Equity compensation allows employees to share in the fruits of a business’s collective labor. In addition to providing great incentives for employees to put the team first, equity gives everyone greater participation in a firm’s success. And, if you have the opportunity, equity compensation can be a key contributor on your path to financial independence.
Equity compensation comes in many forms depending on the motives of employers and the stage of the business lifecycle a firm is in:
Given the rise of equity compensation in the Bay Area alone, we have helped many of our clients navigate the nuances of the different options offered by their employers, even as early as when evaluating different job opportunities. Different taxation rules, third-party valuations, special elections, and more add to the complexity and decision points along the way for consideration.
The Timing of Taxation
One complicating feature of many types of equity-based incentives is that taxation occurs when awards vest—at a time when you may not have the liquidity to cover the tax bill (since you haven’t sold the company stock yet).
With stock options, delaying the decision to exercise can defer taxation, but can put off qualifying for lower capital gains rates and lead to higher ordinary income taxes in a given year.
It is important to weigh these timing issues, so you can make the optimal decision with the information you have and ensure that you have the resources available to pay any corresponding tax bill.
Sometimes taxation is deferred until a “change of control” event, such as an acquisition or IPO. That means there could be a large amount of taxable income to you all in one year. Even though the timing may be uncertain, we have helped clients in these situations evaluate the possible implications and potential ways to mitigate that tax liability when it occurs.
Public or Private?
The value of a public company’s stock is determined by the market. However, when companies are private, the board and eventually third-party assessors set the valuation that determines the economic benefit of equity compensation for tax purposes (a 409A valuation). This adds additional complexity when evaluating the potential benefit and impact on your overall compensation.
For restricted stock, often used by early-stage startups to attract talent when a firm’s cash needs are tight, there is a special election you can make called an 83(b) election. It can lead to preferential tax treatment; however, this election is irreversible and can cause issues if you later leave the company before all your stock vests.
Vesting Schedules, Lock-Up Periods, and Trading Windows
Vesting schedules, lock-up periods, and trading windows may prevent you from selling company stock when you would like to. So, it is important to have strategies in place that work to mitigate the risk of holding a concentrated position if your company stock is a large portion of your overall wealth.
Accounting for Changes
Changing events—personal and/or employer-related—can always impact your plan or complicate past decisions you can’t undo. For example, new equity incentives will vest over time and may change in form as your firm evolves. As we’ve done many times for clients, we can help you construct contingency plans in case circumstances or timelines change.
Whatever your situation, we can work with you to lay out your options, contextualize each decision within your broader financial and life circumstances, and highlight where uncertainties may lie so you can make more informed decisions. This article only scratches the surface of navigating the “nice-problem-to-have” of equity compensation.
We’d love to hear from you and answer questions as you consider your next steps. Please reach out to your Litman Gregory Advisor or contact us here to discuss your goals and implement a plan to help you achieve financial success.
Replay: Market Update Webinar
In this replay of our Market Update Webinar, Chief Investment Officer Jeremy DeGroot answers questions we’ve been receiving from clients on the economy and financial markets. He also provides an overview of how Litman Gregory is navigating the potential impact of the upcoming election and the turbulence surrounding the pandemic.
Tax Planning Opportunities in 2020
As part of our tax sensitivity in managing investment portfolios, we regularly look for opportunities to maximize after-tax portfolio returns. We also help clients identify where it makes sense to take advantage of the changes enacted by the SECURE and CARES Acts. Here we share some tips on how to utilize a variety of techniques in our client portfolios.
How We Think About Elections & Investment Decisions
Each time a U.S. presidential election approaches, we revisit with clients our views about the impact on our investment outlook and portfolio positioning. Here is a quick review of how we think about elections in general within the context of our overall investment approach.