Equity compensation is a pillar of total compensation for the tech workers of Silicon Valley and other areas. However, a lucrative grant can easily end up being a nightmare in taxes unless it is properly planned. To become aware of the important tax events of Restricted Stock Units (RSUs) and stock options (ISOs and NQSOs) to evade surprise bills and realize the maximum returns.
*What is RSU?
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The simplest type of equity is RSUs. Imagine them being stock options of the company that get realized over a period of time.
***a) The Tax Event *
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When your RSUs finally become vested, not when they are awarded, you are taxed. The full value of the shares is considered ordinary income on the day of vesting and is taxed by the federal and state income tax and payroll taxes. Always choose an experienced tax professional (like a [sales tax attorney](https://www.leadingtaxgroup.com/sales-tax-settlement/
)) for help.
***b) What about Withholding? *
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To pay this tax bill, firms usually withhold a part of the shares (usually about 22 percent of federal, and this may be insufficient for high earners in California. These stocks are disposed of (sell-to-cover), and the money is forwarded to the IRS and FTB. The rest of the shares come to you.
You will be subject to extra tax in case the withholding rate is less than your income tax bracket. Intend to save up additional finances, particularly the state tax in California.
Learn about the Differences Between ISO and NQSO
Options provide you with the right to purchase company stock at a predetermined fixed price known as the strike price. This is because tax treatment is completely determined by type.
*a) Non-Qualified Stock Options
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Exercise: Spread (fair market value-strike price) is taxed as ordinary income when you exercise.
Sale: Any additional gain later on the sale of the shares is taxed as capital gain.
*b) Incentive Stock Options
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Exercise: No exercise of regular income tax is payable. This is the trap.
The AMT Trap: The spread upon exercise is an item classified as a preference item under the Alternative Minimum Tax (AMT). By exercising a high value of ISOs in one year, you may cause a huge AMT bill, even though you did not sell a single share. That may result in an astronomical payment of cash tax.
Sale: The tax of the last type is dependent upon holding of the shares.
As Per the Holding Period
In the case of ISOs, the final tax rate depends on two dates: the exercise date and the sale date.
*a) Qualified Disposition
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To obtain preferential rates of long-term capital gain, you are required to satisfy the two-part test:
Retain the shares for a minimum of one year following the exercise date. Consultation with an expert will surely help you handling sales tax audit process.
Retain at least 2 years of ownership of the shares.
*b) Disqualified Disposition
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When selling the shares before either of the two holding periods, a disqualified Disposition results that taxed the gain being taxed as ordinary income.
Tips That Will Help Strategize
*a) Model AMT Before Exercising ISOs
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There is An AMT calculator or a tax professional should be used prior to a massive ISO exercise. Know your possible cash tax responsibility.
*b) Don't Let the Tax Tail Wag the Dog
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In spite of the fact that a Qualified Disposition is ideal, it is possible that it is better to diversify your risk by selling part of the shares than to own one large concentrated position in order to receive a tax benefit.
*c) Maintain Detailed Records
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Keep a list of all your grants, vests, exercises, and sales. Your brokerage might not follow AMT changes, and you have to have your own records.
Equity compensation is a complex topic to navigate, yet with an active strategy, it will turn into the wealth-creating engine that the effective compensation tool is meant to become.