Mistakes to Avoid with Your Equity Compensation
Equity compensation, such as RSUs and stock options, is becoming increasingly common as a key piece of an employee's compensation. Combine that with the tailwind of a strong stock market that we’ve seen for over a decade, and many employees have been in favorable positions to "cash in" on their equity compensation. But as with anything, more digits after a dollar sign equate to the possibility of bigger mistakes.
It is my core belief that those with equity compensation, particularly substantial equity compensation, should not go about it alone. Sure, I may be speaking from a biased perspective, but there is a reason even the brightest minds bring in a second opinion on it. I believe the fear of making a costly mistake is likely the primary reason for this.
Now, let me walk you through the themes of those costly mistakes I have seen over the years.
Timing Issues
Waiting Too Long To Exercise
Particularly for incentive stock options, you should take a strong look at exercising these at your early vesting tranches, or even early exercise if your plan allows it.
When you onboard at a fast growing company, it is often the early days and vesting cycles where you can exercise your ISOs and take advantage of minimized alternative minimum tax (AMT) consequences. While ordinary income tax is not assessed when exercising ISOs, AMT is. AMT is assessed on the "spread," which is the gap between your exercise price and the stock's current market price, and it is taxed at 26% or 28%. California also assesses AMT on this spread.
Taxpayers often have a "cushion" before they trigger AMT, so if exercising in these early days is your strategy, it will be important to run the numbers. If instead you waited five years to exercise, it is possible the value of the stock has increased drastically, and your ability to exercise a substantial amount of ISOs without triggering AMT, or minimal AMT, becomes much more difficult.
Remember, you are doing this in the first place to take advantage of ISO tax treatment. No income tax on the spread, and long term capital gains if held for over a year post exercise and two years from the grant date.
Exercising Too Early
Ah, the opposite of what you just read.
We don't make decisions strictly on taxes, although it may make me sound smart. You must focus on the core fundamentals above all. At the end of the day, if you are exercising in these early days, you are putting your capital at risk in the same company that pays your salary.
I have seen more than the example I just gave above. You exercise early, and your company stock price declines; some even become worthless. If you are at a private company, you may not even see liquidity events.
It is a humble reminder that waiting to exercise adds more certainty to your equity compensation, although the tax bill may be more. Exercising early also takes leverage off the table.
Letting Options Expire
If you leave your company, or it's the other way around, don't tuck tail and forget that you have vested stock options.
Often, you have a 90 day window to take advantage of these options before you are dealing with expiration (also, ISOs turn into NSOs after 90 days). Understand your plan's timeframe.
Even worse is letting in the money options expire while you are still employed. You almost always have 10 years from the grant date to exercise your options, and if you do not exercise them within that window, they expire. At a public company, this should never happen.
Missing the 83(b) Election
An 83(b) election is a notice you file with the IRS within 30 days of receiving restricted stock (or early exercising options), telling them you want to pay taxes on the shares now, based on their value today, rather than later as they vest. This matters because if your company's stock is likely to grow in value, paying tax on a small number today is far cheaper than paying tax on a much larger value down the road as each tranche vests.
Miss the 30 day deadline, though, and the option disappears. There are no extensions or exceptions, which is why it's one of the most costly mistakes people make with early stage equity.
It's not right for everyone (if the company fails, you've prepaid tax on shares that end up worthless), but for those confident in their company's trajectory, it can mean the difference between paying tax at long term capital gains rates versus ordinary income rates on a much bigger number later.
Taxes
Tax Reporting
When it comes to equity compensation, taxes are... funky, to say the least. I have a video series on reporting equity compensation on your tax return, and let's just say those videos are not short.
Depending on the type of equity compensation you have, some of the activity may be reported on a W2, the sales will be reported on a 1099, you will need a supplemental 1099 to make appropriate adjustments to basis, ISOs exercise will come through on Form 3921, and AMT may need to be dealt with.
This leaves taxpayers very vulnerable to making mistakes on their return and ending up paying more tax than they need to. It is very important that your tax professional has a good grasp of reporting equity compensation.
Tax Planning
Don't shoot first and ask questions later when it comes to equity compensation, even though it is easier said than done.
I know it only takes a few clicks in your custodian portal (for public companies) to create the cash and have it sent over to your checking accounts, but run the projections, understand your withholding, and create a strategy. If your goal is to take advantage of the tax treatment options offered, it is important to do this early, particularly for AMT purposes.
Who You Hire
This is a singular blog, and I have gone into several circumstances that can create headaches. It may be even more frustrating if you hire a financial advisor and tax professional, and these mistakes still get made. This stuff is complicated and has taken years of reps and education to become an expert.
Early in my career, an advisor I knew wrote a blog about a key rule of thumb: never keep more than 10% of your liquid investments in your company stock. While well intentioned, there was no mention of taxes, financial goals and planning, or client balance sheets.
Everyone's situation is different, and shutting the door on concentration outright is a dangerous blanket recommendation. Those who are providing you with advice on equity compensation should be experts in the field and be comfortable advising on concentrated positions. Big decisions and proper reporting will be made consistently.
Concentration
Perhaps the most obvious mistake I can write about in this blog is concentration risk. If your income and balance sheet are ultimately dependent on one stock, you are in a vulnerable position. Declining share prices can lead to disaster. I often build a plan for a client, completely excluding their equity compensation, just to get a grasp on how reliant they are on a single stock. It is a great starting place for a concentrated conversation.
I know the tone of this blog was "mistakes," but don't let it scare you. Equity compensation is a great tool for building wealth, but it does require active management.
If you would like a second opinion on your own equity compensation strategy, reach out (dustin@swrpteam.com) and let's talk through it.
This material is purely intended to be general and educational in nature, and should not be construed as specifically tailored investment, financial planning, tax, legal, or other professional advice. Information and data contained herein is as of the date of publication, and may be subject to change in the future without notice. Any investment performance referenced is purely past performance, which is no guarantee of any future performance. Nothing contained herein should be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation of any security or other financial product or investment strategy. All investment, tax, and financial planning strategies involve risk that you should be prepared to bear. You are highly encouraged to consult with professionals of your choosing before taking any action based on this material.