Tax Considerations of Your Stock Plan

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The type of equity compensation you receive from your company will count as taxable income sooner or later. Here, we outlay the general tax consequences for restricted stock units, stock options, and employee stock purchase plans.

Restricted Stock Units (RSU)

Restricted stock units become taxable as the shares transfer ownership to the employee. This is called vesting and your RSUs are subject to a vesting schedule, which outlines when shares become available to you. RSUs can result in abnormally large blocks of income for certain years of your life.

On each vesting date, the market value of the stock received counts as compensation, reportable to employees on a W2. This income is subject to income tax and payroll tax withholding for both federal and state income tax. It is common to allow your company to withhold a number of shares to cover the required withholding. If the withholding is not sufficient, underpayment penalties could result. To prevent such penalties, estimated tax payments might be necessary.

When the RSU shares are eventually sold, the difference between market value at vesting and the sales price will be treated as capital gain or loss.  If the shares were held over 12 months, preferential long term capital gain rates will apply.

Stock Options

The difference between qualified and non-qualified stock options refer to their tax treatment. A stock option has to meet a series of requirements to qualify as a qualified stock option. As long as stock is held for two years from the date of grant and one year after qualified stock options are exercised, favorable long term tax treatment is applied. For regular tax purposes, there are no tax consequences on the date of exercise, unless you immediately sell the stock you receive.

On the other hand, when non-qualified stock options are exercised, there are immediate tax consequences. The value between the market value of the stock received and the price you paid for it (strike price), is considered compensation, reported to employees on the W2. Capital gains taxes will apply to any further growth at either short term rates, or long term rates, depending on when you sell the stock.

Employee Stock Purchase Plan (ESPP)

ESPPs allow employees to purchase stock at a discounted price, up to 15%, based on when it was granted. The taxation of gains from this transaction depends on whether you hold the stock for enough time before selling.

A qualifying disposition is more tax advantaged. Under the rules for ESPPs, the stock must be held for at least two years from its grant date and at least one year from its purchase to be a qualifying disposition. If these conditions are met, you will be taxed as follows on the date of sale:

  • The lesser of amount of the discount from the grant price that your received (15%, for example) or the gain will be taxed as ordinary income.
  • The remaining gain will be taxed at either short term or long term capital gains rates.

In a disqualifying disposition, the requirements for a qualifying disposition are not met and you will be taxed as follows:

  • The amount between the stock price on the purchase date and your discounted purchase price will be taxed as ordinary income.
  • The difference between the current market value of the stock you received and its cost basis (value on the date of purchase), will be taxed as either short term or long term capital gains rates. With nonqualifying dispositions, it is possible to report ordinary gain and capital loss from the same transaction.

Alternative Minimum Tax (AMT)

Alternative Minimum Tax is a parallel tax system that was designed to make sure that high earners pay an appropriate tax by using different calculations of income and disallowing some deductions and incentives. When you file taxes, you will have to pay the higher of ordinary income tax or AMT.

AMT rules cause higher ordinary income to be recognized when you file taxes. AMT does not factor in until your Alternative Minimum Taxable Income reaches a certain amount. For 2020, the income level is $72,900 for individuals, and $113,400 for married filing jointly. For 2021, the income level is $73,600 for individuals, and $114,600 for married filing jointly.

AMT income is recognized on the exercise of qualified stock option.  Even though there are no regular tax consequences, for AMT, the spread at exercise (market value less strike price) is recognized as income. A common tax planning strategy is to exercise enough qualifying stock options to bring AMT liability as close to regular tax liability as possible, without exceeding it. 

Income Is Everything

Stock based compensation is often the majority of people’s assets and income. You might have multiple grants or could be enrolled in all of these types of plans. They can significantly increase your recognized income for tax purposes in the years to come. Projecting out your income over time, and making changes based on your current needs, can save you a lot on taxes in the long run. Seek a financial professional to develop a strategy for your stock plan that reduces your tax impact.