to a 20% long-term capital gains tax rate as of this year. On the flip side, your short-term capital gains tax rate would be equivalent to your income tax rate, which would be close to 40% for this year. To put that into perspective, you could be paying 20% or more above the long-term capital gains tax rate if you literally sold your company stock a day before the one-year holding requirement.
For this reason, among many others, it is important that you work with an experienced executive financial advisor that can help you navigate the world of equity compensation planning as well help you develop strategies that fit your unique financial situation. As outlined here today, a simple decision of holding stock a day or two longer could be a 20% swing in taxation on money that has already been taxed as income. Having the guidance of an experienced advisor can make all the difference when it comes to making executive compensation decisions.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for equity compensation planning for executives. For more information on how Wade and the Carpenter Team can advise you on non-qualified stock options and their tax implications, reach out today for a complimentary consultation.
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