Understanding Company Stock Plans

TRICKS OF THE TRADE

Company Stock Plans

Prepared by: Michael Menninger, CFP®

Many employers offer a variety of stock plans, but they are typically limited to larger public companies whose stocks are traded on the stock exchanges. The most common types of stock plans are:

• Company stock inside 401(k)
• Restricted Stock Units (RSUs)
• Company Stock Options
• Employee Stock Purchase Plans (ESPPs) 

If you need assistance with understanding company stock plans, the investment management planners of Menninger & Associates will be able to assist.

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Company Stock Inside 401(k)

This is the simplest and most common method of purchasing company stock. Simply put, the employee can elect to purchase company stock with any portion of their 401(k), as it becomes just another one of their many (usually around 30) investment choices. Thus, an employee may invest in their company stock, but there are typically no special matching programs that the company will use to incentivize the employee to buy company stock.

However, there is a little-known rule called Net Unrealized Appreciation (NUA) that allows the participant a tax-advantaged opportunity when buying company stock inside their 401(k). This rule has several nuances, but in short, it allows the employee to roll over their company stock to an after- tax brokerage account. In doing so, they pay ordinary income tax on the cost basis, but any gains in the value will then be considered long-term capital gains, which are always taxed at a lower marginal rate than ordinary income.

While this may sound appealing on the surface, the tax burden associated with being taxed on the cost basis could make this option less desirable. Plus, there are certain guidelines the employee must follow in order to qualify for NUA tax treatment. Thus, the employee should carefully review the pros and cons of NUA, administer it properly, and/or consult with a qualified  financial advisor or tax advisor.

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Restricted Stock Units (RSUs)

Restricted stock units (RSUs) have gained popularity over the past decade as a tool for companies to reward valued employees. RSUs are also intended to create incentives for those employees to remain with the company. RSUs are typically granted on an annual basis in the form of a number of shares of company stock. They also have a vesting schedule that ranges from 3 to 5 years, such that (assuming 3-year vesting), the employee will vest 1/3 of the shares each year after the first year. The table below shows how the vesting of RSUs works and assumes a 3-year vesting schedule.

Year Vested

Year Granted	Shares Granted	2020	2021	2022	2023	2024	2025	2026
2020	120	X	40	40	40	X	X	X
2021	150	X	X	50	50	50	X	X
2022	180	X	X	X	60	60	60	X
2023	240	X	X	X	X	80	80	80
Total Vested	690	0	40	90	150	190	140	80

*Examples are hypothetical and for illustrative purposes only. Your benefits will vary.

 

In the table above, it shows the shares granted in 2020 being divided and vested evenly after 1, 2, and 3 years. In 2023, it shows that one-third of the shares granted in 2020-2022 become vested for a total of 150 shares being vested, in that year.

On the date shares are vested, their fair market value is considered compensation (i.e. – W-2 earned income) and is taxed accordingly by Federal, State, Local, Social Security, and Medicare wage tax rates. To pay the taxes, the company sells a portion of the shares (usually about 30% - 40%) and the remaining shares are placed into a third-party brokerage account. This will typically appear on the participant’s pay stub even though no money is actively received.

Using the example above in 2023, the company would sell approximately 60 (40%) of the shares to pay taxes and the employee now owns the remaining 90 shares. For purposes of capital gains treatment, the cost basis of the remaining 90 shares is the share price on the vesting date which is also considered the purchase date. Thus, to qualify for the preferred tax treatment of long- term capital gain, it must be held for more than one year.

Employee Stock Purchase Plans (ESPPs)

Employee stock purchase plans (ESPPs) are typically offered to all eligible employees, rather than a select group of “valued” employees. The ESPP allows the employee to withhold after-tax dollars from their paycheck to buy company stock. Most plans limit employees to 10% of their salary, but the IRS limit is $25,000 per year.

The ESPP has an offering period that is usually 3 or 6 months. During the offering period, the employee withholds money from each pay. At the end of the offering period, they buy the company stock with the money withheld during that period. Here’s the kicker. The company usually offers the stock at the lower of the share price at the beginning and the end of the offering period, and the company also often provides a discount of 5%-15% off the purchase price. For example, if ABC stock price began the offering period at $40 per share and ended the period at $50 per share, the participant would buy the shares at $34 per share (assuming the company allows a 15% discount, or

$6 per share) off the lower price. Thus, the participant immediately has a gain of $16 per share ($50 fair market value minus $34 cost). That’s a great deal!

So how are these shares taxed? That can be a little tricky because there are two components:

1. The 15% discount of $6 per share and, 
2.  The capital appreciation of the stock of $10 from $40 to $50. The discount is considered employee compensation and will be treated as earned income at the time of the sale. The $10 growth is treated as a capital gain and must be held greater than one year to receive the tax-favored long-term capital gain rate.

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Employee Stock Options

There are 2 types of stock options provided by corporations to their employees – Non- Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). Stock options are typically provided by large corporations to more highly compensated and key employees as a means of employee retention. These are described below.

Watch Company Stock Plans Explained

Non-Qualified Stock Options (NSOs)

NSOs are the most common type of stock options seen today. NSOs are issued (“granted”) by the corporation to an employee at the market value of the share prices at the time of the grant (“strike price”). They typically have a 1-5 year vesting period, as well as an expiration date of 10 years from the grant date. After the shares are vested, the employee has the right to “exercise” the stock option. When doing so, they receive the difference between the sale price (market value at that time) and the “strike” price.  Similar to RSUs and the discount on ESPPs, the gains on the exercise of NSOs are treated as earned income, which means it is subject to all levels of taxation (Federal, State, Local, Social Security, and Medicare). There is no capital gains treatment of these shares. On rare occasions, there can be other tax treatments of NSOs, but that is beyond the scope of this article.

Incentive Stock Options (ISOs)

ISOs, are less commonly used by corporations, so they are less frequently seen anymore. Due to a tax law change a few years ago, ISOs lost a tax advantage provided to corporations, so their use has decreased. ISOs are granted by a corporation at the current price of the stock, known as the strike price. The employee will then have a vesting schedule of those options that could range anywhere from 1 to 5 years. Once vesting, the employee has 3 choices.

1. Exercise the stock options by buying those shares at the strike price.
2. Exercising the stock options by immediately selling the shares at the new price and receiving the proceeds.
3. Holding (not exercising) the stock options until a later date when the employee may choose Option 1 or 2 above.

If exercising shares by choice 1 above, the employee now owns the shares, and their cost basis equals the strike price, which is the price they paid for the stock. Further, their purchase date is the day they bought the shares, and if held more than one year (and two years from the grant date), then the individual will enjoy the benefit of tax-advantaged long-term capital gains tax rates. If sold less than one year later the participant pays short-term capital gains tax rates.

Which Employee Stock Options Are Best For You?

Questions About Your Company Stock Plan? Contact a CFP

If you own company stock in any of these types of plans, it is very important to know all of the “rules” established by the corporation, which can be found in the Summary Plan Description (SPD). It is also important to know and understand how the corporation treats these stock plans if the employee terminates (or retires) their employment, to not lose any money. Thus, we encourage you to speak with a qualified financial professional if you have any questions regarding your unique circumstance.

In conclusion, company stock plans can offer some very favorable benefits to the employee. Speak with a Menninger and Associates Certified Financial Planner to discuss your investment goals and help determine which stock plan may be best for you: (610) 422-3773.

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