From the 2001 dot-com bubble collapse to the 2008 economic downturn and recent changes to taxation law, we have all learned that when it comes to planning for the future, we must forecast for all eventualities.

Negotiating your equity compensation is no exception: it is important to play the long game and be aware of the factors that will affect your package – both its value and the tax implications – now and into the future.

While no-one has a crystal ball, working through the scenarios that could impact your equity compensation can help you negotiate the package you feel best works for your requirements. Planning for the longer term regarding your career plans and also for unforeseen events can help you negotiate a plan that protects you from some of the more negative effects of economic turmoil, industry changes and government legislation.

#1 – Market Volatility

Depending on how your equity compensation is structured, market volatility will have varying effects on its value, and will affect your decisions when it comes to exercising your options, as well as having an impact on taxation.

Vesting time period

In the case of restricted stock awards (RSA) and restricted stock units (RSU), both will vest over a predetermined time period. Restricted stock awards still carry value in highly volatile markets and are seen as the less volatile option, especially when coupled with a historical dividend payment schedule alongside an achievable vesting schedule.

Unlike RSUs, RSAs have the option to use an 83(b) tax election to potentially reduce tax exposure, effectively paying taxes on your equity before it vests. This can be seen as an advantage over RSUs, so long as the equity position does not decrease by the time of vesting; you cannot go back and amend a tax return to take advantage of the lower tax implication.

Incentive stock options (ISOs) and non-qualified options (NQOs) typically come with a long expiration date, maybe as much as ten years out. Both options can (and do) lose their value, so they are a risky option in a volatile market: both have vesting and expiration deadlines and so the timing of market peaks and troughs can be critical to their value.

Taxation considerations

In a volatile market, the spread value (the difference between the exercise price and the stock’s current value) is more likely to trigger the alternative minimum tax at time of exercise on incentive stock options (ISOs), than if the spread value remains more stable. This can have a negative effect in terms of taxation; ISOs are normally taxed as regular income or long term capital gains tax.

#2 - Employee Business Purchase/Sale

In the event of a company merger or acquisition, or of the sale of a company’s assets, it is critical to know the provision for the treatment of outstanding awards. This should be made clear in the original equity incentive plan.

In the event of an acquisition or merger, unvested options may be canceled, accelerated or continue to be unaffected. In many cases, a standard plan may state that if options were not assumed by the new employer, they would be vested prior to the completion of the acquisition, so would be accelerated. Be aware, however, that cancellation could be an option, so be sure that the plan wording is unambiguous on this matter.

#3 - Separation of Service

With companies structuring equity compensation to promote executive loyalty, what happens to options in the event of separation of service becomes a very real issue.

Performance shares

Performance shares are usually completely forfeited at the end of employment.

Restricted stock and stock units

In most cases, unless the stock options have been cliff vested in a shorter amount of time than the termination, the unvested partial amount of ownership will be forfeited in most cases unless there is an exception clause for that specific employee. If the employee leaves before the cliff vesting period has completed they will forfeit all stock options. Very few if any employers guarantee full vested options upon leaving before the schedule is complete. Furthermore, the recipient of the restricted stock is still liable to pay capital gains tax whether there is a gain or loss on the purchase.

Your own intentions and career plans may very well dictate how you negotiate your equity compensation package; if you only plan to remain with the company in the short term you may want to pay particular attention to the cliff vesting period and other time-related considerations.

#4 - Death

Most stock options do not have any type of beneficiary on the account. Accelerated or altered vesting arrangements can be made in advance if accounted for. If not, this process will become more complex. The stock option will be taxed on the deceased person’s final tax return. All of this transpires assuming the stock option is transferable; if it isn’t transferable, then the fair market value of the stock option is non-existent.

Many companies have exceptions to their current vesting and exercisability rules. For example, a company may state that in the eventuality of an employee death, the stock option must be exercised by a legal representative or beneficiary before a set amount of time, or even before the expiration date of the stock option. This is the case in most situations but it is critical to review the terms of the company’s plan.

#5 - Tax Law Changes

Tax laws are continuously changing and the smallest change can significantly affect your equity compensation. Tax planning services have become extremely valuable due to changes that have significant impacts on capital gains. Under the American Tax Payer Relief Act (2012), the rates increase in regards to long-term capital gains and qualified dividends.

Specifically, when it comes to taxes:

  • Incentive and non-qualified stock options are not taxable upon grant, and the first taxable event only happens during the sale of the stock.
  • The employer must withhold non-qualified stock options when options are being exercised.
  • With ISOs the employer will not withhold taxes, so employees will have to manage their own taxes.

It is recommended to consult with a professional as tax law changes can significantly impact equity compensation.

Conclusion

The fine detail of your plan must not be taken for granted when it comes to planning for the future. The wording must be unambiguous if you – and your loved ones – are to be protected from whatever lies ahead. With careful planning and professional help, you can ensure that the negative impact of scenarios such as the ones listed above will be minimized.

Don’t take an initial offer at face value: securing professional advice will help you think through future scenarios you may not have considered. It is important to clarify issues from the outset if you are to secure a package that future-proofs the value of your equity compensation.

-Timothy Golas, Partner
Spurstone Executive Wealth Solutions

About Spurstone: Founded on a belief that successful executives deserve more knowledge and service than traditional investment firms provide, Spurstone delivers transparent and efficient client centered strategies. The Spurstone team works with successful families in a Multi-Family Office setting, focusing on the tools, technology and talent these families would otherwise not have access to. To learn more about Spurstone Executive Wealth Solutions, please visit www.Spurstone.com.

*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The opinions expressed in this material do not necessarily reflect the views of LPL Financial. *This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.

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