I’ve recently been learning a LOT about this subject, and thought I’d share. NOTE: This is obviously only applicable in the US.
Lots of companies, especially tech ones, include some form of equity in their total compensation package. Let’s start by getting some terminology right:
- A stock grant is when the company gives you a real, honest-to-goodness, tradable share of stock. You own income tax on the value of the total grant, and companies will often withhold that as part of the grant. Often times, they’ll grant you X number of shares, and then immediately sell some of those to generate cash to pay the taxes. The company’s stock price is the cost basis for these shares, which is an important number to know. Any shares you keep are now tax-paid.
- A restricted stock unit, or RSU, is very common. This is a block of future stock granted to you, which you don’t immediately own. There are no tax consequences at grant time. The RSUs usually vest on a schedule, and when they do, they become a real, tradable share of stock that you own. RSUs have a cost basis associated with them, which is what the company’s stock was worth at the time the RSU was issued. This is an important number to keep track of.
When RSUs vest, you immediately owe taxes on the total cost basis of the vested shares. Again, many companies try to make this easy by letting you elect to have some of those shares sold immediately, generating cash to pay the tax burden, and withholding that tax money for you. So now, you’re sitting on tax-paid real shares. Some companies let you elect to just sell everything, pay the taxes, and get the cash, which is very easy, but might make you miss out on future stock growth. For the sake of argument, let’s say you hang onto the shares for a bit.
- Many companies offer Employee Stock Purchase Programs, or ESPPs. This usually lets you contribute money out of each paycheck, with that cash being used on a scheduled basis to buy stock, often at a discount. You immediately owe taxes on the discounted portion, and the company will often immediately sell some shares to generate cash and pay those taxes. The non-discounted price of each share is its cost basis, which again is an important number to know. So again, now you’re holding onto tax-paid, real shares.
So at this point, with any of the above options, we’re talking about the actual shares you hold and can trade, and we assume you know the cost basis of each share (brokerage accounts track this basis for you, so there’s usually a report you can pull). All of the shares from any of the above scenarios would be tax-paid at this point. Meaning, you’ve paid the tax on the cost basis of the shares.
When you sell those shares, you have another tax consequence.
If the price you sell the shares for is higher than their original cost basis, you have a gain. If you held the shares for 366+ days before selling, this is a long term gain, and if not then it’s a short term gain. Short term gains are taxed just like your salary, and long-term gains have a fixed tax rate (either 15% or 20% at present, depending on your overall income for the year). It is important to pay a quarterly estimated tax payment to the IRS for the quarter in which you realized the gain or they will be very cross with you and might end up levying fines and charging interest. This is no joke.
Some companies may offer the ability to sell shares and withhold taxes for you, but you should make sure you know if that’s happening or not. If it’s not, then you need to send the IRS a check and a 1040ES form, or the IRS will get very, very annoying for you.
If the price you sell the shares for is less than their cost basis, then you have incurred a loss. This loss can offset other gains in the same year, to help “zero out” your tax burden from gains. Losses not used to offset other gains can usually be rolled over into future tax years, something you can often do 2 or 3 times before the loss “expires.” Notably, losses usually can’t offset the other income taxes you owe: they can only offset capital gains, like from selling stock.
Now, for a new twist: the stock option.
A stock option, in the market, is basically the right to buy a share of stock at a future date, for a predetermined price. So, you might pay $20 for an option to buy a share of Big Company in one year. If Big Company is currently trading at $22, then this represents a potentially good deal – you paid $20, saving you $2. But we’re talking a year away! A year from now, if Big Company is $25, then you did well! But if it’s $15, then you lost $5.
Some companies also offer stock options as part of their compensation packages. Like RSUs, these are often granted to you in a big block, and then vest over a set schedule. When an option vests, it will often have a “due date” or “maturity date,” which may or may not be the same as the vesting date. The maturity date is the day where you have to decide what to do with the option.
A key bit is the strike price (or option price, or exercise price) of the options. This is set at the time of the grant, and never changes. When your options vest, you technically have to spend the strike price in order to turn the option into a share. At the time your options vest, you will usually have taxes withheld, based on the strike price of the vested options.
Suppose your company is trading at $50, and you are given a block of options with a strike price of $25 each (they’re commonly discounted heavily when they’re part of a compensation package). 100 of those options vest, meaning you own 100 options valued at $25 apiece. Suppose when they vest, the company’s stock is at $60. You’re doing well!
Many companies will let you exercise and sell as a single transaction, to avoid out-of-pocket expenses. So your 100 options, if they were stock, would be worth $6,000, and they have a collective strike price of $2,500. Suppose your effective tax bracket is 25% (just making the math easier on myself). But you already paid taxes on the strike price portion, so now you’ll only owe on the excess. So, $6,000 minus $2,500 is $3,500, so you’ll say tax on that and keep about $2,625 in this example. Again, some companies will be able to withhold taxes from the transaction for you, especially if you’re working through the company-designated broker.
Options count for long-term and short-term gain, too. If you hold an option for 366+ days, then the difference between the strike price and sale price is taxed as a long-term gain, which may be more favorable to you.
Obviously, you’ll want to talk with your tax professional about your specific circumstances, but I wanted to offer a quick rundown from what I’ve learned!