By: AnnaMarie Mock, CFP®
Sarah, a savvy pharmaceutical executive, has accumulated Non-Qualified Stock Options (NQSOs) and Restricted Stock Units (RSUs) as part of her compensation package.
Sarah had always been meticulous with her finances and records of her stock option grants, exercise dates, and the fair market values at the time of exercise. As her stock compensation vested over the years, she knew proper tax reporting was crucial to avoid any IRS headaches.
However, Sarah consistently encountered challenges when attempting to decipher and extract meaningful insights from her financial data. In previous years, she grappled with unexpected tax liabilities stemming from the intricacies of her stock compensation transactions. Her approach to managing her stock options had been haphazard and lacked a structured strategy. Over time, uncertainty crept in, leaving her questioning the optimality of her exercise and sales decisions. Consequently, she sought professional financial guidance proactively to control her financial situation better.
Armed with the award details, she contacted a trusted advisor specializing in equity compensation and financial planning. Together, they mapped out a tax strategy tailored to her unique situation and financial goals.
The advisor examined Sarah's NQSO portfolio, considering market conditions and potential tax implications. Sarah shared the several goals she wanted to accomplish, which included buying a house in the next 12 months and taking an extended trip to an exotic destination. After a thoughtful analysis, the advisor suggested it was an excellent time to exercise and sell some of her NQSOs to achieve her immediate financial goals. This also set the foundation for a plan of execution moving forward.
Some strategies reviewed
Exercise over time: Exercising NQSOs incrementally, instead of all at once, could help spread the tax burden over several years. This tax-efficient strategy would save significant money in taxes, especially if exercised in a lower tax bracket.
Use the sell-to-cover method at exercise for shares being sold immediately: The "sell-to-cover" method handles the financial obligation without depleting personal funds. Options can simultaneously be exercised, and a portion sold to cover the tax bill. It allows the holder to retain ownership of some shares while ensuring there are no tax surprises to cover the coming tax season.
Consider the cash payment method at exercise for shares being retained: The exercise price is paid out of pocket, which does not reduce the number of options received. The shares issued will equal the amount exercised. This method may only be advantageous when the holder believes the current stock price is lower than its potential future value. Vested RSUs may be used to cover the amount owed without relying on already existing savings.
Consider the purpose of the proceeds: Your goals and financial circumstances will influence when and how you choose to sell stock acquired through equity compensation.
AMT implications: The Alternative Minimum Tax (AMT) can be triggered when exercising Non-Qualified Stock Options (NQSOs) if the fair market value of the shares on the exercise date is significantly higher than the exercise price. AMT can trigger additional, unexpected taxes.
Sarah hesitated at first, fearing the complexities of the stock market and the tax consequences. However, the advisor patiently explained the process, emphasizing the potential benefits of diversifying her investments and securing her financial future.
Sarah decided to proceed. When her NQSOs were vested, Sarah exercised them and understood that it triggered ordinary income tax. She opted for a cashless exercise to streamline the process and ensure enough was withheld for the cost of exercise and taxes. In addition, Sarah sold some of the previously exercised NQSOs that qualified as a long-term capital gain.
Exercised NQSOs will trigger additional taxable income and be reported on a W-2 or Form 1099-MISC.
Form W-2: Most often, the income from NQSO exercises, which your employer provides, is reported on your Form W-2. The income is typically included in your total taxable wages in Box 1.
Form 1099-MISC: You may sometimes receive a Form 1099-MISC from your employer to report the income yourself if they did not include the NQSO income on your W-2.
Confirmations: Confirmation statements provide details about the exercise and may include information such as the exercise date, the number of options, the fair market value, and the exercise price.
Sold NQSOs will generate additional tax forms.
Form 1099-B: This form is provided by the brokerage or financial institution where you sold the NQSO shares. It reports the sale details, including the sale date, sale price, cost basis, and any capital gains or losses resulting from the transaction. The gain or loss will be reported on Schedule D and potentially Form 8949.
As for her RSUs, Sarah knew that they would be taxed when they vested. Sarah's company withheld a portion of her RSUs to cover the tax liability, saving her from potential underpayment penalties.
Form W-2: This form reports the value of the vested RSUs as part of your total taxable income for the year. Your employer provides it and includes the fair market value of the vested RSU shares on the vesting date.
Form 1099-B (Possibly): If you sell the RSU shares after vesting, you may receive a Form 1099-B from your brokerage or financial institution. This form reports the sale details, such as the sale date, sale price, cost basis, and any capital gains or losses resulting from the transaction.
As tax season approached, Sarah knew that reporting her stock options correctly was paramount. When tax season arrived, Sarah was well-prepared and kept an eye out for the tax forms.
Among the documents needed was Form W-2, which detailed all of her income, including the additional earnings from the exercise of her NQSOs and vested RSUs. This was the baseline, the income that needed to be reported accurately.
With her Form W-2, Form 1099s from her brokerage, and detailed records of her stock transactions, Sarah's accountant could file her tax return confidently. Schedule D was used to report her capital gains from the sales, and Form 8949 to provide a breakdown of each sale transaction. Her meticulous record-keeping ensured accurate reporting and ease of data input.
Thanks to her diligence and expert guidance, Sarah ensured compliance with tax laws and optimized her tax strategy and planning. Although there was withholding, it was not enough to cover the full tax need. However, Sarah was aware of the underpayment and prepared to pay the tax bill with some of the stock option proceeds she set aside.
Over time, Sarah watched as her financial goals became a reality. Not only did Sarah confidently make decisions regarding her stock compensation, but she was also able to bolster her home down payment savings, fund her vacation, and diversify some of her assets. The decision to sell her NQSOs, guided by her trusted advisor and accountant, proved wise. It enabled her to achieve her immediate objectives and put her on a path to financial security.
Sarah's story serves as a reminder that with the proper preparation and professional assistance, handling tax obligations can be a manageable part of one's financial journey.
AnnaMarie Mock is a CERTIFIED FINANCIAL PLANNER™ and Partner at HIGHLAND Financial Advisors, LLC, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, employer retirement planning, and investment management. AnnaMarie graduated from Montclair State University with a degree in finance and management and successfully passed the CFP® national exam in 2016. She has been working at Highland Financial Advisors since 2013 as a fee-only, fiduciary Wealth Advisor and is a member of NAPFA.