Managing Your Stock Options: From ISOs to NSOs
Confused by Stock Options?
Do you worry about how to maximize them? Jared Van Arsdale, CPA , partner at Ullman & Co., P.C. joins us to explain what stock options are and the tax implications of each one.
Key Takeaways:
Learn a simple mindset trick so you know when to exercise your options (at 35:27 in video) and if holding your options for the long haul is the right move.
Understand the different types of stock options and how the tax treatment of each stock option type varies.
Learn about restricted stock options, non-qualified, restricted stock units and options held at privately held companies.
If you have unexercised stock options, or are looking for a refresher course, this episode is for you!
Time Stamps
05:20 Grant date, exercise day, and tax implications.
06:38 Non-taxable stock options, buy at set prices.
11:46 Incentivizing growth for company employees with stocks.
15:25 Consider spread size, exercise options for profit.
18:03 Stock options and valuation changes for clients.
19:54 ISOs for smaller tech companies, NSOs for larger.
21:59 ISOs are pretax, NSOs are after tax.
26:41 "It's okay not to remember everything."
28:11 Regularly assess and adjust financial investments for diversification.
-
Michelle Moses [00:00:04]:
Welcome to Me Financial, the podcast designed to inspire your financial life. Hello, everyone, and welcome to the podcast. Thank you so much for listening today. I am Michelle Moses, your host. I'm a certified financial planner, realtor and a former e-commerce store owner. And today, we are going be talking about stock options. And to talk about this, I have Jared Van Arsdale, CPA here. Thank you for being on the show.
Jared [00:00:31]:
Yeah, thank you for having me.
Michelle Moses [00:00:32]:
I find Jared very, very knowledgeable every single time I talk to him. And I know I said that in the other episode, but I'm very excited about this. Can I say very again?
But Jared specializes in tax compliance planning and examination representation for individuals, estates and trusts, and closely held entities. He provides business and tax consulting and is a partner at Ullman and Company here in Phoenix, Arizona.
Michelle Moses [00:00:58]:
So thank you. And as I said, we're going to talk about stock options, and we're going to try to make this as simple as possible.
This was a request from a listener, because he has stock options, at a privately held company. That means that it is not on the stock market. And so it's confusing to people as to how can they get stock options in a business that isn't traded publicly, you know?
Jared [00:01:22]:
And strategy. Right?
Michelle Moses [00:01:23]:
Yes. Yeah. And so how can he utilize those basically? Excuse me. So, let's just get started and dive right in about the different kinds of stock options. And we will be covering restricted stock units and restricted stock all the restricted stock options too. You're going see that they are very, very similar. And so the different kinds of options that you have are called incentive stock options, which we will call ISOs. And the other one is called a nonqualified stock option or NSOs.
Michelle Moses [00:01:57]:
Mhmm. Correct?
Jared [00:01:58]:
Correct. Yeah. I think I think when you hear the term qualified, I always think of pretax. When you have nonqualified, it's effectively just not that. Right? And that's your your effectively after tax deliverable. That's the the way you tend to think about them.
Michelle Moses [00:02:12]:
Just like a qualified plan is your 401 k, and your nonqualified is after tax, which means you've already paid taxes on it. Yeah. Okay. Do you think that the more, common ones are the incentive stock options? Those are the ones that I got when I was working.
Jared [00:02:27]:
Yeah. Well, they're more common from smaller entities looking to grow.
Jared [00:02:31]:
Where if you're working for a public company that trades, the NSOs and restricted stocks are more common.
Michelle Moses [00:02:38]:
Really? Yeah. Okay. So if they're smaller, you're going get incentive stock options.
Jared [00:02:41]:
Typically. Yeah. You tend to see them a lot more in, startup entities, particularly there's, you know, the Palo Alto startup tech entities tend to use it ISOs quite frequently because the strike price or the exercise price is really, really low Right. At the date of issuance and because they're trying to deliver compensational value Yeah. Without actually having to come up with cash.
Michelle Moses [00:03:01]:
Right. Because they can't issue the cash. Right. Yeah. Yeah. And that's what I mean, I guess that's what we should start off talking about is why do people, you know, why do companies give these? And it's to basically give more compensation and to give bonuses to employees without actually having to
Jared [00:03:17]:
Come up with cash.
Michelle Moses [00:03:18]:
Come up with cash to do it. Right? Yeah. And so and it's also a way where people, they'll get, you know, you know, a highly compensated person or, you know, maybe a CEO or, you know, whatever, a technology officer. And that is a way for them to then get them to, like, recruit them.
Jared [00:03:36]:
Incentivize them. Yeah. For not only for recruitment, but also incentivize them for performance.
Jared [00:03:40]:
Right? It's like your your base comp is here, but the total value of your total comp is here if the company performs under your leadership or the combination of leadership, etcetera. Right? And so tend to be, like, in startup entities, they don't have the cash to deliver the highly compensated employees' needs. Right? It's like, hey. I know you're taking a 50% pay cut to come here, but I'm going issue you all these options and ISOs and some other structured compensation.
Michelle Moses [00:04:10]:
Right? So you're going participate in the growth of the company?
Jared [00:04:12]:
And to incentivize you to participate in that growth to, you know, obviously lend your hand to that growth. And at the end of the day, the goal is that you're, you know, 4, 5, 10. You have a, you know, a large payoff or, you know, hopefully, there's some version of a IPO or some type of private equity purchase or something where all of the
Michelle Moses [00:04:31]:
Where you could exercise those options.
Jared [00:04:33]:
Right.
Michelle Moses [00:04:33]:
Okay. Alright. And so how would you describe can we go back and again so the ISOs, I think those are the simplest ones to understand, in my opinion. Incentive stock options because, basically, when you get these right, I mean, you're getting, like, a sheet of paper or, you know, whatever emailed to you. And, so there's different things to be looking out for. Right? And so what are those? Because it's like the grant price or there's different names for everything. Strike strike price. The there's a vesting schedule just like you have inside your 401 k.
Michelle Moses [00:05:07]:
Right? And what am I missing? Oh, the actually and and then there's any limitations on it.
Jared [00:05:12]:
Yeah. Limitations. And with how is it measured. Right? And then things to that effect. But the think let's go through those definitions quickly just to clarify.
Michelle Moses [00:05:19]:
I totally agree.
Jared [00:05:20]:
We have the grants or with the date they deliver your option to you. Right? So here's your grant date. Right here, Michelle, your option to purchase a 1,000, you know, stock at some future point in time. Right? Then you have an exercise day or a strike date, right, whereas where you actually take possession of the stock. You exercise your option, stock's delivered. Right? And then after that, it's really it's your asset at that point. The question is but where it gets complex is, where is the tax implication between date of delivery versus date of sale and what happens in them?
Michelle Moses [00:05:58]:
Right. Because when you actually get the stock option, there is no taxable event.
Jared [00:06:02]:
In ISOs. Yeah.
Michelle Moses [00:06:03]:
In ISOs. Right. And it's just an option to buy the stock because you could leave the company and then leave all those stock options behind.
Jared [00:06:10]:
Right.
Michelle Moses [00:06:10]:
Okay.
Jared [00:06:11]:
Yeah. There usually is very limit there's significant limitations on ability to transfer. Like, if someone passes away or terminates employment, they're just gone.
Michelle Moses [00:06:17]:
Right. They are just gone. Right.
Jared [00:06:18]:
And more importantly, why ISOs tend to be with smaller entities or privately held entities is there's a $100,000 cap per employee. So you do you just limitations on the actual ability to deliver a lot of value. Right? So as, like, in company increases in value, it tends to decrease the amount that you can deliver. Okay.
Michelle Moses [00:06:38]:
Okay. And so once you get these, it's not a taxable event. You just have the option to purchase the stock at a set price at a day in the future. So let's say you got 1,000 and then 2 years from now, you might be able to have 250, 250, you know, and then a year later, another 250 a year after that, you know, so you're going out for years and you have the option to purchase it at that same price. Right. Okay. So what someone can do is, you know, let's say the vesting schedule is 2 years, you have the option to buy 2 50 shares at whatever that strike price is listed on there. And if you are at a publicly traded company, you're hoping that the stock price is higher than what is on your what you're granted.
Michelle Moses [00:07:26]:
Yeah, otherwise, you're not going to exercise it. Because it would be better for you to go out in the stock market and purchase the stock for a cheaper price than for what you want because you want them to be in the money. Isn't that what people Yeah. That's what I used to say.
Jared [00:07:38]:
Yeah. Yeah. Okay. What tends the 10 item that you'd wanna focus on with ISOs, these incentive options, is that they again, they tend to be a very low exercise price because it was delivered to you when the company was increased in value or, you know, early in stages. Right? And so let's say it's a dollar. You know, by a time that vesting schedule is, hopefully, it's worth a $100 and you have a 100 x return. Right? You have this tremendous amount of spread between what it costs you versus the value you're receiving. And that is where the value is delivered to that employee, right, and to, you know, the people that we represent.
Jared [00:08:15]:
Right? But what they do with it and what the and the intent of that is for them is simply is that they're are they trying to exercise and take a home as compensation? Like, it's exercise a cell Mhmm. Type of thing where you have a, you know, obviously, a taxable event at the data of sale. So the so take a step back. The ISOs are generally determined to be qualified or pretax until the date of sale. Right?
Michelle Moses [00:08:40]:
So once you so once you exercise and buy the actual stock, you still that's when you owe some tax. So let's pretend you're going hold on to the stock. Okay? You're not going you're not going to buy the stock and then immediately sell it in the market. You're going to exercise your 250 options to buy 250 shares, I should say, and you're going hold on to the stock. That is a taxable event. Correct?
Jared [00:09:07]:
On ISOs Mhmm. When you purchase it. Mhmm. The reason is qualified is you purchase it at the decreased value, take possession. We don't we don't have an immediate income tax impact.
Michelle Moses [00:09:18]:
Okay.
Jared [00:09:18]:
But often reason we tend to see in tax paid is because, well, mainly we don't exercise unless we plan on selling. Right?
Michelle Moses [00:09:27]:
Right.
Jared [00:09:28]:
It's most common. Right? We don't tend to exercise and pay the money and just take possession because often there's not a market to sell it to. Right? So we tend to exercise and sell instantaneously because the market opens up for us to sell.
Michelle Moses [00:09:41]:
Right. Okay.
Jared [00:09:42]:
Does that make sense?
Michelle Moses [00:09:43]:
Yeah.
Jared [00:09:44]:
Okay.
Michelle Moses [00:09:44]:
So most people with incentive stock options will exercise and sell within one day. Usually. And then it'll become a taxable event.
Jared [00:09:50]:
Yeah.
Michelle Moses [00:09:50]:
Okay. And we we should really plan on that. You're going take home, like, 70% of that.
Jared [00:09:56]:
Yeah. Yeah. And and yes. For the most part. Right? So here, I don't wanna get too into
Michelle Moses [00:10:02]:
Yeah. Yeah. Yeah. I'm just saying an estimate.
Jared [00:10:04]:
Yeah. Yeah. Exactly. There's depending what you wanna focus on, it's a spread between the market value and your your exercise price. What you're paying for it. Because depending on what happens, that's where the tax impact is. Right? And if you sell it instantaneously, absolutely, you have immediate tax impact. Right? We're if you exercise and hold, there still could be a tax effect associated with AMT.
Jared [00:10:30]:
Really complicated. Mhmm. And it gets even more complicated the the longer you hold them.
Michelle Moses [00:10:35]:
And this is why Jared has a job.
Jared [00:10:36]:
Yeah. A little bit. And, it gets but sometimes that happens simply because, an employee wants to take possession before a subsequent event. Right? Some there's a company coming in to buy it or
Michelle Moses [00:10:52]:
Or they're going public. Or they're
Jared [00:10:53]:
going public or something's happening where they need to take possession and they don't have a means of sale to the market. Okay. So they so they end up having this possible tax event from AMT purposes. But if there's an open market for you to sell into, yes. Absolutely. More often than that, you extraize and immediately sell. Be okay with paying the capital gains, and, yes, you might end up walking home with, you know, 70, 75¢ on it.
Michelle Moses [00:11:18]:
Okay. Okay. And so for my my listener question of privately held company that is issuing stock options, there is no option to exercise them until there there is someone coming in to purchase the company or you are go that company is going be going public. Yeah. Correct? Okay.
Jared [00:11:37]:
Yeah. That's pretty common because they need a source of cash to to pay you. Right? The reason you're getting these because they can't give you compensation via cash, so an external party coming in
Michelle Moses [00:11:46]:
They're just trying to incentivize you to grow the company so that they can then go public because that is, like, their goal. Right. Okay. And I think it is, it's a good time to mention this, that there are investments in my world where they will go into companies and this happened, with I think Dropbox is a good one, that they went into Dropbox before it went public, and they give the employees an option to purchase all of those stock options. And then what they do is they pull them together and they make funds out of them. And so a lot of employees will like to do that, just so that they aren't at the whim of the market, and it's kind of a sure thing. So that is an option. But you definitely, if you are at a privately held company, and you have these stock options, just know that that is an option before you actually go public.
Michelle Moses [00:12:36]:
And it's usually, 6 months, 6 to 12 months before all of that. Yeah. Usually Happens.
Jared [00:12:42]:
Yeah. It's usually like a little blackout window where they allow external parties to come in and buy. Right? And the thought process is that you can create some certainty for yourself.
Michelle Moses [00:12:50]:
Exactly. Right?
Jared [00:12:51]:
It's like, I have a lot of risk on the table. Let's say, it's 90% of my overall compensation for x nber of years. This is one particular set of options. Fall through the floor.
Michelle Moses [00:13:04]:
Yeah. You don't know what it's going do.
Jared [00:13:06]:
Yeah. So this gives me some certainty. I could sell it to some party and take some money off the table before the whims of the actual tradable market. Take it for a ride. Right. It was kind of a thought process.
Michelle Moses [00:13:17]:
Right.
Jared [00:13:17]:
And these companies come in and they they might try to buy they're going to try to bridge hedge their risk associated with buying it at a discount from you. But, again, it's certainty versus uncertainty. You know, how much do you wanna leave
Michelle Moses [00:13:29]:
to the
Jared [00:13:29]:
whims of the market?
Michelle Moses [00:13:30]:
Yeah. I think it's kinda like, I did an episode on annuities. You're giving up a little bit of money for some certainty.
Jared [00:13:35]:
Yeah.
Michelle Moses [00:13:35]:
Yeah. And that's just what people do. Okay. So have we missed anything just on the covering the top level of ISOs? I know it can get really complicated based upon whatever attack situate your personal tax situation is and whether you should exercise them. But I think just as general knowledge.
Jared [00:13:54]:
Yeah. The the one thing to know simply from, determination of tax is that there's one item called a what's called a disqualifying disposition, meaning that you're granted you exercise an ISO. You now have an another whole period afterwards within usually 1 or 2 years. And if you if you sell within that 1 or 2 years after exercise, you have ordinary income.
Michelle Moses [00:14:20]:
And what are these called?
Jared [00:14:21]:
It's called disqualifying disposition. Well, if you sell it too quickly after you take possession, you have a disqualifying dis a disposition. Sometimes it doesn't matter because the prices tend to align, but sometimes it does when the there's a increased value.
Michelle Moses [00:14:44]:
So when there's a huge difference in price
Jared [00:14:46]:
spread is big.
Michelle Moses [00:14:47]:
So let's say your exercise price is $10 and the size or the and then the price of the stock is a $100. So you're saying that is too big of a Well,
Jared [00:14:57]:
it's it's it's a differentiation in tax rates. Right? Whereas if you have a disqualifying disposition, it could result in ordinary income, where you're planning on capital gains, which might be 10 or 20% less.
Michelle Moses [00:15:10]:
And how do you determine if it is this disqualified?
Jared [00:15:13]:
If there's a whole period after you take possession, it's it's
Michelle Moses [00:15:16]:
All the time?
Jared [00:15:17]:
Yeah. It I wrote it down. 2 years from the grant date or 1 year from the date you exercise.
Michelle Moses [00:15:22]:
Okay.
Jared [00:15:22]:
So it's
Michelle Moses [00:15:22]:
And this is always with ISOs?
Jared [00:15:24]:
Always with ISOs.
Michelle Moses [00:15:25]:
Oh, okay.
Jared [00:15:25]:
Yeah. So and, again, if the spread's not too big, it doesn't matter to you too much. Right? But if the spread grows by the time you get to there, sometimes it might be valuable to exercise and hold. Right? To kinda lock in the price and get past that date. So when you do sell, it's all capital at that point in time.
Michelle Moses [00:15:44]:
Well, and especially if you're thinking about leaving, you're going wanna exercise, hold the stock, and then hold it for
Jared [00:15:49]:
Right.
Michelle Moses [00:15:50]:
Is it what how what can you repeat the Yeah. 2 years
Jared [00:15:52]:
from the data grant or 1 year 1 year from the date you exercise.
Michelle Moses [00:15:55]:
Okay. So if you if you get granted, I think that's a lot of times why they have the, vesting schedule and the limitations. It's just so that you have to once you're issued the stock options because I've never heard that, but I've always just seen it that you can't sell them for 2 years. Like, so once they're issued, then you can exercise them for 2 years anyway.
Jared [00:16:12]:
Yeah.
Michelle Moses [00:16:13]:
And then you've got your vesting schedule.
Jared [00:16:14]:
The one that tends to bite us isn't the 2 years from Grant. We're tend we tend to be locked into that. The one that tends to bite us is the 1 year from the day you exercise.
Michelle Moses [00:16:21]:
Okay.
Jared [00:16:22]:
Right? And that that because sometimes you exercise and legally sell, Sometimes if that price is too far apart, you might have an ordinary income impact associated with that. But it really depends on all the facts. I just make note of it. Just asse that just because it's an ISO, it doesn't mean it's always capital.
Michelle Moses [00:16:39]:
Okay.
Jared [00:16:40]:
Right? So it could there's could be a portion that comes out as ordinary income.
Michelle Moses [00:16:43]:
So, basically, you get okay. So you get granted. You wait 2 years. You buy the stock. You still have to wait another year
Jared [00:16:51]:
Right.
Michelle Moses [00:16:51]:
No matter what. No. It the you
Jared [00:16:53]:
can do whatever you want.
Michelle Moses [00:16:54]:
You can do it. I mean, you can exercise it, but then it becomes ordinary income.
Jared [00:16:57]:
Yeah. Yeah.
Michelle Moses [00:16:58]:
But if you wait a year of whole and hold that stock, then it becomes capital gains.
Jared [00:17:02]:
The computation's a little bit more complicated than that, but give it to that thought
Michelle Moses [00:17:05]:
process.
Jared [00:17:06]:
But can I make just one general thought process? Yeah. Is when you think of any version of option, if your goal as a as an employee is to treat it as compensation Treat it as compensation. Be okay with the some of it coming out as ordinary income because you don't plan on holding it. You plan on taking it home. Right?
Michelle Moses [00:17:26]:
Okay.
Jared [00:17:27]:
If your intent is to stay on the wave of growth with that company and hold it as an investment, and be okay with holding it as an investment. Okay. And then you get the benefit from the lower capital gains rates, but you also take the risk associated with holding that position longer.
Michelle Moses [00:17:45]:
See, I love that. And I that's what I love about finances that we can get into all the nbers and, you know, and taxes. I mean, all of it. But it's really a mindset. I mean and so you have just wrapped that up in this little succinct, you know, statement, And I just love that because it's just a change of mindset.
Jared [00:18:03]:
Yeah. Exactly. Because if if I'm I had a nber of clients particularly, I say, I think go GoDaddy, Cloudera, Slack, Red Hat, all these other ones where you have these large acculations of stock options. Right? And, you know, what what that really comes to mind is when a client that had a, like, 25 years with acculated options and ESPs and everything all at IBM. Thankfully, IBM's, like, price has stayed, like, steady for, like, 25 years. So they're not really too much impacted by that, but the companies have a lot of valuation changes. A lot of them, if you if you hold a lot of it, a lot of your whole
Michelle Moses [00:18:39]:
Yeah. Your whole wealth. Yeah. Is in this one stock.
Jared [00:18:43]:
Like, regardless what the tax cost is, take some of it off the table every once in a while. Yeah. Right?
Michelle Moses [00:18:48]:
And and because you don't wanna have all your eggs in one basket.
Jared [00:18:50]:
Risk is really, really high in the tax cost. As I think of it as a you exercise, and let's say the price is a 100. You have this huge tax impact, and you're you know, like, there's really this I can't justify paying 37% tax rates on this deliver. Yeah. Right? And then 6 months later, the market takes 30% away from
Michelle Moses [00:19:14]:
you. You might as well just sold it and taken the money.
Jared [00:19:16]:
And take and taking the money. Right? You're in the almost exact same spot.
Michelle Moses [00:19:20]:
Right.
Jared [00:19:20]:
You were 6 months prior.
Michelle Moses [00:19:22]:
Right.
Jared [00:19:23]:
And you now you have to consider, do I take even less, or do I gotta sit here and take more risk and wait for it come back?
Michelle Moses [00:19:29]:
Right. Right? And and Yeah. I think it's important
Jared [00:19:33]:
minimize that bull.
Michelle Moses [00:19:33]:
Yeah. I just think it's really important that people don't focus so much on just not paying tax. Like, you've got to pull yourself out of that and think about whatever your long term goals are. You need to think about what, yes, what could happen. And, yes, like a doomsday scenario.
Jared [00:19:48]:
Yeah.
Michelle Moses [00:19:49]:
Really. And is it really that bad to pay 30 or 35% and take home most of the money?
Jared [00:19:54]:
Yeah. So when you see the ISOs, they tend to be with against smaller companies or tech companies or some companies that need a lot of cash flow from the market to pay employees type of mindset. And there tends to be a lot of valuation change where you see these other options, like, we go into, NSOs tend to be Fortune 500 companies or large publicly traded entities. And, yes, there's still a good amount of fluctuation in certain industries, but some some industries are relatively stable. Think of, like, utilities and things of that effect tend to be pretty straight across the board. Right? You don't have too much value change in their asset position, and they're just getting more and more options, and it's really just compensation. Yeah. At that point.
Michelle Moses [00:20:33]:
Okay. And I think it's important to, you you mentioned a couple of things in story is end story. Employee stock purchase plan. You kind of mentioned that a couple of sentences ago or I guess a couple minutes ago. And, these are different than the in store employee stock purchase plan. And those are where you're just buying the stock at a discount, and you're just putting it into your account. There's I mean, it's pretty straightforward.
Jared [00:21:00]:
Yeah. It's after tax money.
Michelle Moses [00:21:01]:
Yeah.
Jared [00:21:01]:
It's like instead of putting it in your checking account, you buy employ your employer's stock at a discount.
Michelle Moses [00:21:07]:
Just because you work there, you get a discount. Yeah. You know? It's like working at a retail store, and you get a 15% discount for buying stuff there. It's it's the exact same thing. And I have seen people get way too much stock in in those, you know, like that. So it's too much of their net worth.
Jared [00:21:22]:
It might feel like buying something on sale. Yeah. It's like it's like just because it's on sale doesn't necessarily mean you need to
Michelle Moses [00:21:27]:
purchase it. Yeah. Or put that much of your net worth into it, you know. Yeah. Yeah. So because so you just wanna make sure you're not putting all your eggs in one basket. And, and before we were before we started, we were talking about how ISOs are very similar to restricted stock options. No.
Jared [00:21:45]:
Units.
Michelle Moses [00:21:46]:
Units. Restricted stock units. So if you have an ISO or restricted stock units or
Jared [00:21:53]:
NSO.
Michelle Moses [00:21:54]:
Or sorry. NSOs are stock units, but ISOs are inter are the same as Yeah.
Jared [00:21:59]:
So ISOs are pretax. Right? Because that's their intent, then they have their income tax implications associated with it. We just spent tremendous amount of time. NSO or nonqualified option is pretty much an after tax option because it comes out as wages. Restricted stock units are very similar. They're there's the contracts structure differently, that's why they have a a different fancy title, but they could also come out as wages. So when you see nonqualified options and their expiration dates and their vesting schedule, they tend to be granted to you, but you have limitations on access and vesting in take possession. Where a restricted stock unit is delivered to you in advance, I'm sorry, is delivered to you in the future until you vest.
Jared [00:22:48]:
Right? So there but at the end of the day, the in both those circstances, the minute you take possession or you exercise, you have an ordinary wage implication. It's just added to your w two.
Michelle Moses [00:23:00]:
So that means you're going pay and what he means by that is that you're going pay so security tax, you're going pay all your FICA taxes, Yeah. Your Medicare, all that.
Jared [00:23:06]:
Yeah. What tends to happen is that the employer and, again, these tend to be, Fortune 500 companies. They they, publicly traded companies. They sell approximately 1 third of your options to the market to generate the cash to pay those taxes. Right? So they'll pay all you'll be granted a 100. Right? And 66 will appear in your Fidelity account. And you're like, I thought I had a 100. Well, it's because they sold the other 33a half to pay your Social Security, Medicare, and your income taxes.
Jared [00:23:35]:
What tends to happen is, particularly when these nbers get really big, is that the income tax be tends to be a little too low and you end up being underpaid at the end of the day. Not the worst place to be in because you just got a tremendous amount of value. Mhmm. Right? But you tend to lose about a third of the options before they turn into stock Okay. For both of those circles.
Michelle Moses [00:23:54]:
Okay. So and I think the point is is that if you see the word restricted stock, whatever comes units or options or whatever comes after after the end of that, that it is very, very similar to the stock options that we're talking about in this podcast. Non
Jared [00:24:10]:
in unqualified options.
Michelle Moses [00:24:12]:
Yes. Yeah. So, okay. So there's basically the 2. There's the ISOs and the NSO wait. NSO. Sorry. We have so many so many acronyms.
Jared [00:24:23]:
It's a good good reason to know that even though you might spend a tremendous amount of time in this Yeah. It is incredibly easy to get tripped up.
Michelle Moses [00:24:33]:
Oh, absolutely.
Jared [00:24:33]:
We name them all kinds of different things.
Michelle Moses [00:24:35]:
Yes. We we
Jared [00:24:36]:
we tend to we tend to call them different things. Yeah. Right? Employers will call them different things because they wanna give it a fence title for the fancy executive, and it it it all It all
Michelle Moses [00:24:44]:
ends up being the same thing.
Jared [00:24:46]:
So we always have to try to break it down. Then so ISO is pretax. Non qualified is after tax. That's why it comes out as wages. You know, same as the reason I compare it to restrict to stock units, this contract might be different, but they for tax purposes,
Michelle Moses [00:25:00]:
it's it's compensation. Yeah.
Jared [00:25:02]:
It comes out. It adds to your w two.
Michelle Moses [00:25:05]:
Whereas with incentive stock options, you could possibly make them capital gains.
Jared [00:25:09]:
Yeah. They they that's the reason they're pretax is because you're trying to get the capital.
Michelle Moses [00:25:13]:
Yeah. And capital gains basically means that you're taxed between 5 15% depending on how much money you make. So it is you're paying less tax, essentially. Whereas you're going pay more like 30% of your wages if it comes as as income because as a wage because you're going be paying on all your Social Security.
Jared [00:25:32]:
Yeah. Yeah. They're like a taxes. When your income's high and you have a marginal tax bracket in the thirties, it's going feel like you're losing 40, 45% of your value because all of the additional taxes and employment taxes on top.
Michelle Moses [00:25:44]:
Right. Right. And that's why people freak out. But again, it's compensation. Right? I know. And, again, you're taking money home that you weren't going be taking money you know, you weren't going be getting it before. So
Jared [00:25:53]:
When you think of these after tax programs, like the restricted Yeah. Just that that's just what is the way it's structured. Here's your units. Yeah. Just that that's just what is the way it's structured. Here's your units. Go sell them in the market to get your money. The type of mindset.
Michelle Moses [00:26:11]:
And then you can hold it or you can sell it just like you would in any other stock account.
Michelle Moses [00:26:15]:
If you wanna hold on to it and you believe in the company, that's fine. And it will be transferred into your, you know, your own account. And then you can, you know, I have some people that retired and we, exercised a lot of these and then they held on to the stock because they thought it was going go up. And then we sell them for their vacations every single year.
Michelle Moses [00:26:34]:
And that's just how we look at it.
Jared [00:26:35]:
Yeah. It says, at that point, you've been delivered the value. You could choose to diversify it however you want. Yeah. At that point.
Michelle Moses [00:26:41]:
And I think it's important, you know, how I couldn't remember the acronym. You know, these things, they are very complicated, you guys. I mean, this is why you have people like Jared to go to and, ask whether that you should exercise them. I remember when I I first took this job, I really beat myself up that I couldn't remember the, contribution limits for IRAs and all of the retirement plans that I really committed to that every single year. And then one time I saw a CPA be like, I don't know. I can't remember and then looked it up, and I was like, oh my god. I can just look it up. I mean, I don't need to memorize all of this.
Michelle Moses [00:27:15]:
I just need to know where to look it up. And so
Jared [00:27:18]:
It changes every year.
Michelle Moses [00:27:19]:
Yeah. I mean, everything changes. You can't fit fit it all in your head. And I mean, I even got notes in front of me. And I was like, oh, was it NSO? Is it a you know, because there's u and s and yes, there's all kinds of, yes, acronyms. So, don't beat yourself up because we can't remember it either. I mean, we can. We know what we're talking about, but to be able to specifically say, you know, what it is is yes.
Michelle Moses [00:27:42]:
That takes a whole another level.
Jared [00:27:43]:
Yeah. I I think that ultimately, I got one more we wanna Yeah. Touch on regards to restricted stock itself. But the the, I think the nber one takeaway I try to convince all of our clients and people I talk to is simply determine your goal of what you're going do. Right? And that might change the longer you're there, you know, you know, 6 months in, you're like, I can't do
Michelle Moses [00:28:05]:
this anymore. Yeah. Yeah.
Jared [00:28:07]:
It might change
Michelle Moses [00:28:08]:
Then you're like, I better exercise these because I need to get out of here.
Jared [00:28:11]:
Yeah. Exactly. And your incentives change, you know, life happens, whatever it might be. But try to try to identify a plan and then quantify its value pretty consistently. Like, every quarter, every 6 months, you know, kind of revalue and see how much Mhmm. How much of your net worth you have in this one thing. And then adjust your plan as it's like, you know what? I need to take some of this off the table, and here's comes an option for me to do that or something to that. And then go from there because the last thing you want is you want is a large acculation of your net worth in there.
Jared [00:28:42]:
And then because of inaction, you allow it just to go an extra 6 months or so or another year, and the valuation falls off the table, and now you're stuck.
Michelle Moses [00:28:53]:
Yeah. Right?
Jared [00:28:53]:
And that that's probably the worst circstance, and that's happened a lot, you know, with this these entities that is particularly startup entities where they have huge valuations. And, hanistically, we wanna just say, yep. This is going keep going. Right? And then the value drops by, like, 80, 90% because a competitor enters a market or something like that. And then you watch, like, 90% of your net worth disappear.
Michelle Moses [00:29:16]:
Right. Right. And you so it's more about taking a balanced approach and, yes, and I've seen that happen. And it, you know, stuff can happen just out of the blue. It's, there's a lot of people here in town that work for Wells Fargo. And you know, when they had that big where they're opening up all the accounts, and they have all the penalties, and, you know, their stock was flying high for a long time, and a lot of people weren't worried about it. And, you know, oh, they're doing great. Well, they're not you know, not everybody does great forever.
Michelle Moses [00:29:45]:
It's just it's kind of the name of the game. So do you think we're missing anything? I feel like we kinda touched on
Jared [00:29:50]:
Yeah. Well, let me touch on one thing. Okay. Because this tends to come up a lot with again, similar to it's not similar to ISOs, but it tends to enter the same conversation. That's just where restricted stock or restricted stock awards. You tend to see usually, the valuation is issued in these privately companies, small companies at 0. It's like you're getting this stock option because you're entering in when everybody else we just started this company. I'm going give you some options.
Jared [00:30:16]:
You can't do anything with them. They're valued at 0, but here's what's called an 83 b election filed with the IRS, and it tends to confuse somebody pretty quickly, because they have no idea. They're just know they're starting a new job. Right? And they got these options that are currently worth nothing, you know. But that that piece of paper is in credibly important because it locks in the price for tax purposes at the price at the date of delivery.
Jared [00:30:41]:
So restricted stock is not the same thing as restricted stock units or ROCs. Restricted stock is simply stock that you're being delivered today, and that's taxable to you at its value at that point in time. We tend not to see that very often unless the price is 0 or something really, really small. Right? And and I think And
Michelle Moses [00:31:00]:
so if they don't file that, will the IRS not believe you? Is that
Jared [00:31:04]:
If you don't file it, you're effectively tax implication is at the later point in time
Michelle Moses [00:31:10]:
Of whatever the stock price is.
Jared [00:31:12]:
When the price when the exercise price is significantly higher. So we tend to make this election. You can elect to to pay tax at the date of delivery. Absent that election, you pay tax at the date of exercise, and that might be a very significantly higher market value.
Michelle Moses [00:31:27]:
Oh, wow.
Jared [00:31:28]:
So let's say, for example, we start a company and we you know, you issue me units. And you say, it's currently worth nothing because I literally started it 5 minutes ago, but here's an 83 b election because you got 25% of the company. Make sure you file it because it has a zero valuation or 0 transfer market value. Right? After that point in time
Michelle Moses [00:31:49]:
So, essentially, you wouldn't pay any taxes because it's 0.
Jared [00:31:52]:
I I I've recognized a taxable event, but it's 0 in value. But everything after that is capital gains. Right?
Michelle Moses [00:32:00]:
Mhmm. Absolutely. That's the lower taxable amount.
Jared [00:32:03]:
Yeah. And the the the benefit is I've made this election. I've locked in these lower tax rates. Right? Absent that election, which tends happen because they tend to not file it, they get it, and they forget to file it with the service.
Michelle Moses [00:32:19]:
What if they found it 2 years later in their paperwork? Could they file it then?
Jared [00:32:23]:
It it gets into a Maybe. No. No. That's no. Because the the time, the line you have to have a timely file that the data transfer. So you Okay. If you let too much time go by, you can't go back and retroactively define your intent.
Jared [00:32:39]:
You know, so the action's gone. It has to be timely filed.
Jared [00:32:41]:
And so the thought process being is that a good example. We had a client that, I think it was a a medical consulting or surgical center type of thing, and the company had just started. They had valued his options, restricted stock options, at, I think, a dollar or maybe, like, a dollar 40. They actually had to hire someone to come up with this complex. And I think he he had, like, a $40,000 income event as a result because he had a 100000 options or something. He paid tax on that 40,000, that valuation, but he got no comp. He had no cash for that. 6 years goes by, and the valuation is now $2.40.
Jared [00:33:24]:
Right? He pays tax on that appreciation at capital gain. Absent that election, 83 b election, he would have paid ordinary income at the 2.40 instead of
Michelle Moses [00:33:34]:
For all of the 2.40? Of it. 2.40 times however many shares.
Jared [00:33:37]:
Yeah. Exactly. So it it's it's, again, it's only I've only seen it common in small entities that are starting because they wanna deliver this immediate tax value when the valuation's significant smaller.
Michelle Moses [00:33:51]:
Okay.
Jared [00:33:52]:
And sometimes it turns into nothing. It's 0 today, and 5 years from now, it's still 0.
Michelle Moses [00:33:55]:
And that's just straight restricted stock. Straight restricted stock. Yeah. Not a restricted stock unit or yes.
Jared [00:34:01]:
Yeah. The same thing process is the the one item that is comparable to ISOs is that it tends to be you can't do anything with it until 10 years' time when we sell a company. There's the IPO or some buyer comes in, some liquidity event happens, and they can pay you.
Michelle Moses [00:34:15]:
Right. And I think it's important to to say this that when a company issues these, there's usually somebody at the company or a lawyer that they've hired or someone that if you were to ask around at HR, the person that does your benefits, that they'll be able to direct you to someone that would be able to explain this or at least send you an email to explain it, and then you could send it to somebody like us. So I know that there's options out there. So don't just get these things and just go, Oh, I don't know what it is. You know, there are people at your company that will probably be able to explain it. And they probably do have some sort of marketing piece put together that will explain what you have.
Jared [00:34:55]:
Yeah. Don't ask HR. HR would be glassy eyed. I I have no idea what you're Well, I
Michelle Moses [00:34:58]:
know, but they know where to point you. You know what I mean? They know they know, like, the the ways of the who put this all together and who put the plan together. Yeah.
Jared [00:35:06]:
Because the whole purpose of the employer is to deliver value to you Yeah. That they can't currently give it to you in cash. Right? So they wanna say, listen. I need to keep you as talent, and I need
Michelle Moses [00:35:16]:
to keep you.
Jared [00:35:16]:
I need you to know that I'm giving you a tremendous amount of value. So here's, you know, Sally and Jeff, and they'll tell you exactly how you quantify this and how you get your value out of it as some future points.
Michelle Moses [00:35:27]:
Yeah. And I think when you're thinking about these, and they are so complicated, obviously, I mean, because we're just touching the surface of them, that it you know, just come away with one little thing. And I think Jared's point about just knowing what your intent is, is if you're going to just use it as compensation, or if you really believe in the company, and you're going to stay there long term, that's great, you know, that you could just remember that one thing, and know that gives you a purpose with what your with this one part of your bucket. I'm going put it that way. And so I don't think you need to remember all the details, because, gosh, we don't remember all the details of everything. You know, we have to review files and
Jared [00:36:08]:
I may have only spent like an hour and a half like remembering all
Michelle Moses [00:36:10]:
the stuff. I know. I may have spent like an hour and a half studying yesterday to make sure that I remember how these work. And, so don't beat yourself up. I mean, this is, you know, we have to go back and, you know, somebody comes to us. And then I say, well, let me look this up and make sure I know, because it's not as common as, hey, I'm just going put money in an IRA. That I can just do off the top of my head. But a lot of this stuff and especially like it reminds me of like cash balance plans.
Michelle Moses [00:36:37]:
You know, a lot of that stuff just gets very confusing. So if you have all of these, you know, DB plans and, you know, stock options, Just know that they do take just some research.
Jared [00:36:50]:
So here's a here's a great point I try to press with a lot of clients. You every time, and I think we talked about this when when I was on last, is that in exchange for a tax benefit, a lower rate or deduction or something pretax, you're always giving up something in exchange. Right? You know, talk about cash balance plans and other things to that effect. And they tend to come with complexity. Right? So you wanna make sure that the dollars assigned to this complexity are worth it
Jared [00:37:22]:
Right before you dive ahead into it. Right? And so we we wanna is often these options tend to come up with a tremendous amount of future value that you can't easily quantifiable today. Right? And it there might be some complexity at the front end to understanding that, but just know that in when the valuation does go up at some future point in time, it was worth the effort.
Michelle Moses [00:37:45]:
Right.
Jared [00:37:45]:
Right? When you're at purposely adding complexity to your life and you get a $1,000 of value, be okay knowing that you just wasted your time and your effort Yeah. You know, and some money maybe, you know, type of mindset. Just make sure that if you're adding complexity to your life, that you're getting something in exchange.
Michelle Moses [00:38:01]:
Yeah. I kind of use that when people wanna buy a house with an IRA. Yeah. I'm like, it's very complex. There's a lot of paperwork, and we need to make sure that you wanna do something like this. Yeah. You know? So
Jared [00:38:11]:
We're going add a couple third parties involved.
Michelle Moses [00:38:13]:
Yeah. And you're going have a lot of fees, and you're going have to do a lot of paperwork, and it's going be a lot to keep up with. Is it worth it? And I think that's, you know, those are the kinds of things to think about because it does, it just gets more and more complicated because there's, I just think of it more legal jargon, more legal paperwork and things like that. So, well, Jared, thank you so much for being on. And everybody, I hope that, this shed a little bit of light on stock options and just gave you, walking away with a couple things that you've learned. And thank you so much for listening, and, be sure to leave a review or let me know if you have other topics that you want to hear about. Thank you so much, guys.
Disclaimer: The information provided in this podcast is for general informational purposes only and should not be construed as professional financial advice. Always consult with a qualified financial advisor or professional before making any financial decisions. The hosts and guests of this podcast are not responsible for any actions taken based on the information presented.