RUEDI: Weighing your options when it comes to stocks

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Tesla CEO, Elon Musk, has been making headlines recently regarding the sale of a portion of his shares in the company he founded in 2003. The amount of taxes he will pay as a result of those sales are also getting a lot of attention.

Tesla shares have soared in value this year, so it is understandable that Mr. Musk might want to capitalize on some of his profits. However, it appears that the sales may be more motivated by a deadline to act on company stock options that Musk received as compensation in lieu of a traditional salary.

The options allow Tesla shares to be purchased at a fraction of their current market price, but as owner of these options Musk had a limited window to act on them or risk letting them expire unused. Stock options and other stock awards are often included in compensation packages to attract talent and align interest with company shareholders.

While most individuals won’t have the nine-figure proceeds or tax bills like Elon Musk, the process of effectively exercising stock awards are an important consideration for everyone who may own them.

Stock options are granted in three common ways — Non-Qualified Options, Incentive Stock Options, and Restricted Stock Units. Each style has unique exercise requirements and tax implications.

Non-Qualified Stock Options (NSOs)

A company can grant NSOs to employees, directors, outside consultants, or anyone who provides service to a firm. The grants are issued with an “exercise” price closely related to the current market value of the company’s shares.

Typically, these grants also come with a vesting schedule, a period of time before the owner can exercise the options and purchase company shares. Nothing is taxable when the stock options are granted, but once they are exercised, the situation becomes more complex.

Once options have vested, the owner can choose to purchase company shares for the stated price listed in their options. The difference between purchase price of the shares and their current market value become taxable ordinary income to the owner. Any subsequent sale of those shares is treated at prevailing capital gains rates depending how long they were held after exercise.

Incentive Stock Options (ISOs)

ISOs are more restrictive as to whom they can be awarded. Like NSOs, ISOs are not taxable when they are granted. However, ISOs are also not taxable upon exercise by the owner.

In the case of ISOs, the difference between the exercise price and the current market value is included as income for the purpose of calculating any alternative minimum tax that may be due. To qualify for preferential tax treatment upon sale, an owner needs to hold the stock for one year after exercise and at least two years after the date they were granted.

It should also be noted that ISOs must be exercised no more than three months following termination or they expire.

Restricted Stock Units (RSUs)

RSUs are issued as an unsecured benefit to their owners. Often, vesting parameters are tied to certain company performance metrics and/or a time period that an employee must remain with the firm to earn any benefits. Once an employee achieves all vesting parameters, the RSUs are exchanged for a set number of shares of the company’s stock.

The current market value of the stock as of the vesting date are treated as taxable ordinary income to the owner. Unlike options, RSU holders aren’t required to come up with funds to purchase shares. Keep in mind, RSUs only have value once all requirements have been satisfied and could be forfeited if an employee leaves the company prior to vesting.

There are numerous tax considerations and claiming strategies that may be implemented by employees who hold options or restricted stock units. Please consult with your financial advisor and tax preparer before executing any transactions with your compensation awards.

Ruedi is a financial advisor with Savant Wealth Management, Bloomington.