The myStockOptions Blog

Instacart IPO: Long-Awaited Liquidity For Employee RSUs And Stock Options

After hinting at an initial public offering (IPO) last year, delivery service Instacart has finally gone public with a listing on Nasdaq. It is the highest-profile venture-backed company to go public since the end of 2021. The IPO has been heralded as a sign of a potential resurgence in initial public offerings after a dearth in 2022 and the first half of 2023.

As with many later-stage startup companies, Instacart’s initial public offering (IPO) is as much about its human capital as its financial capital. Grants of restricted stock units (RSUs) and stock options are important forms of compensation for Instacart employees—but to cash in, they needed a liquidity event for the company’s stock.

That is why, in an interview with CNBC on IPO day, Instacart CEO Fidji Simo proclaimed: “This IPO is not about raising money for us. It’s really about making sure that our employees can have liquidity on stock that they worked very hard for.”

Filed under its formal corporate name Maplebear Inc., the company’s S-1 registration statement with the Securities and Exchange Commission (SEC) discloses details about Instacart’s equity programs for employees.

RSUs With Double-Trigger Vesting

Larger, later-stage pre-IPO companies often grant RSUs instead of stock options for many reasons, including concerns about shareholder dilution and high valuations leading to exercise prices that go underwater. Instacart is no exception. In its later stages before going public, the company moved in a big way from grants of stock options to grants of RSUs. No stock options were granted at Instacart in 2020, 2022, or the first six months of 2023.

The equity capitalization table from its S-1 shows the following total outstanding grants as of June 30, 2023, for its non-voting common stock:

Stock Options	29,910,133
RSUs	63,467,028

In a now common practice for later-stage pre-IPO companies, Instacart structured its RSU grants (and some of its stock options) with both the usual service-based vesting plus a second vesting condition that requires a liquidity event for the grant to fully vest:

1. With service-based vesting, you must work at the company for a specified period after grant. The service-based vesting period for these awards at Instacart typically runs four years, with a cliff vesting for part of the grant at one year of service followed by continued vesting monthly or quarterly.
2. With vesting based on a liquidity event, vesting conditions are met upon the earlier of (1) a change of control (e.g. a merger or acquisition) or (2) the effective date of a registration statement for an initial public offering of the company’s common stock.

Instacart also has some grants that vest only upon the satisfaction of both service-based vesting conditions and market-based vesting conditions (e.g. the achievement of specified future valuation or capitalization amounts). To make it even more of a puzzle to grasp all their different equity grants, the company made others that vest only upon the satisfaction of service-based, liquidity-event-based, and market-based vesting conditions.

Tax Hits For Employees

Many of Instacart’s employees have grants that met their vesting conditions immediately after the IPO. This will result in a big tax bill for employees when the shares are delivered. In fact, the value of the shares they receive will probably push most employees into the top tax bracket for all of their income in 2023—the one potential downside to the liquidity and wealth the IPO creates for them.

The S-1 registration statement explains that the company assumes a 47% tax-withholding rate for holders of its RSUs and shares of non-voting restricted stock that will vest and settle in connection with this offering. The company will automatically withhold shares from the RSU grants to pay the taxes owed, a practice referred to as “net settlement.” Instacart assumes a 43% tax-withholding rate for holders of its stock options, mostly via net option exercises.

$2.6 Billion Financial Impact

The use of stock compensation and the immediate non-cash accounting expense for the way the grants are designed to vest is so large that Instacart states the following in its registration statement (our bolding for emphasis):

“In the quarter in which this offering is completed, we will recognize approximately $2.6 billion of stock-based compensation expense associated with the satisfaction of the liquidity event-based vesting condition for outstanding RSUs and shares of outstanding restricted stock, for which the service-based and/or market-based vesting conditions have been fully or partially satisfied on or before August 15, 2023. As such, we expect to incur a net loss for the quarter and year in which this offering is completed, primarily as a result of recognition of this stock-based compensation amount.”

Amid dilution concerns, the company’s growing cash position enabled it to offer cash alternatives to employees. For example, the registration statement disclosed that in April 2023 it offered employees the choice to elect cash in lieu of a portion of certain equity awards.

Lockup Of Employee Shares With Potential For Earlier Sales

The liquidity for employees that Instacart’s CEO mentioned is not immediate. Instacart did separately register on SEC Form S-8, for employees’ public resale, all of the shares of common stock issuable under its previously granted equity incentive awards, along with those the company will grant in the future under its new equity incentive plan and separate employee stock purchase plan (ESPP).

Employees still will need to wait 180 days to sell their shares under the standard post-IPO lockup provisions. The S-1 registration statement reveals an exception that allows earlier sales during an open trading window should the stock trade at more than 120% of its IPO price for at least five of ten consecutive trading days. One of those days must occur after the company’s first quarterly earnings announcement.

Further Resources

Equity compensation is a key benefit for many employees at private companies, from startup to IPO or M&A stages. myStockOptions has articles, FAQs, videos, and quizzes that explain all aspects of private company stock compensation, from the basics to tax and financial planning.

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WEBINAR: 10b5-1 Trading Plans And Other SEC Rules Advisors Must Know

Thursday, October 12, 2023
2pm to 3:40pm ET (11am to 12:40pm PT)

Get crucial insights on the SEC's new rules for 10b5-1 plans and their impact, along with a solid grounding in other key SEC requirements, including Rule 144, Section 16, and insider trading.

Join us on Oct. 12 (2pm–3:40pm ET, 11am–12:40pm PT) for a webinar on the fundamentals and mechanics of Rule 10b5-1 trading plans, new SEC rules, evolving best practices, and most effective designs for executives, employees, and anyone else who wants to regularly sell stock to meet financial goals but knows material nonpublic information about the company.

Discover how to use these plans to maximize your clients' wealth in company shares, stock options, and restricted stock/RSUs while protecting them from insider-trading charges. The webinar's panel of experts will provide real-world case studies:

• Michael Andresino (JD), Partner, ArentFox Schiff LLP
• Rich Baker (MBA), Exec. Dir., Morgan Stanley Executive Financial Services
• Megan Gorman (JD), Founder, Chequers Financial Management
• moderator: Bruce Brumberg (JD), Editor-in-Chief and Co-Founder, myStockOptions

2.0 CE credits for CFP, CPWA, CIMA, CEP/ECA, EA (live webinar only), and CPE for CPAs (live webinar only); 1.5 potential self-determined CE credits for CFAs

Register now. Time/date conflict? No problem! All registrants get access to the webinar recording, which offers 2.0 CE credits for CFP, CPWA/CIMA, and CEP professionals, plus the webinar slide deck and handouts.

Stock Options In Private Companies: Deciding Whether And When To Exercise

Stock options in startups and other private companies can be very profitable. The stock may become highly valuable if the company goes public or is acquired. However, options in private companies are also risky, as the stock is illiquid until then and may be forfeited if the company fails.

Options in a private company, as with public companies, can be either nonqualified stock options (NQSOs) or incentive stock options (ISOs), though ISOs are more common for startups. In a potential twist, with private company options the terms of your grant may allow you to exercise them before they vest, including immediately at grant (sometimes referred to as early-exercise options). If you do this, you get restricted stock that has a vesting schedule identical to the options, and you make a Section 83(b) election with the IRS within 30 days of your exercise.

For all of these reasons, it's complicated. Some of the most common questions we get at myStockOptions.com involve whether and when to exercise private company stock options.

A recent myStockOptions webinar on stock option exercise strategies featured three leading advisors. Webinar panelist Megan Gorman, the founder of Chequers Financial Management in San Francisco (and also a Forbes.com senior contributor), discussed rules of thumb to go by when you have stock options in a private company.

1. Don’t Risk Money You Can’t Afford To Lose

“Can you afford to lose the money?” is the first question Megan asks her clients with stock options in private companies. The planning complication here revolves around the illiquidity of private company stock, which is neither registered with the Securities and Exchange Commission (SEC) nor listed on any trading market.

When you exercise stock options in a public company, you can typically sell shares at the time of exercise to pay the exercise cost and any taxes. You can’t do that in a private company. “When you exercise stock options in a private company, you will have to put out money to buy the shares,” Megan explains.

Moreover, as the stock acquired cannot easily be sold, you risk tying up that money in illiquid stock if the company does not go public or gets acquired—or losing it if the company fails. “For some people that risk may work, and for some people it may not,” cautions Megan.

Alert: If you are exercising your options while losing your job or moving on to another company, make sure you know your company’s rules on post-termination exercises. Vesting is likely to stop, and to avoid forfeiting the options you will probably need to exercise them either immediately or within a specified number of days after your termination date.

2. Remember You May Owe Taxes

You may be surprised to learn that income recognition and taxation at the time of an option exercise are not delayed by the lack of liquidity in private company stock. This is also true for the lockup period of the stock after an initial public offering (IPO). Therefore, Megan asserts, you must think ahead about paying the taxes you will owe after you exercise stock options in a private company.

Whether you have NQSOs or ISOs, any spread between the exercise price and the fair market value of the stock will require you to think about taxes. As with the exercise cost, you cannot sell any shares at exercise to pay taxes, as you can do with stock options in a public company. With NQSOs, for the required tax withholding your company may hold back shares, take the money from your salary, or make you pay it separately.

“Run some tax planning to understand what is going to happen here if you exercise,” Megan recommends. With ISOs in particular, she advises, be sure you know whether any spread at option exercise will trigger the alternative minimum tax (AMT).

3. Methods To Help You Avoid A Liquidity Crunch

Once you’ve exercised your stock options and acquired the shares, the money you paid is stuck in private company stock that cannot easily be sold. As private companies are now taking longer to go public or get acquired, they are increasingly sponsoring share liquidity programs, notes Megan.

“Your company may have an ongoing liquidity-type program, such as the one at SpaceX,” she says, adding that often these companies organize their liquidity programs through tender offers. (SpaceX regularly conducts secondary offerings and tender offers as a way for employees to sell equity.)

Megan also points out that resale markets have developed for employees with illiquid stock in private companies, including firms that can lend against private stock.

“The startup equity market has evolved,” she observes. “There is a segment of the startup market where you can get financing on your equity to help you with liquidity. There are providers out there that will work with you. But move slowly. Truly understand what you’re getting into.”

For more on this topic, see an article at myStockOptions: Financing Stock Option Exercises In A Private Company.

4. Consider Exercising Right Before The Company’s IPO

Of course, the ideal liquidity event for private company stock is either an IPO, in which the company becomes a publicly traded issuer listed on the NYSE or Nasdaq, or an acquisition by another company for a purchase price at a substantial premium.

If the company is preparing for an IPO, timing your option exercise just before the IPO could make a lot of sense, explains Megan. “Sometimes it’s really great to exercise private company stock options right as the IPO is happening, because you know the stock is going to go public. It’s a sure thing.” You can get yourself ready for it, she adds, and exercise at a time that may minimize risk.

“But know when the IPO lockup period ends,” Megan warns. After the IPO you will be unable to sell shares for a specified period, often up to six months. During that time the stock price could fall, raising another risk.

5. Planning Depends On Your Own Personal Circumstances

Remember that financial planning for stock options in a private company is complex. It must ultimately be built around your own personal circumstances, which may be very different than those of your colleagues. Consider the guidance of an advisor with experience in this niche.

“I can’t emphasize enough that this planning is very subjective,” Megan cautions. “It depends on the person, their risk tolerance, their finances, and their goals. Always move slower rather than faster with this planning.”

She urges clients to have a stock-selling strategy that plans for where the proceeds will go, and also reminds them to not let the “tax tail wag the financial planning dog” (i.e. don’t let taxes be the primary driver of your planning).

Further Resources

The webinar in which Megan and other top financial and tax experts spoke is available on demand on the myStockOptions Webinar Channel: Stock Option Exercise Strategies: Managing Risk & Building Wealth, also featuring Bill Dillhoefer (President and CEO, Net Worth Strategies) and David Marsh (Financial Planning Case Manager, Ameriprise Financial).

myStockOptions.com has an extensive section with resources on the special tax and financial planning issues for stock options in private companies.

Stock Options & RSUs: 6 Pro Tips For Navigating Volatility

For many of you who have equity comp, the extreme market fluctuations of 2020–2022 may be your first experience of volatility after a decade of rising markets. Know that it's normal to feel a little rattled. Sudden stock-price declines can stress out even the most experienced holders of stock comp (and their financial advisors).

Sooner or later, volatility may force you to make decisions that affect your financial future and long-term wealth. Should you change your financial plan or stick with it?

Financial strategies for equity compensation amid volatility and falling stock prices were dominant themes in two recent myStockOptions webinars. In one webinar on stock option exercise strategies and another on planning for restricted stock and RSUs, panels of financial advisors and tax experts discussed how to navigate volatility and down markets. This diverse group, including CFPs, EAs, and JDs, presented a variety of insights from different angles.

1. Listen To Your Risk Tolerance

David Marsh, a financial-planning case manager at Ameriprise (Minneapolis), pointed out in the stock option webinar that market declines offer a useful period to “confirm or reset risk tolerance.” In good times for your company’s stock price, he observed, it’s easy to be aggressive and bullish in your financial strategy. It’s harder to keep up that resolve when the stock price tumbles. In fact, he continued, a falling stock price can give you a helpful reality check on your tolerance for investment risk.

He suggests you listen to what your emotions in a downturn are telling you. “How much of a downturn are you willing and able to stomach, and how does that impact your goals? If you’ve been relying on equity comp to meet regular living expenses, that’s a real danger zone which comes to light in stock-price volatility and downturns.” Insights you derive from dark times for the stock price can help you re-examine your goals for share proceeds and re-assess the portion of them that is discretionary.

With nonqualified stock options, he went on, a reduction in the difference between the stock price and the exercise price may seem to create a tempting opportunity to exercise the options. That starts the holding period for the beneficial tax treatment on long-term capital gains at sale when the stock price eventually recovers. This is a common strategy for incentive stock options (ISOs).

However, with nonqualified stock options (NQSOs) there may be better uses for the same money. “You should compare whether to exercise and hold NQSOs or maybe just hold on to that option and put the cash to work in another way,” he advised. “Consider investment risk and tax factors. What I would bear in mind is that if you’re game enough to exercise NQSOs at this time, I would say let’s take that cash and simply buy more shares. If indeed the stock price does recover, by increasing the equity position in the company we may produce a better result.”

2. Welcome New Option Grants, But Have A Layoff Plan

Megan Gorman, the founder of Chequers Financial Management (San Francisco), complemented David’s thoughts in the stock option webinar with the fact that a depressed stock price is an excellent time to get new stock option grants. Playing a long game, she emphasized, is key to success with equity compensation. “If you go back to March 2009, when the stock market was miserable, it was an amazing time to get a grant with a very low exercise price,” she observed. The stock-price increases during the long recovery made option grants awarded at that time extremely wealth-generating.

But beware of layoffs, she cautioned. Option grants have finite terms and typically only very short periods when options can be exercised after job termination. “It’s important to have a strategy for exercising options and selling stock in the event you are laid off. In these more volatile markets, think about the fact that you are at risk of losing your job. Don’t lose the equity awards you worked so hard for.”

3. Don’t Forget The Big Picture, But Revisit Your Cash Position

Keep your big-picture financial goals in mind, advised Chloé Moore, the founder of Financial Staples (Atlanta), in the restricted stock/RSU webinar. “Things are a little volatile now, but keep a handle on your financial goals. Focus on what you can control: continue to build savings, pay off debt, and put yourself in a stronger financial position to shield yourself as much as you can from the impact of volatile markets.”

To that end, now is a good time to increase your cash position, she noted. “Your restricted stock units can help with this,” she points out. “That’s a good reason to sell the shares as soon as the stock vests.” If you’re using your RSUs to fund your lifestyle, it’s crucial “to revisit cash flow,” she asserted.

4. Try To Be Logical Rather Than Emotional

This is often easier said than done, but it’s an attitude worth reinforcing. In the RSU webinar, Meg Bartelt, the founder of Flow Financial Planning (Bellingham, Washington), addressed the irrational tendency to place too much importance on the grant price of restricted stock/RSUs. If the stock price falls between grant and vesting, this mental “anchoring” makes it easy to feel as if you’ve lost something.

“If you received Google RSUs a year ago, the much higher grant value is really depressing now,” she mentioned as an example. “Your projected comp used to be $500,000. Now it’s $300,000. But it’s important to remember that the $500,000 was literally never yours. The only thing that is yours is the number of shares, if you stick around long enough at the company. Be aware of that bias.”

Should you hold your RSU shares or sell them? The test for answering this question, Meg pointed out, “doesn’t change with the stock price.” Rather, she went on, it’s always this: “If you had cash of the same amount, would you buy stock in the same company?” If the answer is yes, you probably want to hold your shares. If the answer is no, you probably want to sell them. “The answer may change with the stock price and market conditions, but not the logical framework,” she emphasized.

Daniel Zajac, the managing partner of Zajac Group (Exton, Pennsylvania), brought up an alternative approach to minimize downside risk in volatile markets if you have both stock options and RSUs. Speaking alongside Meg and Chloé in the RSU webinar, he suggested doing an analysis to determine whether it makes sense for you to hold your vested RSU shares and instead exercise your options and sell those shares. That can safeguard the generation of proceeds you need for specific goals.

5. Watch Your Estimated Taxes; Look Ahead To Future Grants

Meg also observed that a big drop in income between last year and this year means that if you pay estimated tax to keep up with income spikes from RSU vestings, you should revisit how much estimated tax you’re paying. “Estimated tax vouchers for the current tax year are based on last year’s income. If you use last year’s estimated tax vouchers for this year’s lower income, you’re going to be way overpaying estimated taxes this year.”

The inverse is also true, she continued, should you lower your estimated tax payments this year. If the stock price goes back up next year, you want to be sure you’re not underpaying estimated taxes on the basis of your lower income this year.

Daniel echoed Meg’s observations by stressing the importance of “actively working with a CPA” to be sure that you’re neither overpaying nor underpaying estimated tax throughout the year, instead of simply relying on the safe harbors based on your prior year’s income. “If you have significant equity comp,” he stated, “you should be doing quarterly check-ins for estimated taxes.”

Daniel and the other presenters in the RSU webinar also pointed out that a fallen stock price presents new opportunities. If your annual equity comp grants are based on a percentage of your salary, “you may be getting additional shares because the stock price is lower.” This is good news to offset the bad news of a lower stock price.

6. Now Is The Time To Seek Professional Financial Advice

Bill Dillhoefer, the CEO of Net Worth Strategies (Bend, Oregon), which developed the StockOpter analysis tool, urges employees with equity comp in a downturn to seek advice from a professional financial planner, if they haven’t already. “When the stock price is going up, you may be getting advice from the watercooler chat and think you don’t need a financial advisor,” he said in the stock option webinar. Confidence is easy in bull markets. However, the game changes when stock prices tank and a bear market looms.

Bill emphasized how much a financial advisor can help you make better decisions and avoid mistakes with stock compensation. A good advisor can “establish and track diversification criteria based on risk.” He recommended understanding your “forfeit value,” a metric an advisor can calculate that shows the value lost if you leave your company to work for a competitor. Even if you’re generally confident in your knowledge of personal finance, advisors can help you “be a little more secure about lasting through these volatile markets without going crazy.”

Further Resources

The webinars in which these financial-planning experts spoke are available on demand at the myStockOptions Webinar Channel:

• Stock Option Exercise Strategies: Advanced Bootcamp
• Restricted Stock & RSU Financial Planning: Advanced Bootcamp

myStockOptions.com has other resources and tools on financial planning amid volatility and down markets.

Stock Options & RSUs From Startup To IPO Or M&A: Top Financial Advisors Cover 5 Key Topics

Fast-growing private companies rely heavily on equity compensation to recruit, motivate, and retain the best employees. Grants are typically stock options, restricted stock, or restricted stock units (RSUs). However, stock comp in private companies is surprisingly more complex and varied than what’s commonly used in mature public companies. The many challenges range from the inability to sell stock at exercise to fund the exercise costs to lockup restrictions on shares after the IPO.

A recent webinar held by myStockOptions.com presented practical guidance and case studies from three financial advisors with expertise in the financial and tax planning for private company equity awards and shares. Discussed in this article are five of the many topics covered.

1. When To Exercise Stock Options In A Private Company

At private companies in the early stages of growth, stock options predominate. By contrast, in public companies RSUs are more likely to be awarded for new-hire and annual grants. These startup company grants may include what are called “early-exercise stock options,” which allow you to buy the stock immediately. At exercise, you receive restricted shares that still must vest before you own the stock. Assuming a timely 83(b) election is made with the IRS, this comes with advantages and risks.

One potential benefit is “the ability to invest in the company early, possibly at a reduced tax cost,” as explained by webinar panelist Meredith Johnson, Director of Tax at BPM in San Francisco. “Exercising early converts future appreciation from ordinary income to capital gains and starts the clock toward a long-term holding period,” added panelist Devin Blackburn, a Senior Vice President at Northern Trust Wealth Management in Chicago. Exercising early also starts the holding period for the special 0% tax rate for qualified small business stock (QSBS).

But it’s important to note that early exercise is not for everyone. “I usually advise clients to wait to exercise private company stock options until they have to (e.g. changing jobs, options expiring) or possibly for an upcoming liquidity event,” said panelist Kristin McKenna, the Managing Director of Darrow Wealth Management in Boston. “Consider the time value of the money that would be used for option exercise—other ways to use that cash and other cash needs until the stock has liquidity.” That strategy was echoed by Meredith Johnson: “If there is embedded gain in the private company options, I typically recommend timing the option with a liquidity event (tender offer, etc.).”

2. Expect RSUs In A Later-Stage Private Company

As the private company matures and moves toward an IPO or acquisition, equity grants tend to shift toward restricted stock units (RSUs). You don’t exercise RSUs, unlike stock options. Once the RSU vesting conditions have been met, the shares are delivered to you.

While RSUs in public companies typically have just one vesting requirement (e.g. length of employment from time of grant), RSUs in private companies have “double-trigger” vesting. In other words, two conditions rather than just one must be met before the RSUs vest and the underlying shares are delivered to you. “Usually time is the first trigger, and an event such as an IPO or a company acquisition is the second and final trigger,” explained Meredith Johnson.

Crucially, you cannot control the timing of taxation with RSUs, as you can with stock option exercises. This raises a myriad of tax-planning issues, leading to the next topic.

3. Need A Plan For The Taxes On Equity Comp

When you receive stock in a private company, whether by option exercise or RSU vesting, the IRS and the SEC don’t care that you can’t sell the shares to pay the taxes owed. The same tax rules apply to illiquid private company stock as to freely tradeable public company stock. Therefore, before a stock option exercise or RSU vesting date, you need a way to pay the taxes that you may owe.

With incentive stock options (ISOs), when you exercise and then hold the shares you need to consider the alternative minimum tax (AMT). Plus, while no withholding applies with ISOs, even when you can sell some of the shares, that doesn’t mean you may not owe taxes! With nonqualified stock options (NQSOs), you have withholding and taxable compensation income for the spread at exercise, plus Social Security and Medicare taxes (FICA). With double-trigger RSUs, you will face compensation income when all the vested shares are delivered in one batch at the specified time after the second trigger, and then also the FICA taxes when the IPO occurs.

Depending on your tax bracket, the flat federal withholding rate on stock compensation may not be enough to cover the total tax you really owe on the value of the shares you receive. (The rate is 22% for yearly supplemental wage income up to $1 million and 37% for amounts over that.) In this case, you need to think about paying quarterly estimated taxes, making adjustments in your salary withholding, or at least plan to pay extra taxes (and potential penalties and interest) with your tax return for the year.

All of the webinar panelists emphasized that not considering the tax impacts is an especially big mistake with private company stock comp. As Devin Blackburn put it: “lack of planning for the dreaded ‘liquidity crush’—you’re wealthy on paper but have a persisting cash deficit.” You need to think about “how to pay tax without liquidity,” Kristin McKenna reiterated.

4. Actions Before And After The IPO Lockup

Some companies, such as Airbnb, Robinhood, and Snowflake, have allowed employees to sell a small percentage of shares at the time of the IPO and/or shares later before the expiration of the lockup. However, in general, you may not be able to sell any shares for up to six months after the IPO date (and often longer with SPACs).

Plus, if you’re a company executive or key employee who often knows material nonpublic information, you may also be subject to frequent blackout periods. That is when the company prohibits you from selling stock and thus potentially committing insider trading. That creates the need to consider the use of Rule 10b5-1 trading plans.

This is another planning area where mistakes can easily occur. “Understand the attributes of all your grants, share holdings, the lockup period, and any blackout periods,” explained Devin Blackburn. She also emphasized the need to “model various scenarios that reflect multiple price targets to manage expectations and emotions.” For example, with unexercised ISOs, when about six months from the IPO, evaluate exercising and holding pre-IPO. Although this may trigger the AMT, after the lockup ends you can then sell the stock, with all the sales proceeds over the exercise price getting taxed as long-term capital gain.

This is the time to tie everything together about your grants and stock holdings. “Calendar the IPO, lockup, sales windows, and tax payments so that you can better coordinate sufficient liquidity to meet your tax obligations,” added Meredith Johnson. “Understand the immediate tax impact of an IPO (double-trigger RSUs) and whether there is an opportunity to opt in to alternative tax withholding. Review vesting schedules, early-exercise provisions, and consequences of separation from service.” She suggests a goals-based planning model that considers appropriate cash needs to determine a client’s sales strategy.

Kristin McKenna recommended that you “use the calendar year to your advantage.” This can help you decide whether it’s time to take profits and risk off the table, such as selling before year-end, which also avoids any AMT on ISOs exercised early in the year. She also urges her clients to get organized with separate bank account for taxes and cash to exercise, while tracking the lockups’ end and any special milestones, such as those related to an acquisition vesting or payout.

5. Lessons Learned From The Recent Big Wave Of IPOs, M&A, And Startup Financing

There has been a “sheer explosion of IPOs” over the past year, noted Devin Blackburn. “They are up more than 650% compared to a year ago.” Like many of their colleagues, the advisors on the webinar panel have been thoroughly battle-tested by guiding clients from the startup stage through the hectic climax of an IPO or acquisition, and then in the newly acquired wealth beyond. “Never assume that someone with a tidal wave of wealth has an adequate team, wealth plan, or estate-planning documents,” added Devin. “Founders, employees, and early investors need guidance.”

“Client education and communication are particularly important for clients who are unaccustomed to working with professional advisors,” observed Meredith Johnson. “Have the uncomfortable discussion about market risk—founders in particular see their stock in a rosy light.”

“Recognize that things can change quickly,” warned Kristin McKenna. “The market for IPOs and M&A can change rapidly, and stocks don’t just go up.” She advises her clients to “focus on what you can control.” Controllable factors she emphasizes include portfolio diversification to manage the risks of concentration in your company’s stock. They also include carefully watching “lifestyle inflation,” i.e. the growth of spending with sudden new wealth.

Further Resources

The webinar in which these advisors spoke is available on demand at the myStockOptions Webinar Channel. In addition to what’s covered in this article, the advisors addressed numerous advanced topics, such as estate planning, SPAC acquisitions as way to go public, and company-sponsored liquidity sale programs (e.g. tender offers) for later-stage private companies. The sections Pre-IPO and M&A at myStockOptions also cover a range of topics on the financial and tax planning for equity comp in private companies.

myStockOptions Webinar Channel

See the myStockOptions Webinar Channel for upcoming webinars and past webinars on demand. Each on-demand webinar (100 mins) offers 2.0 CE credits for CFP, CPWA/CIMA, and CEP:

Stock Comp Financial Planning For Private Company Employees: From Startup To IPO Or Acquisition: Equity comp in private companies is different. Learn the related financial and tax planning with three leading financial advisors, including real-world case studies.

Restricted Stock & RSU Financial Planning: Advanced Bootcamp: Insights from a panel of three leading financial advisors, including case studies, to provide practical expertise for restricted stock/RSUs in public and private companies.

Stock Option Exercise Strategies: Advanced Bootcamp: It is crucial to have a plan for stock option exercises. This webinar features compelling strategies from a panel of three experts in financial and tax planning for option exercises.

Stock Compensation Bootcamp For Financial Advisors: Whether you are new to stock comp or want to sharpen your knowledge, our bootcamp webinar provides practical information and insights to maximize success.

Strategies For Concentrated Positions In Company Stock: Wealth is won and lost through the management of concentrated company stock positions. In this webinar, experts at managing concentrated stock wealth explain strategies and solutions.

10b5-1 Trading Plans And Other SEC Rules Advisors Need To Know: Learn the fundamentals, best practices, and most effective designs for Rule 10b5-1 trading plans. This webinar features top legal and financial experts presenting practical guidance and real-world case studies for financial advisors.

Financing Stock Option Exercises In A Private Company: A Financial Advisor's Guide

Many private companies are growing fast, with the intention to go public or be acquired. They tend to rely heavily on stock options or restricted stock units (RSUs) to attract, motivate, and retain the best employees. However, employees with stock compensation in a private company, whether in startup, growth, or pre-IPO phase, face a big obstacle that their counterparts in public companies do not.

The stock of private companies has no liquidity, as it's not listed on stock exchanges and resales are restricted by both SEC and company rules. In other words, you cannot sell your shares, even to pay taxes owed on them or to help fund the exercise of stock options. Stock options in private companies can create wealth; but unlocking its value when the stock has no immediate liquidity calls for special planning.

For insights on what you can do, and the growth in firms that provide financing to exercise private company stock options, we asked Valerie Gospodarek, CFA, an independent financial advisor with over 25 years of experience in the finance industry. She specializes in helping clients with their executive compensation, including stock options, restricted stock, and deferred compensation plans.

What is different about exercising stock options in a private company?

When you receive stock options from a company that is publicly traded, you have much greater flexibility in how to exercise them. Among the various exercise methods available, you can choose a “cashless” or “sell-to-cover” exercise, requiring no upfront payment. With these types of exercises, two transactions actually take place, although they happen practically simultaneously and are often viewed as just one. The first transaction consists of purchasing the shares at the exercise price. The second transaction consists of then selling all those shares (or a portion of, in the case of a “sell-to-cover” exercise) at the current market price and using the proceeds to pay for the share purchase in the first transaction and withhold any required taxes (for nonqualified stock options, not for incentive stock options).

With a private company, you can execute the first part of the exercise transaction—purchasing the shares at the exercise price. However, because the shares just acquired have no public market in which they can be sold and are not registered with the SEC, you cannot use the second part of the transaction (selling the shares) to finance the first part (purchasing the shares and paying any taxes).

How does this challenge for private company employees affect their ability to maximize the benefits of stock options?

It means you must come up with the cash required to both purchase the shares at the exercise price and pay for any tax withholding. The price to exercise (and the corresponding taxes) can be significant, and often employees don’t have this large sum of cash readily available to cover these costs. Even if purchasers for these private company shares exist, the company’s stock plan documents often restrict these types of resale transactions.

Do employers provide any financing for option exercises and the corresponding taxes?

Private companies may provide loans to their employees for the purpose of exercising their options, but I do not generally recommend this alternative to my clients. Should the company fail, creditors of the company can, and most likely will, aggressively seek repayment of these loans. At that point, the optionholders then find themselves without a job AND obligated to repay a loan on worthless shares of the company’s stock.

It is worth knowing that if you do use a promissory note from your employer to exercise your stock options and it is a nonrecourse note (i.e. no personal liability if you default), it is not considered an exercise for tax purposes until the note is substantially paid. When the promissory note is with a third party (e.g. a bank) and the stock is pledged as collateral, this is considered an exercise and the standard tax treatment at exercise applies, even if the stock price drops and you default on the loan.

How do you help a client think through whether to self-finance an exercise?

Clients not only need to have the ability to self-finance, but also the willingness. Therefore, the first topic I typically discuss with clients is their prospects for the company, including their expected upside/downside potential for the business and stock, and the anticipated timing for a liquidity event (i.e. IPO or acquisition).

I’ve found that most employees are typically quite bullish about their employer’s prospects, so I often play devil’s advocate to try to temper their overly bullish outlook and come to more reasonable expectations. As part of this discussion, I ask the client how much they would be willing to invest in their company knowing that there is a chance that it could go to zero.

Clients must be comfortable not only with the possibility of losing their entire investment but also with the fact that they will not get back any of the taxes they paid to exercise those options that are now worthless shares of stock. While this is particularly relevant if the employer is in its early stages and any potential liquidity event is several years away, it is a scenario that all optionholders should consider before investing their own capital. If this risk of loss will keep the client up at night, then it likely makes more sense to consider outside financing.

When a client decides to self-finance the exercise, how do you help them decide how to do it (e.g. from savings, borrowing from relatives, a home equity loan)?

When we have determined that a client’s employer’s prospects are attractive and that the client is willing to accept the risk of investing their own funds, then we will review the client’s ability to self-finance by looking at their current savings and cashflows. When it’s determined that there is cash remaining after a client’s expenses are met for the next 2–3 years, we will discuss the pros and cons of using their reserves to exercise their options.

If the anticipated timing for a liquidity event for the stock is within a year and the potential upside is significant, then I will likely recommend that they self-finance the exercise and retain all the potential upside, rather than committing a significant portion of it to an outside financing company. If the liquidity event is 1–2 years away, we will discuss a combination of self-financing and outside financing.

If clients do not have cash available to fund such an investment, but it still makes sense to self-finance, we will then look at their other assets that might be able to fund the option exercise. In this case, they may have other taxable investments trading at losses or minimal gains where the upside potential is less than that of their private company stock. I generally do not recommend that clients take loans against, or cash out, retirement plans to generate cash, as these tend to be more expensive and risky ways to raise funds.

If clients do not have cash or other investments available to finance their option exercises, we will then discuss the advantages and disadvantages of using traditional loans, especially home equity loans if they have significant equity in their primary residence. However, while it is difficult to beat the low interest rates on home equity loans currently, many traditional lenders will not allow for loan proceeds to be used for investments, limiting their use as a source of funds to exercise stock options. In addition, clients must be comfortable with the fact that should their company stock go to zero, they still need to repay the amount they were loaned to purchase those now worthless shares.

Relatives may be willing to provide loans to clients for the purpose of exercising their stock options, and these loans may have more attractive terms than those from outside financing companies. If this is the case, we will discuss not only the terms of the loan, but how borrowing from a relative may affect their future relationship with that relative. If the terms are better than what would be owed to an outside company, and the client is confident that accepting and possibly not repaying the loan will not damage their relationship if the company fails, then I will likely support this alternative.

If none of these alternatives for self-financing or family financing make sense for the client, then we will discuss funding the exercise wholly with outside financing.

Have there always been outside companies that specialize in provide financing for exercising stock options?

A whole cottage industry has sprouted up over the past decade that provides financing capital to private company optionholders. This industry has become quite large over time, with one of the largest financing companies having provided funding to employees at 80% of all US-based “unicorn” startups just since January 2020.

What are some of these providers of outside financing for private company option exercises?

Some of the larger, more prominent providers include (in alphabetical order) Equity Bee, ESO Fund, Liquid Stock, Quid, and SecFi. An internet search of “stock option financing” and/or “stock option lenders” will result in these and several other financing firms.

How does this type of financing work? Are these financing companies actually investing in the stock options or just lending to employees to exercise them?

These financing companies may provide the financing themselves if they manage a private equity or hedge fund for this purpose, or they may just act as an intermediary, connecting investors to optionholders. Either way, the financing company delivers the funds employees need to exercise their options themselves and pay the corresponding taxes.

It is important to note that these financings are not traditional loans that have annual percentage rates and fixed repayment dates. They are contractual agreements where the optionholder agrees to repay the funds (plus fees and some of the stock’s upside—more on this later) after the stock becomes liquid, such as after an IPO.

Many of these financings are “nonrecourse,” meaning that should the company fail, the optionholder is not responsible for paying back the financing amount. Because the financing company is bearing the risk of not being repaid, it will want to review the optionholder’s company for its potential upside, similar to how investors research which publicly traded stocks to invest. This may or may not require that the optionholder’s company share nonpublic information, including financial data.

The contract between the financing company and the optionholder is initially based upon the optionholder’s willingness to repay the financing amount plus the agreed upon upside and fees, since most shares acquired upon exercise are not typically able to be used as collateral due to restrictions in the company’s stock plan documents. The financing amount plus the agreed upon upside and fees are generally repaid after any lockup period has expired and the optionholder is able to dispose of their shares in the public market.

Do the terms of these agreements differ by the company providing the financing?

There are nuances in how each company structures their financing. For example, some may charge an additional fee for “brokering” a deal, in other words finding investors interested in providing the financing. In these cases, that fee would be in addition to the upside paid at the end of the lockup period. Other financing firms may only agree to provide financing if the optionholder’s employer agrees to allow it access to other optionholders within their company. Still other firms may require the shares become collateral for the financing once any lockup period has ended.

Does an employee lose some of the upside in using this outside financing?

Yes. Optionholders can generally expect to give up one quarter to one half of the stock’s upside on average, including fees, with these types of financings. For an example of how this works, see Exhibit 3 in Stock-Option Financing in Pre-IPO Companies (Rock Center for Corporate Governance at Stanford University Working Paper Forthcoming).

This upside (and fees) is what the financing company receives for taking on the risk of the company potentially failing, as discussed earlier. Every financing deal will be priced differently depending upon the specific circumstances, including, but not limited to, the perceived upside of the stock, the length of time expected until a liquidity event for the stock occurs, and the amount of financing provided.

Does using outside financing change the tax treatment at exercise?

Generally speaking, no, but some of the arrangements may allow for the amount paid by the optionholder to the financing company above the initial financing amount to qualify as a capital loss, potentially offsetting gains from selling shares. These financing structures are complicated, though, so I always recommend that clients consult with a tax professional who specializes in stock compensation before entering into any stock option financing contracts.

What are the pros and cons of using an outside financing company to exercise?

One of the largest advantages is optionholders’ ability to exercise their options without having to self-finance with what could be a very significant outlay of cash. This is of particular benefit if employees are facing potential forfeiture of their vested options without the funds to exercise them, for instance if leaving their company for another job. Another benefit is not losing one’s own money or having to repay a nonrecourse financing should the employee’s company fail and the stock goes to zero. Lastly, obtaining outside financing may allow the optionholder to exercise their options earlier than without that funding. Taxes can be significantly lower by exercising early, particularly when the stock price is low after grant. Early exercises also start the capital gains holding period for future sales of the stock to qualify for the lower long-term capital gains tax treatment (versus ordinary income).

Giving up a portion of the stock’s upside (plus fees) if the stock ends up being very successful is obviously the biggest detractor to receiving outside financing. In addition, the added tax complexity that can arise from complicated structures used by outside companies in providing financing can result in significant tax consulting and preparation fees.

Additional Resources

See the section Pre-IPO at myStockOptions.com for more information and insights on financial planning for employees in private and pre-IPO companies. myStockOptions has also held a special webinar on these topics: Stock Comp Financial Planning For Private Company Employees: From Startup To IPO Or Acquisition (available on demand at the link).

myStockOptions Webinar Channel

See the myStockOptions Webinar Channel for upcoming webinars and past webinars on demand. Each on-demand webinar (100 mins) offers 2.0 CE credits for CFP, CPWA/CIMA, and CEP:

Stock Comp Financial Planning For Private Company Employees: From Startup To IPO Or Acquisition: Equity comp in private companies is different. Learn the related financial and tax planning with three leading financial advisors, including real-world case studies.

Restricted Stock & RSU Financial Planning: Advanced Bootcamp: Insights from a panel of three leading financial advisors, including case studies, to provide practical expertise for restricted stock/RSUs in public and private companies.

Stock Option Exercise Strategies: Advanced Bootcamp: It is crucial to have a plan for stock option exercises. This webinar features compelling strategies from a panel of three experts in financial and tax planning for option exercises.

Stock Compensation Bootcamp For Financial Advisors: Whether you are new to stock comp or want to sharpen your knowledge, our bootcamp webinar provides practical information and insights to maximize success.

Strategies For Concentrated Positions In Company Stock: Wealth is won and lost through the management of concentrated company stock positions. In this webinar, experts at managing concentrated stock wealth explain strategies and solutions.

Stock Options & RSUs: 5 Costly Mistakes To Avoid

Stock compensation is complex: make no mistake about it. However, that's easier said than done. It's actually all too easy to make costly mistakes with grants of stock options or restricted stock/RSUs, and the related taxation.

In two myStockOptions “advanced bootcamp” webinars this summer, leading experts in stock options and RSUs discussed equity comp blunders to avoid, among many other topics (Stock Option Exercise Strategies and Restricted Stock & RSU Financial Planning). This article covers five common mistakes as explained by these webinar panelists.

Mistake No. 1: Not Understanding Your Grant Or How It Works

This point may seem obvious, but you’d be surprised. Employees sometimes tell their financial advisors they have “stock options” but upon inspection of the plan documents it turns out they have another type of equity comp. So, first of all, confirm which type of equity grant you have.

A related mistake is simply failing to read all the stock plan documents and not fully understanding the terms of the grant. Study up on them. “Grant info needs to be organized, saved, and updated to provide ongoing guidance,” suggests Bill Dillhoefer, the CEO of Net Worth Strategies, the company behind the StockOpter equity compensation analysis applications for financial advisors.

Crucially, understand that stock options have a set period during which they can be exercised after vesting. When the option term ends, unexercised stock options expire and are irrecoverable. Understand the timeframe of your stock options and steps you must follow so that you’re not caught in a scramble to exercise on the final day before expiration. You do not want to let valuable in-the-money stock options expire.

RSUs bring some different planning factors. “Roughly how much will each vested amount be worth, pre- and after-tax?” asks Meg Bartelt of Flow Financial Planning. As an advisor who works with clients at pre-IPO and newly public companies, she also considers the special traits of RSU grants made by private companies. With her clients, she evaluates whether simply working at the company for a specified length of time after the grant is enough for the shares to vest or whether the stock plan requires a second vesting trigger involving a liquidity event (i.e. IPO or acquisition by a public company).

Mistake No. 2: Not Understanding The Taxes Or Letting Taxes Drive Decisions

You need to understand the taxation of your grants before you do anything with them. The tax treatment is crucial for both avoiding IRS problems and making the most of your gains. At the same time, the financial advisors all caution, understanding the taxation doesn’t mean taxes should be the principal driver of decisions.

“While taxes are key factors, it’s dangerous to base decisions principally on tax aspects and neglect coordination with goals and investment risk,” warns David Marsh, a Financial Planning Case Manager at Ameriprise.

In other words, “the tax tail should not wag the option dog,” says Megan Gorman of Chequers Financial Management. However, she acknowledges, “to build wealth, you have to deal with tax consequences.” So how do you get the balance right?

Model tax scenarios for your stock options and be prepared, Megan advises. For example, she points out that you should “be prepared for your company’s tax withholding to not be sufficient to cover your tax bill.” The IRS default flat withholding rate of 22% for supplemental wage income, such as the spread at option exercise or restricted stock unit (RSU) vesting, is often lower than your actual income-tax rate, she observes.

While the withholding rate jumps to 37% for supplemental wage income in excess of $1 million during the calendar year, employees between those extremes still need to pay the taxes not covered by the 22% default rate. The shortfall can be paid in quarterly estimated taxes based on the amount owed, among other methods.

Stock options aren’t the only equity awards with tricky taxes. Mistakes with the taxation of RSUs can also be very costly. “The worst-case scenario with RSUs, in my opinion, is that you lose money on them,” says Meg Bartelt. “And that’s a possibility if you do not sell enough RSUs immediately to cover your full tax bill.” The concern? The stock price could suddenly fall after vesting. “The bottom line is that if the stock price drops enough after the initial withholding of 22% before you sell more shares to pay your taxes, then the shares you still have can be worth less than the taxes you still owe.”

“Get ahead of the game by preparing a projected tax return to see the impact of vesting RSUs on your tax return,” advises Daniel Zajac, co-founder of Zajac Group. “Consider ways to defer other income and/or increase deductions to reduce the spike in your taxable income,” he adds. “For example, increase 401(k) contributions, participate in a nonqualified deferred compensation plan, make bigger charitable donations, or separately increase salary withholding.”

Lastly, watch your tax bracket. Stock compensation can push your income for the year into a higher bracket, leading to more taxes—something that careful timing of option exercises and RSU vestings can avoid. “The total picture of your grants is really important,” says Daniel Zajac. “I’ve seen clients create cash by exercising and selling nonqualified stock options when they’ve just had RSUs vest. That could needlessly push them into a higher tax bracket.”

Mistake No. 3: Forfeiting Your Grant In Job Termination

If you leave your company, the vesting of your stock options stops and the term usually ends early, requiring you to exercise the options soon after your departure to prevent forfeiture. These rules and timeframes can vary according to the reason you left work (e.g. job change, disability, death, retirement).

Chief among the option terms to know are the vesting provisions and what would happen upon job termination, which usually triggers a very short window for option exercise before the grant term expires. “It’s crucial to clarify equity awards’ terms for vesting and at separation of service,” says David Marsh of Ameriprise. “Realize they may not all be the same.”

As for restricted stock units, job termination stops the vesting of RSUs. So if you have a big vesting date coming up, you may want to stick around for it before any planned job change or retirement.

Other types of job terminations and life events may affect vesting differently. “How do leave of absence, disability, death, acquisition of your company, etc. affect the vesting schedule?” is something Chloé Moore, founder of Financial Staples, wants her clients to understand and communicate.

David Marsh lamented that many optionholders neglect to designate a beneficiary for vested stock options in case of death. “This is usually allowed in the plan, but often employees are unaware of that.” Also be sure that beneficiaries and executors of your estate know the option exercise deadlines.

Mistake No. 4: Not Having A Strategic Plan For The Shares

When you exercise stock options or when your RSUs vest, a big mistake is not having a plan ready to go for your newly acquired shares.

Overconcentration in company stock is a major danger employees face with shares they get from equity awards. Loyalty to your company’s stock can work against you if too much of your wealth is tied up in the stock and the price then drops. “It’s amazing to me how many times clients who understand they have a lot of company stock lose track of how concentrated they are and how movements in the stock price and new grants affect that concentration,” says David Marsh. “That’s a particular blind spot,” he warns.

Indeed, it would be hard to find a financial advisor who doesn’t extoll the virtues of diversification. “Investments that are diversified—your money is invested a little bit in a lot of different stocks or bonds—perform better, on average, than investments that are concentrated in one stock,” points out Meg Bartelt.

She often advises clients with just-vested RSU shares to sell all the stock. “Let’s say your RSUs are worth $100,000 when they vest. If I gave you $100,000 in cash income instead, would you go out and use that money to buy your company stock? If your answer is no, then that is literally the same, financially, as selling all your RSU shares.”

In her view, “you’re better off selling them all and using the money immediately for some current need (such as a down payment on a house) or other financial opportunity (such as paying off debt), or investing the money in a broadly diversified, low-cost portfolio.”

Chloé Moore has helped many clients strategize for RSU vesting. In one example that she presented during her webinar segment, her approach included:

• Allocated monthly savings, cash bonuses, and sign-on bonus to short-term savings goals.
• Kept 25% of shares that vested after the one-year anniversary (about 30% of the portfolio and a smaller percentage as the portfolio grew).
• Set aside reserves to pay the tax bill (worked with a CPA to estimate each year’s tax liability).
• Sold remaining shares as they vested and split the proceeds between student loans and savings goals, then eventually a diversified taxable account.

Daniel Zajac often suggests that his clients establish a sell schedule. “One strategy that may balance the decision to immediately retain 100% of the shares or sell 100% is to implement a plan that sells a certain number or percentage of shares over a set period. Setting a sell schedule allows you to intentionally reduce your company stock according to a formula. That removes some of the emotional decision-making from the process. You don’t need to guess what the stock price will do next, or decide you will sell when the price reaches X per share, but change your plans once the price does hit that point. You then risk the price going back down before you do sell.”

Mistake No. 5: Getting Bad Advice On Financial And Tax Planning

Stock compensation is a complex employee benefit. “Complex benefits require us to move slowly and think through issues,” says Megan Gorman. She implores employees with equity comp to obtain guidance from a qualified financial advisor and/or tax expert, and to avoid relying on tips from co-workers. Bill Dillhoefer echoed this sentiment, observing that applying advice from “water-cooler” chats with co-workers can lead to mistakes.

Everyone’s individual circumstances differ. Identifying strategies that work for you is yet another good reason to consult a financial planner. “Strategies are incredibly personal,” agrees Megan. “For your own unique situation, you may need to do very different things than your colleagues.”

Further Resources

On myStockOptions.com, the online educational resource with content and tools devoted to all things equity comp, employees and their financial advisors can prepare for stock option exercises and RSU vesting. For more on mistake prevention, see the following articles:

• How To Avoid The Most Common Stock Option Mistakes by wealth advisor Beth Walker
• How To Avoid Mistakes And Create Wealth With Your Stock Options by CFP Paul Palazzo

In addition, all of the financial advisors quoted in this article have discussed planning strategies in detail during webinars that are available on demand at the myStockOptions Webinar Channel.

 

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WEBINAR: Stock Comp Financial Planning For Private Company Employees: From Startup To IPO Or Acquisition

• Sept. 22, 2pm–3:40pm ET, 11am–12:40pm PT
• 2.0 CE credits for CFP, CPWA/CIMA, CEP, and EA

Initial public offerings (IPOs) are booming as fast-growing private companies go public. Important wealth-building and tax-minimizing decisions are faced by employees and executives at private companies who have stock options, restricted stock, restricted stock units (RSUs), or founder's stock.

In 100 minutes, this webinar covers the fundamentals of private company stock grants and related strategies for financial and tax planning that can help advisors serve these clients effectively, build wealth, and prevent expensive mistakes. The webinar features three leading financial advisors presenting practical guidance and real-world case studies. Their insights and expertise apply to clients at both startups and later-stage private companies, from the time of grant until the company goes public or is acquired.

For a detailed agenda of topics covered, see the webinar registration page.

Time conflict? No problem. All registered attendees get unlimited streaming access to the webinar recording for their personal viewing, along with the presentation slide deck. Therefore, even if you have a time conflict, please still register, as you will receive a link to the recording and presentation.

The Tao Of Stock Options: Exercise Strategies From Stock Option Gurus

When we started myStockOptions.com in 2000, stock options were all the rage in equity comp. While other forms of equity compensation have since come to the fore, most notably restricted stock units (RSUs), stock options remain a major form of equity award for millions of employees in the US.

In this spirit, we recently returned to the roots of our trusted brand name in a very popular webinar, Stock Option Exercise Strategies: Advanced Bootcamp. During this educational event, three experts in option financial planning presented their tips for making the most of an option grant, from basic to advanced concepts. Some of the insights from these option gurus are summarized below.

The Tao Of Stock Options: Be Patient, Grasshopper

Taoism tells us that mindfully strategic inaction, expressed in the concept of wu wei (literally "doing nothing" in Chinese), is often the most effective approach to the challenges of living. And so it often is with employee stock options. Waiting as long as possible to exercise stock options—i.e. doing nothing and letting the value grow until a strategic moment—is often the soundest exercise strategy.

It’s important to note that there are two types of stock options with very different tax treatments. Nonqualified stock options (NQSOs) are the simpler and more common type. Incentive stock options (ISOs) are less common and more complex in that they can offer potential tax advantages but more risk. Most of the discussion in this article concerns NQSOs in public companies.

1. Waiting To Exercise Is Often Best

Stock options let you buy shares of your company’s stock at a fixed price for a specified period, typically over a term of 10 years. Under nearly all grants, you have to work at the company for a specified length of time (the vesting period) before you can exercise the options. If you leave your company, the vesting stops and the term usually ends much earlier, requiring you to exercise the options soon after your departure to prevent forfeiture. These rules and time periods can vary according to the reason you left work (e.g. job change, disability, death, retirement).

Private companies sometimes grant stock options that employees can exercise early, allowing you to start the capital gains holding period sooner and recognize little or no income at vesting. You want to check whether you have this type of stock option and carefully follow the rules (e.g. a timely Section 83(b) election), though this is not the focus of this article.

Options Align Your Pay With Company Performance

In short, stock options let you share in the growth of your company's value without any financial risk until you exercise the options (i.e. acquire shares). If your company’s stock price rises during the option term, the discount between the current stock price and your lower exercise price (the “spread”) can make stock options valuable for creating substantial wealth.

Leverage And Tax Deferral

The fixed purchase price creates the famous financial “leverage” of stock options. For example, if the stock price rises by 20%, the value of your unexercised stock options grows by much more than 20%. As soon as you exercise the options and thus purchase actual shares of stock, the leverage ends. Thus it’s important to think carefully about the right moment to make that move.

Moreover, while cash bonuses and most other forms of compensation are taxable when you receive them, stock options defer taxes until you exercise them. Before you exercise your options, their built-in value is subject to pre-tax growth—which can be significant.

For all of these reasons, the panelists in the myStockOptions webinar agreed: often no advantage exists in exercising nonqualified stock options in a public company soon after vesting, paying taxes on the spread, and then holding the shares for long-term capital gains (unless special circumstances occur, such as job termination). As long as the stock price continues to rise, thus increasing the spread over the exercise price, the leveraged value of the options grows without any tax hit, and your net after-tax proceeds will be larger.

In other words, the “Tao of Stock Options” might be the paradox that doing nothing for as long as possible could confer the greatest value.

Opportunity Cost

Consider also the opportunity cost of exercising and holding NQSOs. Financial advisors often liken stock options to an interest-free loan. “An option’s value is enhanced by the ability to use the capital that would otherwise be invested in the stock for some other investment,” said webinar panelist Bill Dillhoefer, CEO of Net Worth Strategies (creator of the StockOpter decision-making tool for employee stock options).

For example, he explained that if your options have a 10-year term and the company’s stock price keeps rising, the options have growing tax-deferred value before you have spent any money on them. Funds that you would otherwise put into buying the company’s stock can be used for other investments, then directed later into the option exercise at a strategic moment for larger gains.

Bill’s approach, which he detailed in the webinar, applies various ratios that consider special factors to calculate the optimum time to exercise options. For instance, when the stock price is much higher than the exercise price, these options with a big spread have less leverage and smaller upside from stock-price increases. These are the NQSOs that you might want to exercise and then immediately sell the shares.

2. Risk Versus Reward

As always with investing, stock options involve risks as well as rewards. If the stock price plummets below your exercise price, the value of the options vanishes (i.e. they go “underwater”). Decisions about when to exercise must therefore factor in the outlook for the company’s stock price.

The webinar panelists also discussed the risk of overconcentration, i.e. having too much of your net worth tied up in the stock of just one company. A single stock price can quickly fall. A diversified stock portfolio helps to mitigate that risk. When you calculate your concentration level, you should include any vested stock options you have. That can give you yet another reason to wait on exercising your options until you have a solid post-exercise plan that includes selling shares for diversification.

How can you balance the risks and the rewards? “Fundamentally, it is useful to base decisions with any type of equity award primarily on financial goals, timeframes for those goals, and the investment risk along the way,” explained David Marsh, Financial Planning Case Manager with Ameriprise Financial.

“Create perspective,” asserted his fellow webinar panelist Megan Gorman, a financial advisor, founder of Chequers Financial Management, and a Forbes senior contributor. “If you show the best-case scenario, also show the worst.”

To lessen concentration risk and promote diversification, a strategy formulated with a financial advisor should also extend well beyond exercise, said Megan. “Have a strategy on selling stock and where the proceeds are going to be reallocated to.” When you have a strategy, one way to document it (and provide some protection from accidental insider trading) is with a Rule 10b5-1 trading plan. She uses these for her executive clients.

3. Taxes

All of the webinar panelists agree that taxes should not be the principal driver of decisions. “While taxes are key factors, it’s dangerous to base decisions principally on tax aspects and neglect coordination with goals and investment risk,” warned David Marsh. In other words, chimed in Megan Gorman, the tax tail should not wag the option dog.

Nevertheless, Megan continued, it is important to model tax scenarios for your stock options and be prepared. “To build wealth, you have to deal with tax consequences.”

She added that for NQSOs you should “be prepared for your company’s tax withholding at exercise to not be sufficient to cover tax bill.” The IRS default statutory withholding rate of 22% for supplemental income, such as the spread at option exercise or restricted stock unit (RSU) vesting, is often lower than your actual income-tax rate. While the withholding rate jumps to 37% for supplemental wage income in excess of $1 million during the calendar year, employees between those extremes will have to plan how to pay the taxes not covered by the 22% default rate. The shortfall can be paid in quarterly estimated taxes based on the amount owed, among other methods.

4. Understand The Stock Plan Documents

One of the biggest mistakes with stock options is failing to read the stock plan documents and not fully understanding the terms of the grant, according to the experts in the webinar. “Grant info needs to be organized, saved, and updated to provide ongoing guidance,” cautioned Bill Dillhoefer.

Chief among the option terms to know are the vesting provisions and what would happen upon job termination, which usually triggers a very short window for option exercise before the grant term expires. “It’s crucial to clarify equity awards’ terms for vesting and at separation of service,” stated David Marsh. “Realize they may not all be the same.”

He also noted that many optionholders neglect to designate a beneficiary for vested stock options in case of death. “This is usually allowed in the plan, but often employees are unaware of that.”

5. Seek Help From A Qualified Advisor

“Stock options are complex employee benefits,” asserted Megan Gorman during her segment of the webinar. “Complex benefits require us to move slowly and think through issues.”

She implores optionholders to obtain guidance from a financial advisor and tax experts with experience in stock options, and to avoid relying on tips from co-workers. “Exercise strategies are incredibly personal,” Megan emphasized. “For your own unique situation, you may need to do very different things than your colleagues.” Bill Dillhoefer echoed this sentiment, observing that applying advice from “water-cooler” chats with co-workers about stock options can lead to mistakes.

More Insights Into Option Exercise Strategies

For many more insights about option exercise strategies, see financial-planning articles by expert contributors at myStockOptions.com. In addition, the webinar where Bill, David, and Megan presented advanced planning strategies and case studies, involving both NQSOs and ISOs in public and private companies (Stock Option Exercise Strategies: Advanced Bootcamp), is available on demand at the myStockOptions Webinar Channel (more details on that below).

myStockOptions Webinar Channel

See the myStockOptions webinar channel to register for our upcoming webinars and purchase our past webinars on demand in streaming format. On-demand webinars include:

Restricted Stock & RSU Financial Planning: Advanced Bootcamp (100 mins). This lively webinar features insights from a panel of three leading financial advisors, including case studies, to provide practical info, guidance, and expertise for restricted stock/RSUs in both public and private companies. 2.0 CE credits for CFP, CPWA, CIMA, and CEP.

Stock Option Exercise Strategies: Advanced Bootcamp (100 mins). Stock options can offer great leverage, but it must be wielded wisely. It is crucial to have a strategic plan for stock option exercises. This webinar features compelling insights from a panel of three experts in option exercise strategies. 2.0 CE credits for CFP, CPWA, CIMA, and CEP.

Stock Compensation Bootcamp For Financial Advisors (100 mins). Whether you are new to stock comp or want to sharpen your knowledge, our bootcamp webinar provides practical information and insights to maximize success. 2.0 CE credits for CFP, CPWA, CIMA, and CEP.

Strategies For Concentrated Positions In Company Stock (100 mins). Wealth is won and lost through the management of concentrated company stock positions. In this webinar, experts at managing concentrated stock wealth explain the wide range of strategies and solutions available for preventing losses and meeting goals. 2.0 CE credits for CFP, CPWA, CIMA, and CEP.

Know Your Options: Comparing NQSOs And ISOs

Stock options became famous during the 1990s. It was then that many companies, even those beyond the tech industry, started to make broad-based option grants to rank-and-file employees, not just to executives, as a strategy to lure top talent. Even Seinfeld took notice. "So," Elaine says to Jerry and George in "The Money" (1997), "you understand how my Peterman stock options are gonna work?" While George (of course) feels only petty envy that she makes more than he does, it is a very good question. Before you exercise employee stock options and do any financial planning with them, you need to understand which type of options you have and their tax treatment.

While since the 1990s many companies have come to favor other equity grants, such as restricted stock units (RSUs) and performance shares, stock options remain a major form of equity compensation. Companies can grant two types: nonqualified stock options (NQSOs), the more common variety, and incentive stock options (ISOs), which offer some tax benefits but also raise the complexities of the alternative minimum tax (AMT).

Which Type Of Options Do You Have?

Before exploring the differences between NQSOs and ISOs, you must check your grant agreement and know which type of options you have. Many companies now have omnibus stock plans in which they are authorized to grant not only both types of stock options but also restricted stock, RSUs, performance shares, and stock appreciation rights (see, for example, Uber’s 2019 equity incentive plan). This is why you need to look at your specific grant to be sure of the award type you are receiving. If it’s still not clear to you, then ask the stock plan administrator or person at your company in charge of managing the employee stock option plan.

Nonqualified Stock Options

A nonqualified stock option (NQSO) is a type of stock option that does not qualify for special favorable tax treatment under the US Internal Revenue Code. Thus the word nonqualified applies to the tax treatment (not to eligibility or any other consideration). A few basic NQSO facts:

• NQSOs are the most common form of stock option and may be granted to employees, officers, directors, contractors, and consultants.
• Unexercised NQSOs can be transferred to others, such as upon divorce or gifting.
• There is no tax-code limit on the total number or value of NQSOs that can be granted.

You pay taxes when you exercise NQSOs. For tax purposes, the exercise spread is compensation income and is therefore reported on your IRS Form W-2 for the calendar year of exercise.

Example: Your NQSOs have an exercise price of $10 per share.

• You exercise them when the stock price is $12 per share.
• You have a $2 spread ($12 – $10) and thus $2 per share in ordinary income.
• You sell the stock at $16 per share, giving you $4 per share in capital gains ($16 –$12 tax basis). Whether the gain is long-term or short-term depends on your holding period after exercise.

When you exercise NQSOs, your company will withhold taxes: federal income tax, Social Security (up to the yearly limit), Medicare, and state taxes (if applicable). This withholding appears on your Form W-2 for that calendar year.

When you sell the shares, whether immediately at exercise or after a holding period, you need to report the stock sale on Form 8949 and Schedule D of your IRS Form 1040 tax return. For a detailed explanation of the tax rules, see the related sections of the Tax Center at myStockOptions.com.

Incentive Stock Options

Incentive stock options (ISOs) qualify for special tax treatment under the Internal Revenue Code and are not subject to Social Security, Medicare, or withholding taxes. However, to qualify they must meet criteria specified under the tax code:

• ISOs can be granted only to employees, not to directors, consultants, or contractors.
• There is a $100,000 limit on the aggregate grant value of ISOs that may first become exercisable (i.e. vest) in any calendar year.
• For an employee to retain the special ISO tax benefits after leaving the company, the ISOs must be exercised within three months after the date of employment termination (longer periods apply for disability and death).
• Unlike NQSOs, ISOs cannot be transferred to others (e.g. upon divorce or by gifting).

ISO Holding-Period Rules: Benefits But Risks

After you exercise ISOs, if you hold the acquired shares for at least two years from the date of grant and one year from the date of exercise, you incur favorable long-term capital gains tax (rather than ordinary income tax) on all appreciation over the exercise price. Meeting the holding-period requirements of an ISO can result in substantially lower taxes.

Example: Your exercise price is $10, i.e. the stock price at grant. You exercise when then market price is $15.

Holding period	Sale price	Taxable income
Less than 1 year from exercise*	$17	$5 ordinary income (reported on W-2) + $2 short-term gain
1+ year from exercise, 2+ years from grant	$17	$7 long-term capital gain, no ordinary income

*ISO taxation depends on: (1) when shares are sold; (2) the sale price relative to the exercise price and the market price at exercise.

However, the exercise spread on shares acquired from ISOs and held beyond the calendar year of exercise can subject you to the alternative minimum tax (AMT) and additional tax-return reporting (e.g. Form 6251). This can be problematic if you are hit with the AMT on paper gains but the company's stock price then plummets, leaving you with a big tax bill on income that has evaporated.

Alert: If you have been granted ISOs, you must understand how the AMT can affect you. You should do an AMT calculation whenever you exercise ISOs and hold the shares.

Summary

The table below, from myStockOptions.com, summarizes and compares selected major traits of NQSOs and ISOs.

Option type	Eligibility	Event that triggers taxes	Taxes	Withholding?	Tax at sale
NQSOs	Company employees, executives, directors, contractors, and consultants	Exercise	Ordinary income tax, Social Security, and Medicare on the exercise spread	Yes, at exercise	Capital gains tax
ISOs	Only company employees and executives	Sale, unless AMT incurred	Ordinary income tax, AMT, or none*	No	Capital gains tax*

*ISO taxation depends on: (1) when shares are sold; (2) the sale price relative to the exercise price and the market price at exercise.

Further Resources

For more knowledge and financial-planning insights on these different types of stock options, see the NQSO and ISO sections of myStockOptions.com. To discover what your gains would be after exercising options and selling the stock, try the site's Quick-Take Calculator for Stock Options and other tools. For potential differences in these grants at private companies, see the section Pre-IPO at myStockOptions.com.

Private Company Grants Of Stock Options & RSUs: IRS Guidance Provides Limited Support

Equity compensation in privately held companies is tricky for both employers and employees because the companies’ stock is not publicly traded and is therefore illiquid. Introduced by a complex provision of the Tax Cuts & Jobs Act (“tax reform”), which took effect this year, a new section of the tax code, Section 83(i), seeks to make equity comp more appealing to private companies. It lets them make grants of nonqualified stock options (NQSOs) or restricted stock units (RSUs) in which the recipient can defer income taxes for up to five years from NQSO exercise or RSU vesting as long as the grants meet certain conditions. These are called “qualified equity grants.”

However, the initial reaction by private companies to this new opportunity has been cautious and cool. Before plunging in, many have awaited clarification and guidance from the IRS on the many technical requirements and details of the new grant type. In Notice 2018-97, the IRS finally issued guidance for companies on qualified equity grants, with more to come, but it may do little to enhance the appeal of these grants for smaller startups.

The Tax Problem Congress Wanted To Solve But Only Made More Complicated

While stock options and restricted stock units are popular at startups and other pre-IPO companies, employees cannot sell stock at exercise or vesting, even to pay the taxes owed on the income. The IRS confirmed in regulations issued during 2014 that the tax measurement date (at exercise for options and at vesting for restricted stock) is not delayed by any lack of liquidity or securities law restrictions on resales of stock.

The fact that the tax treatment for stock grants at pre-IPO and large publicly traded companies is identical seems oddly unfair when you consider the vastly differing liquidity situations of private and public company employees. While private companies want to use equity grants to motivate, retain, and create employee-shareholders, they do not want to obligate their employees to pay taxes on shares they cannot sell. Seeking to ease this conundrum, Congress first considered the Empowering Employees Through Stock Ownership Act. That bill eventually transformed into part of the Tax Cuts & Jobs Act. To provide for qualified equity awards, it added Section 83(i) to the Internal Revenue Code.

Qualified Equity Grants: Outline Of New Tax Deferral

Instead of automatically delaying when taxation occurs after employees receive illiquid private company stock as compensation, Section 83(i) imposes elaborate rules on what types of grants qualify, what types of employees qualify for these grants, employee deferral elections, and procedures companies must follow. The table below summarizes some of the main features of the new Section 83(i).

Key Facts For Tax Deferral Of Private Company Stock Grants

Eligible types of stock compensation	NQSOs and RSUs
Tax deferred	Federal income tax
Deferral period	Five years, unless triggered earlier
Election required	83(i) election within 30 days of exercise or vesting
Company requirements	Numerous, including grants to 80% of employees

For more details on this tax code provision, see our related article: Private Company Stock Options And RSUs: 10 Facts To Know About The New Tax-Deferral Opportunity.

Three Topics IRS Guidance Addresses

In Notice 2018-97, the IRS clarifies and creates rules in three areas that are evidently the most pressing for companies.

1. Time requirement for the 80% rule. To make qualified equity grants, the company must issue grants to at least 80% of employees in a single calendar year. The law does not provide for a cumulative basis that considers grants from prior years. Apparently, the IRS felt it had to go with the statutory language.

Potential impact: This makes it more difficult for early-stage startups, as they primarily make new-hire grants, not annual grants that can more easily fit into a calendar year. For example, imagine a 10-employee startup in which everyone gets meaningful grants at hire. Next year, the company hires two more employees, who also get meaningful grants. Although 100% of employees have equity awards, the company made grants to only 20% in that year, and therefore those grants cannot be tax-qualified. Don’t blame the IRS for this outcome until Congress amends the law.

Big private companies, such as the Unicorns (e.g. Uber, Airbnb), along with other large late-stage pre-IPO companies that make broad-based grants, will find it easier to meet the 80% rule. Their grant practices have probably evolved to become more regular, with annual and bonus grants.

2. Tax withholding. Companies must set up a procedure to escrow the deferred shares employees receive at exercise with options or vesting with RSUs. They then use some of the shares to pay the withholding tax that is eventually due after five years or a liquidity event. Employees must agree to this arrangement at the time of their deferral election.

Potential impact: This new requirement, not stated in the new law, addresses company and IRS concerns about how the taxes will be paid. This becomes a big issue if no liquidity event occurs or when ex-employees cannot be located. The approach does add more costs, procedures, and communications to what companies are obligated to implement.

The requirement makes qualified equity grants more appealing to well-established private companies that are likely to go public or get acquired. They have the resources to set up this type of arrangement. Their employees also assume less risk and thus more potential benefit with the deferral, as they are acquiring stock that has demonstrated value and the potential for liquidity within the five-year deferral period.

3. An opt-out: Companies can designate grants that are ineligible for the employee deferral election. They do this by not setting up the share escrow arrangement or not following other conditions for qualified equity grants.

Potential impact: Companies were concerned that they could unintentionally meet the conditions allowing employees to make a deferral election, potentially causing the company to be penalized for not following the new law’s requirements for employee notices and communications. While the IRS guidance clarifies how companies can opt out of the provision, the pressing need for IRS guidance on how to opt out suggests companies are not eager to make these type of stock grants. Early-exercise stock options or vesting conditions that require an IPO or acquisition will probably remain more popular ways to specially structure stock grants at private companies.

For more information about the taxation of stock options and restricted stock/RSUs, see the Tax Center at myStockOptions.com. The website’s section on pre-IPO companies covers topics related to stock grants at private companies.

SCOTUS Decision On Stock Options At Railroad Companies: Do The Justices Understand Stock Compensation?

Some interesting summer reading came our way in a recent Supreme Court decision that features stock options: Wisconsin Central Ltd. v. United States. The decision is an easy read that provides some insights into what the justices in our highest court know about equity compensation. While initially it appears that the application of the decision is narrow and applies only to employee stock options (also perhaps RSUs and other types of stock compensation) at railroad companies, the implications are broader.

In short, by a 5–4 margin, the Supreme Court ruled that options are not taxable compensation under the Railroad Retirement Tax Act (RRTA) because they are not "money remuneration" as meant by the term in the statute, which was written in 1937. Significantly, when Congress adopted the RRTA it also enacted the Federal Insurance Contributions Act (FICA), which taxes "all remuneration," including benefits "paid in any medium other than cash." Therefore, according to Justice Neil Gorsuch, who wrote the majority opinion, "the Congress that enacted both of these pension schemes knew well the difference between 'money' and 'all' forms of remuneration and its choice to use the narrower term in the context of railroad pensions alone requires respect, not disregard."

The RRTA, which few stock comp professionals are familiar with, provides funding for pension-like benefits to railroad employees instead of Social Security retirement benefits. The spread at exercise would still be subject to the standard income tax rules, as the NASPP recently confirmed in its blog. For railroad companies, a commentary from PwC provides some guidance on the decision. Of course, for those not working on the railroads, the spread at the exercise of nonqualified stock options (NQSOs) remains subject to Social Security and Medicare taxes.

Does The Supreme Court Understand Stock Options?

The vote on the court followed the conservative-versus-liberal pattern of many 5–4 decisions. Therefore, in our view, the majority opinion and the dissenting opinion (by Justice Breyer, joined by Ginsberg, Sotomayor, and Kagan), represent an argument over two points:

• the approach the Supreme Court should take in interpreting statutory language
• the ability of government agencies, such as the Treasury Department and the IRS, to issue regulations when terms of a statute are ambiguous

Like any well-written Supreme Court decision, this case can be analyzed on many different levels. At myStockOptions.com we were interested to see how well the Supreme Court justices understand and explain stock options and equity compensation. They seem to know how stock options work, they recognize the differences in the taxation of ISOs and NQSOs, and they comprehend the underlying purpose of equity compensation for employers. Justice Gorsuch succinctly states that the goal of options is "to encourage employee performance and align employee and corporate goals" and describes in his own way the various exercise methods. In his dissent, Justice Breyer discusses how companies use stock options to compensate employees—in part, "hoping that by doing so they will provide an incentive for their employees to work harder to increase the value of the company."

For Justice Gorsuch, the author of the majority opinion, it didn't seem to matter as much that stock options can be easily exercised and the shares sold for money. Yet in the minority opinion, Justice Breyer elucidates in detail the procedure for cashless exercises and provides data on how a large percentage of employees at railroad companies use this exercise method. He also notes that many of the country's "top executives are compensated in both cash and stock or stock options," with stock-based compensation often exceeding cash salary. The strongest argument in his dissenting opinion is that cashless exercise makes options almost identical to money remuneration. After reading a summary of the justices' questions during the oral argument and the lawyers' replies, we do wonder if the decision hinged on whether the justices who supported the majority opinion fully understood how cashless exercises really work. For stock plan professionals who lived through the intense debates as to whether stock options should be expensed on the income statement (they have been since 2006), it is odd that the decision does not mention the accounting rules, even in its discussion of whether options have a "readily discernible value."

Stock Options And Tax Returns: Nine Big Mistakes To Avoid

Although they are called "stock options," the tax-return reporting for options is anything but optional. Whether you exercised stock options and held the shares during 2016 or sold shares acquired from stock options, the resulting income or gain must be included in the tax return that you file in 2017. As with much of equity compensation, tax issues with stock options can be tricky.

Alert: If you sold stock during 2016, you must file with your tax return IRS Form 8949 along with Schedule D, using what your brokerage firm reports to you on IRS Form 1099-B. In most situations, the cost-basis information on Form 1099-B for stock sales from equity compensation cannot be used "as is" for accurate tax-return reporting. If you do not understand the rules, you will overpay taxes (see a related FAQ at myStockOptions.com).

Below are several mistakes to be aware of and avoid when completing your return.

1. With a cashless exercise/same-day sale, the spread is reported on your W-2 and on your tax return as ordinary income. Even though you never owned the stock after exercise, you still need to report this transaction on Form 8949 and Schedule D, which are used to report capital gains and losses on all stock sales. You may even have some small gains or losses, depending on how your company calculates the spread at exercise and on any commissions and fees for the stock sale. For an annotated example of how to report the cashless exercise on these forms, see the FAQ on this topic at myStockOptions.com.

Alert: If the IRS were to receive a report of your gross sale proceeds from your broker (on Form 1099-B) but without a corresponding report of the sale on your Form 8949 and Schedule D, it would think you had failed to report the gain on the sale. Assuming a tax basis of $0, the IRS computers would then automatically send you a notice for the taxes due.

2. With nonqualified stock options (NQSOs), for employees the spread at exercise is reported to the IRS on Form W-2 (for nonemployees, it is reported on Form 1099-MISC). It is included in your income for the year of exercise. (Income from an ISO disqualifying disposition, such as an early sale, will also appear.) Thus, when you report the sale on Form 8949, if Box 1e on your 1099-B reports the exercise price as the cost basis, do not list the exercise price as your cost basis without also making an adjustment in column (g). Only for ISO stock sold in a qualifying disposition will the tax basis equal the exercise price.

Alert: If the cost basis is not reported on Form 1099-B, avoid double taxation by listing the market price on the date of exercise as your cost basis in the stock. The basis should be the exercise price plus the amount of ordinary income you already paid taxes on. For an annotated diagram showing how to report the company stock sale on Form 8949 and Schedule D, see the related FAQ.

3. You will also mistakenly double-report income if you do not realize that your W-2 income in Box 1 already includes stock compensation income. Wrongly thinking it was left out may prompt you to erroneously report the income on your Form 1040 in the line for "Other income" (Line 21 on the 2016 form). Doing that would cause the income to be taxed twice as ordinary income. Stock comp income is included in the Box 1 amount that you enter in Line 7 of Form 1040. You use Line 21 only if your company mistakenly omits the exercise income from your W-2 or 1099-MISC.

Each type of exercise method can create its own confusion with the reporting of shares sold either at exercise or later. For example, if you sold only some of the shares in a sell-to-cover exercise, you don't want to report on your Form 8949 the cost basis for all the shares exercised. This would result in a much larger tax basis and a capital loss for these shares sold.

4. With incentive stock options (ISOs), when you exercise and hold through the calendar year of exercise, remember that you need to complete an AMT return (Form 6251) to see whether you owe AMT. If the tax amount is higher than the ordinary income tax, you need to pay AMT. Your company does not send you a W-2 for this spread amount when you hold the ISO stock, so remember to do this. For more details on the AMT, see the content sections AMT and AMT Advanced.

Alert: ISO exercises in a given tax year are reported on IRS Form 3921 early in the following year. The form helps you collect information for reporting sales of ISO shares on your tax return. It also helps in the AMT calculation at exercise. The IRS receives a copy of the form, ensuring that it knows about your ISO exercise and therefore any AMT triggered by the exercise income.

5. When you have paid AMT because of your ISO exercise and hold, you get a tax credit. The rules now get even more complex. You do not need to sell the stock to start using this credit. In addition, every year until the credit is used up, you do need to complete IRS Form 8801 to calculate it, as explained in a related FAQ. Once you have sold the stock, avoid paying or calculating more AMT than is required for your ISO stock sale by reporting (as a negative amount) your "adjusted gain or loss" on Part I of IRS Form 6251. For more details, see the relevant FAQ. See also a general FAQ on mistakes to avoid on your tax return after you have paid AMT stemming from ISOs.

To read four other crucial tips on tax-return reporting involving stock options, see the full FAQ about this topic on myStockOptions.com. You may also want to read our in-depth article on tax returns involving stock options. Additionally, we have FAQs detailing the biggest tax-return blunders to avoid with restricted stock and RSUs, employee stock purchase plans, or stock appreciation rights.

If you are reporting stock sales acquired from any type of stock compensation, our FAQs with annotated diagrams of Form 8949 and Schedule D are a valuable resource to help you avoid expensive errors.

Stock Options In Startup Companies Could Become More Popular Than Ever Under Proposed Tax Change

Alert: A version of this bill was enacted as part of the Tax Cuts & Job Act, though with a five-year deferral period. See our blog commentary on the adopted legislation.

Stock options continue to be very popular at startups and other pre-IPO companies, where they are often broadly granted to most or all employees. While these options can have wealth-creating potential, one big challenge is lack of liquidity: employees cannot sell the stock at exercise to pay the exercise price and any taxes owed. As the IRS confirmed in regulations issued during 2014, the tax measurement date (at exercise for options and at vesting for restricted stock) is not delayed by any lack of liquidity or securities law restrictions on resales of stock.

The fact that the tax treatment for stock grants at pre-IPO and large publicly traded companies is identical seems oddly unfair when you consider the vastly differing liquidity situations of private and public companies. Seeking to address this imbalance, recently proposed bipartisan legislation could provide a new optional tax treatment (pun intended) and make stock options more appealing than ever at startups and other pre-IPO companies. Introduced in the House of Representatives and the Senate on July 12, as explained by an article at The Hill, the Empowering Employees Through Stock Ownership Act seeks to give employees in privately held companies extra time to pay taxes on the income they recognize at exercise. The proposed extra time is considerable. Instead of paying taxes at exercise with nonqualified options (or at RSU vesting when settled in stock), this legislation would allow tax deferral for up to seven years.

Senators Mark Warner (D–VA) and Dean Heller (R–NV), members of the Senate Finance Committee, sponsored the bill in the Senate, while Representative Erik Paulsen (R–MN) is the sponsor in the House. In the press release supporting the bill, Sen. Warner states that "extending employee stock programs to a broader universe of workers will strengthen business growth and create new economic opportunities, especially for rank-and-file workers." For his part, Sen. Heller asserts that "it's important to give employees the flexibility to pay their taxes on stock options."

Company And Employee Requirements

To make the new deferral election available (under Section 83 of the Internal Revenue Code), a company would have to issue what the bill calls "Qualified Equity Grants." These grants would need to be made to at least 80% of the company's employees annually. The company would have to provide information or a warning about the tax impact, especially if the share price should decline, and it would be required to report future tax liability on each employee's Form W-2. Qualified grants would be unavailable to major owners, corporate officers, and the highest-paid executives.

Sounding in some ways similar to the procedure for the Section 83(b) election, the deferral election for qualified equity grants would need to be made by employees within 30 days of either when the shares became transferable or when they were no longer subject to a substantial risk of forfeiture, whichever occurred earlier. If the company were to go public or the employee were to sell the shares for cash during the seven-year period, taxes would have to be paid at the time of the liquidity event. The deferral election could also be revoked by the employee at any time, triggering taxes at that point.

Details Still Need To Be Worked Out

Open issues remain. A few questions that occurred to us:

• How, exactly, would these grants be structured?
• Why is the deferral for seven years?
• What information would be required in the election, and how would it be filed?
• How would this deferral election apply to early-exercise stock options that result in restricted stock which must then vest?
• Would Social Security and Medicare taxes be deferrable as well as income tax?

Nevertheless, this bill is a good way to start a discussion about changing the tax treatment of stock options and restricted stock units in startups and other pre-IPO companies. The approach of this legislation is more understandable than that of the Expanding Employee Ownership Act of 2016, which recently proposed another new type of stock option (covered at the end of a recent commentary elsewhere on this blog).

Section 409A Regulations: IRS Changes Affect Nonqualified Deferred Comp And Stock Plans

From myNQDC.com, our other website, comes news affecting nonqualified deferred compensation (NQDC) plans. On June 21, 2016, the IRS issued proposed regulations that modify and clarify various parts of the final regulations on IRC Section 409A and the previous proposed income-inclusion regulations. Although these changes and elucidations may be welcome, they do not alter the cumbersome and complex 409A regulatory framework for NQDC or reduce the onerous taxes and penalties that a participant must pay when the company's NQDC plan is not in compliance, and they concern only very specific situations. The main impact of the proposed regulations is on NQDC plans, but the changes also affect certain situations involving stock options, restricted stock units, and stock appreciation rights.

In the view of experts, these proposals formalize previously informal guidance that the IRS has been providing, offer new flexibility in some areas, and set forth a few new requirements. The IRS is allowing reliance on this guidance now and will not assert any position that runs counter to it.

The proposed regulations present a lengthy list of items. They seek to do the following:

(1) Clarify that the rules under Section 409A apply to nonqualified deferred compensation plans separately and in addition to the rules under Section 457A.

(2) Modify the short-term deferral rule to permit a delay in payments to avoid violating federal securities laws or other applicable laws.

(3) Clarify that a stock right that does not otherwise provide for a deferral of compensation will not be treated as providing for a deferral of compensation solely because the amount payable under the stock right upon an involuntary separation from service for cause, or the occurrence of a condition within the service provider's control, is based on a measure that is less than fair market value.

(4) Modify the definition of the term "eligible issuer of service recipient stock" to provide that it includes a corporation (or other entity) for which a person is reasonably expected to begin, and actually begins, providing services within 12 months after the grant date of a stock right.

(5) Clarify that certain separation pay plans that do not provide for a deferral of compensation may apply to a service provider who had no compensation from the service recipient during the year preceding the year in which a separation from service occurs.

(6) Provide that a plan under which a service provider has a right to payment or reimbursement of reasonable attorneys' fees and other expenses incurred to pursue a bona fide legal claim against the service recipient with respect to the service relationship does not provide for a deferral of compensation.

(7) Modify the rules regarding recurring part-year compensation.

(8) Clarify that a stock purchase treated as a deemed asset sale under Section 338 is not a sale or other disposition of assets for purposes of determining whether a service provider has a separation from service.

(9) Clarify that a service provider who ceases providing services as an employee and begins providing services as an independent contractor is treated as having a separation from service if, at the time of the change in employment status, the level of services reasonably anticipated to be provided after the change would result in a separation from service under the rules applicable to employees.

(10) Provide a rule that is generally applicable to determine when a "payment" has been made for purposes of Section 409A.

(11) Modify the rules applicable to amounts payable following death.

(12) Clarify that the rules for transaction-based compensation apply to stock rights that do not provide for a deferral of compensation and statutory stock options.

(13) Provide that the addition of the death, disability, or unforeseeable emergency of a beneficiary who has become entitled to a payment due to a service provider's death as a potentially earlier or intervening payment event will not violate the prohibition on the acceleration of payments.

(14) Modify the conflict of interest exception to the prohibition on the acceleration of payments to permit the payment of all types of deferred compensation (and not only certain types of foreign earned income) to comply with bona fide foreign ethics or conflicts of interest laws.

(15) Clarify the provision permitting payments upon the termination and liquidation of a plan in connection with bankruptcy.

(16) Clarify other rules permitting payments in connection with the termination and liquidation of a plan.

(17) Provide that a plan may accelerate the time of payment to comply with federal debt collection laws.

(18) Clarify and modify Section 1.409A-4(a)(1)(ii)(B) of the proposed income inclusion regulations regarding the treatment of deferred amounts subject to a substantial risk of forfeiture for purposes of calculating the amount includible in income under Section 409A(a)(1).

(19) Clarify various provisions of the final regulations to recognize that a service provider can be an entity as well as an individual.

Provisions Specific To Stock Plans

Some of the proposals in the regulations listed above directly affect stock plans in a few narrow situations. They include the following.

Stock repurchase rights. The proposed rules clarify that after an involuntary separation for cause (e.g. for a violation of a noncompete) where the company has the right to repurchase underlying shares received from a stock option or SAR exercise or RSU vesting, for less than the fair market value, doing so will not make the stock rights subject to Section 409A.

Pre-employment inducement grants. For stock rights to be exempt, the employee must be working for the company or providing direct services to the company on the date of grant. The proposed rules exempt grants made to someone who is reasonably expected to start work within 12 months and actually does so. This allows grants to employees before actual employment begins. However, the rules for incentive stock options already do not allow those types of options to be granted before employment starts.

Restricted stock for deferred compensation. The proposed regulations clarify that unvested property, such as restricted stock, cannot be used to meet a distribution obligation under a deferred compensation plan. (Previously, it was believed by experts that an employee could elect to receive payment of deferred compensation subject to 409A in either cash or restricted stock without having to meet the subsequent deferral election rules.)

Additional Reading

So far, the most helpful commentaries on the proposed regs that we have seen have come from the following sources:

• Wilson Sonsini Goodrich & Rosati
• Skadden Arps Slate Meagher & Flom
• Groom Law Group
• Ropes & Gray
• Practical Law Company
• McGuireWoods
• Latham & Watkins
• Miller & Chevalier
• PricewaterhouseCoopers

For background information on IRC Section 409A, how it affects NQDC plans and participants, and the 409A penalties for noncompliance, see the articles and FAQs on 409A at myNQDC.com, which we are in the process of updating for the changes. Meanwhile, at myStockOptions.com, detailed FAQs cover the general impact of 409A on equity compensation and the particular impact on discounted stock options and on restricted stock units that feature deferral of share delivery.

Stock Options And Tax Returns: Nine Big Mistakes To Avoid

With stock options, tax-return reporting is not optional. Whether you exercised stock options and held the shares during 2015 or sold shares acquired from stock options, the resulting income or gain must be included in the tax return that you file in 2016. As with much of equity compensation, tax issues with stock options can be tricky.

Alert: If you sold stock during 2015, you must file with your tax return IRS Form 8949 along with Schedule D, using what your brokerage firm reports to you on IRS Form 1099-B. In most situations, the cost-basis information on Form 1099-B for stock sales from equity compensation cannot be used "as is" for accurate tax-return reporting. If you do not understand the rules, you will overpay taxes (see a related FAQ at myStockOptions.com).

Below are several mistakes to be aware of and avoid when completing your return.

1. With a cashless exercise/same-day sale, the spread is reported on your W-2 and on your tax return as ordinary income. Even though you never owned the stock after exercise, you still need to report this transaction on Form 8949 and Schedule D, which are used to report capital gains and losses on all stock sales. You may even have some small gains or losses, depending on how your company calculates the spread at exercise and on any commissions and fees for the stock sale. For an annotated example of how to report the cashless exercise on these forms, see the FAQ on this topic at myStockOptions.com.

Alert: If the IRS were to receive a report of your gross sale proceeds from your broker (on Form 1099-B) but without a corresponding report of the sale on your Form 8949 and Schedule D, it would think you had failed to report the gain on the sale. Assuming a tax basis of $0, the IRS computers would then automatically send you a notice for the taxes due.

2. With nonqualified stock options (NQSOs), for employees the spread at exercise is reported to the IRS on Form W-2 (for nonemployees, it is reported on Form 1099-MISC). It is included in your income for the year of exercise. (Income from an ISO disqualifying disposition, such as an early sale, will also appear.) Thus, when you report the sale on Form 8949, if Box 1e on your 1099-B reports the exercise price as the cost basis, do not list the exercise price as your cost basis without also making an adjustment in column (g). Only for ISO stock sold in a qualifying disposition will the tax basis equal the exercise price.

Alert: If the cost basis is not reported on Form 1099-B, avoid double taxation by listing the market price on the date of exercise as your cost basis in the stock. The basis should be the exercise price plus the amount of ordinary income you already paid taxes on. For an annotated diagram showing how to report the company stock sale on Form 8949 and Schedule D, see the related FAQ.

3. You will also mistakenly double-report income if you do not realize that your W-2 income in Box 1 already includes stock compensation income. Wrongly thinking it was left out may prompt you to erroneously report the income on your Form 1040 in the line for "Other income" (Line 21 on the 2015 form). Doing this will cause the income to be taxed twice as ordinary income. You use Line 21 only when your company mistakenly omits the exercise income from your W-2 or 1099-MISC.

Each type of exercise method can create its own confusion with the reporting of shares sold either at exercise or later. For example, if you sold only some of the shares in a sell-to-cover exercise, you don't want to report on your Form 8949 the cost basis for all the shares exercised. This would result in a much larger tax basis and a capital loss for these shares sold.

4. With incentive stock options (ISOs), when you exercise and hold through the calendar year of exercise, remember that you need to complete an AMT return (Form 6251) to see whether you owe AMT. If the tax amount is higher than the ordinary income tax, you need to pay AMT. Your company does not send you a W-2 for this spread amount when you hold the ISO stock, so remember to do this. For more details on the AMT, see the content sections AMT and AMT Advanced.

Alert: ISO exercises in a given tax year are reported on IRS Form 3921 early in the following year. The form helps you collect information for reporting sales of ISO shares on your tax return. It also helps in the AMT calculation at exercise. The IRS receives a copy of the form, ensuring that it knows about your ISO exercise and therefore any AMT triggered by the exercise income.

5. When you have paid AMT because of your ISO exercise and hold, you get a tax credit. The rules now get even more complex. You do not need to sell the stock to start using this credit. In addition, every year until the credit is used up, you do need to complete IRS Form 8801 to calculate it, as explained in a related FAQ. Once you have sold the stock, avoid paying or calculating more AMT than is required for your ISO stock sale by reporting (as a negative amount) your "adjusted gain or loss" on Part I of IRS Form 6251. For more details, see the relevant FAQ. See also a general FAQ on mistakes to avoid on your tax return after you have paid AMT stemming from ISOs.

To read four other crucial tips on tax-return reporting involving stock options, see the full FAQ about this topic on myStockOptions.com. You may also want to read our in-depth article on tax returns involving stock options. Additionally, we have FAQs detailing the biggest tax-return blunders to avoid with restricted stock and RSUs, employee stock purchase plans, or stock appreciation rights.

If you are reporting stock sales acquired from any type of stock compensation, our FAQs with annotated diagrams of Form 8949 and Schedule D are a valuable resource to help you avoid expensive errors.

Tax Reporting For Stock Compensation: Understanding Form W-2, Form 3922, And Form 3921

The end of January is in sight. Along with snowflakes, personal tax-return documents are in the air—or rather, hopefully either in your safe possession or on their way to you. When you have stock compensation, tax-return documents and the information they contain can be confusing and hard to decipher.

Making Sense Of Form W-2 When Stock Compensation Is Reported

Employees who had income from stock compensation or an employee stock purchase plan in 2015 must understand where that income is reported on Form W-2 so that they can complete their tax returns properly. In the Tax Center at myStockOptions.com, we have a section of FAQs about Form W-2 reporting for stock compensation. Each one includes an annotated diagram of Form W-2 that clearly interprets this sometimes cryptic document.

Restricted Stock, RSUs, Performance Shares

The vesting of restricted stock, the share delivery from restricted stock units (RSUs), and the vesting of performance shares all prompt W-2 reporting of the income received. The treatment on the W-2 is essentially the same for all three grant types. Income is included in the following places:

• Box 1: Wages, tips, and other compensation
• Box 3: Social Security wages (to income ceiling)
• Box 5: Medicare wages and tips
• Box 16: State wages, tips, etc. (if applicable)
• Box 18: Local wages, tips, etc. (if applicable)

To learn which boxes show the taxes withheld, and other reporting details for all three grant types, see the related FAQs, including annotated diagrams, in the Tax Center.

Alert: If you made a Section 83(b) election to be taxed on the value of restricted stock at grant, your W-2 for the year of grant, not vesting, will show the income and withholding.

Stock Options

If you exercised nonqualified stock options last year, the income you recognized at exercise will be reported on your W-2. The income from a nonqualified stock option (NQSO) exercise appears on the W-2 with other income in:

• Box 1: Wages, tips, and other compensation
• Box 3: Social Security wages (up to the income ceiling)
• Box 5: Medicare wages and tips
• Box 16: State wages, tips, etc. (if applicable)
• Box 18: Local wages, tips, etc. (if applicable)
• Box 12 (Code V)

That last item, Code V in Box 12, identifies the NQSO income included in Boxes 1, 3, and 5. For the places where the tax-withholding amount appears, see our FAQ on W-2 reporting for NQSOs. (The W-2 reporting is, by the way, identical for stock appreciation rights, with the exception that Code V is not used.)

With incentive stock options, the spread value appears on the W-2 only when you make what is technically called a disqualifying disposition, i.e. when you sell or gift the stock before you have met the required holding periods of one year from exercise and two years from grant. In that case, the income appears on the W-2 as compensation income. Unlike with NQSOs, your company does not withhold federal taxes on ISO exercises and no money is owed for Social Security and Medicare, even with a same-day sale or any later disqualifying dispositions. For the details of W-2 reporting for ISOs in this situation, see our FAQ on this topic in the Tax Center.

Employee Stock Purchase Plans (ESPPs)

The W-2 reporting for ESPP income depends on whether your company's ESPP is tax-qualified or not and, if it is tax-qualified, how long you hold the shares. For a nonqualified ESPP, there is withholding on the income you recognize at purchase, and the income and withholding are reported on your W-2 in a way resembling that for nonqualified stock options. With a tax-qualified ESPP, nothing appears on your W-2 until you sell the shares. The details of all three situations are clearly presented, with annotated diagrams, in the section on ESPP W-2s in the Tax Center at myStockOptions.com.

Form 3922 For ESPPs And Form 3921 For ISOs

Form W-2 is not the only important piece of tax paperwork that companies are sending these days. In 2015, did you buy shares in your company's employee stock purchase plan (ESPP)? Did you exercise incentive stock options (ISOs)? If so, you should have by now received from your company either IRS Form 3922 (for ESPPs) or IRS Form 3921 (for ISOs). Companies must issue these forms to employees by the end of January, and they must also file them with the IRS (though the IRS filing need not occur until the end of March if it is electronic).

Alert: In 2016, the amount of the IRS penalty doubled for companies that file information returns late or fail to distribute the employee statements.

For employees, many companies issue the information on their own substitute statements instead of using the actual IRS forms. A substitute statement allows a company to aggregate all purchases or exercises in one form rather than issuing a separate IRS form for each transaction.

While Forms 3922 and 3921 may seem confusing at first glance, they are useful because they can help you gather information you will need to prepare your tax return. As the forms also ensure that the IRS has ample information about your ESPP purchases and ISO exercises, they mean that accurate and timely tax-return reporting is more important than ever.

Annotated Diagrams Of Forms 3922 And 3921

To help companies and participants understand these forms and the related tax rules, myStockOptions.com has an article and FAQ on Form 3922 for ESPPs and an article and FAQ on Form 3921 for ISOs. These include annotated examples of the forms that translate IRS jargon into understandable language. You will find this content in the ESPP and ISO tax sections of both myStockOptions.com and the Knowledge Centers that we license to companies and stock plan service providers.

Each ESPP purchase is reported on a separate Form 3922, which presents the following information:

• date of grant (usually the beginning of the offering period)
• stock FMV on the date of grant
• purchase price per share
• price per share had the grant date been the purchase date (for purchases where the purchase price was not fixed or determinable on the grant date)
• purchase date
• stock FMV on the purchase date
• date of transfer of legal title
• number of shares for which legal title is transferred

Each ISO exercise is reported on a separate Form 3921, which shows the following details:

• grant date
• exercise price per share
• exercise date
• the stock FMV on the exercise date
• number of shares exercised

Sell Shares In 2015? The Fun Is Just Beginning

If you sold shares from stock compensation or an ESPP last year, you will need guidance to report the sale proceeds on your tax return. Fortunately, the Tax Center at myStockOptions.com features the section Reporting Company Stock Sales. Each FAQ in the section includes annotated diagrams of Form 8949 and Schedule D, the two crucial forms for stock-sale reporting. These FAQs clearly explain how the information on Forms W-2, 3922, and 3921 can help you accurately complete IRS Form 8949 when you prepare your tax return.

Resources For Stock Plan Participants And Companies

All of our tax-season content, including our popular annotated tax forms, is available for corporate licensing. Help your participants make the most of their stock compensation by giving them resources for avoiding expensive mistakes on tax returns.

The excellence of our resources is attested by the many testimonials we have received, so don't just take our word for it. As one of our licensees puts it, employees "find the tax information and annotated tax forms extremely helpful." In the words of another client, "employees understand concepts much better with the straightforward illustrations." Please contact us for licensing details (617-734-1979 or [email protected]).