Making the most of your executive benefits package while balancing the litany of other demands on your time can be daunting for many corporate executives. This is particularly true with respect to equity compensation plans. Between your increasing responsibilities at work and the demands of your family and other commitments, it’s a lot (to put it mildly).
As an executive, you likely find yourself facing some unique financial planning challenges due to the nature of your compensation package. Stock options, restricted stock, deferred compensation plans, performance shares, bonuses, and other forms of executive compensation create complexity. Good, but complex, nevertheless. If you have ever been overwhelmed by the sheer amount of financial details related to all of these compensation vehicles, you are certainly not alone.
It's crucial to understand the specific financial planning opportunities you have as a corporate executive with a more intricate compensation structure to ensure that you can maximize the benefits to you and your family while minimizing risks to the extent possible. This article explores how executives can make the most of complex compensation packages and identifies common pitfalls you might not otherwise see coming.
Understand Your Equity Compensation Package
Making the most of your financial situation starts with carefully understanding your full equity compensation package – what it includes and how it works.
As a corporate executive, your equity compensation over time may include some or all of the following offerings:
Non-Qualified Stock Options (NQSO): This is equity compensation where the employed person has the right to buy company shares at a fixed price (“exercise” or “strike” price). Once vested, the option shares are eligible to be purchased at the strike price and then sold at the prevailing market price (presumably higher than the strike price). The sale of these shares creates ordinary taxable income as well as employment (FICA) taxes.
Restricted Stock Units (RSU): RSUs are also known as “share grants,” and provide employees with shares of company stock that are subject to certain restrictions (as the name suggests). These are usually given to an employee as part of their compensation versus needing to purchase them. Like non-qualified stock options, restricted stock units are also subject to vesting conditions. Once the RSUs have vested, the original shares are taxed as ordinary income (plus FICA tax). Shares are often withheld to pay the taxes and the executive is issued a net after-tax share amount. When the executive eventually sells these shares, any growth since the vesting date is taxed as a capital gain (long-term if held for 1 year or more).
Performance Shares: This is an equity compensation tool that utilizes certain company-wide performance criteria to determine if, and how many, shares will be granted to executives. These can be tricky to plan for because the range of possible outcomes is so wide based on factors largely outside of the executive’s individual control. The executive could be granted zero shares if the company does not hit certain metrics or could receive a significant grant of shares if they do. Once granted, these shares typically follow a vesting schedule similar to standard restricted shares (RSUs) and the tax treatment is the same.
Employee Stock Purchase Plan (ESPP): ESPPs are run by the employer offering them to its employees. They allow employees to purchase company stock at a discount – up to 15%. Employees contribute through payroll deductions, which build until the purchase date. Employees who sell their stock are subject to capital gains or losses and will generally pay a lower tax rate if they hold the stock for more than a year and sell it more than two years after the offering date.
Get Your Equity Compensation Details Organized
Along with any of the equity compensation offerings comes a lot of corresponding paperwork. Getting organized is key to observing critical details about your equity compensation.
- Your Documents: Have your official equity compensation package documents somewhere easily accessible. These documents may include your Stock Plan, Option Agreement, or Restricted Stock Grant Agreement.
- Your Vesting Schedule: This pertains to stock options and restricted stock units only. Know when your shares are fully vested and when you are eligible to exercise them. Employee stock purchase plans do not have a vesting schedule, but they could be taxed differently depending on when they are sold so be aware of those details.
- Your Expiration Dates: Typically, stock options that are not sold will expire after 10 years. But there are likely other rules around when shares might expire, so be certain to note these dates so that you don’t lose your shares.
- Important Dates: The following details can be valuable to jot down and keep track of as you continue to participate in equity compensation programs: enrollment date, purchase date, grant date, exercise date, purchase price, discount amount, expiration date, vesting dates, number of options vesting per vesting period, grant type, strike price, and any other critical pieces of information that impacts your financial opportunity.
Common Pitfalls to Avoid with Equity Compensation
Having equity compensation offers a unique financial opportunity to executive professionals. However, just having equity compensation alone does not mean guaranteed financial success. There are mistakes that could undermine your financial potential. The common missteps to avoid when it comes to equity compensation can be summarized into three categories:
- Not Being Disciplined About Selling
Executives who have accumulated a decent amount in company stock need to be very mindful of their concentration risk. If they are receiving new grants each year, which is typical, their concentration problem is growing every year if they are not disciplined about selling when shares vest.
- Not Preparing for the Tax Impact
When you sell, there are immediate tax consequences. Employees can and should be prepared so that they are not stuck with a tax bill without sufficient funds to cover it. Often, the vesting of restricted stock and the exercise of stock options results in executives being under-withheld because of quirks in the IRS withholding rules. However, with proactive tax planning, you can be prepared for the amount of additional tax owed, make estimated payments if necessary, and avoid underpayment penalties or a big surprise in April.
- Missing Trading Windows.
Employees could find themselves subject to insider trading violations if they trade outside of open trading windows. Be extremely mindful of when your open trading windows are, and you can lean on your financial advisor to help you manage your employer's stock and options so that you operate lawfully. One option: there are plans sanctioned by the SEC that allow executives to sell shares outside of trading windows by putting a public plan in place during a trading window.
- No Plan to Spend, Reduce Debt or Reinvest the Proceeds.
Lastly, exercising your equity compensation can result in a windfall of cash. Knowing how you want to either spend that cash or reinvest it so that it supports long-term financial goals is paramount to making the most of your equity compensation. Too often, we see executives exercise options or sell company stock and then fail to have a plan for the proceeds. Whether the plan is helping with a major purchase, paying down debt, or reinvesting in a more diversified portfolio, having a plan before you sell is important.
With smart planning and good guidance, you can benefit tremendously from equity compensation plans and avoid many common mistakes. Even with all the resources your company may provide to help you participate in and understand your equity compensation program, working with a dedicated wealth advisor with experience in the area of executive compensation who can offer personalized support will typically lead to the best result. An experienced financial advisor can work with you to stay aligned with your overall financial goals, encourage discipline, avoid missed opportunities, and guide strategic decisions around equity compensation within the context of your overall financial picture.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.