Since the technology boom of the mid 1990s, company stock plans have become ubiquitous beyond Silicon Valley. The appeal of these plans, which include but are not limited to stock options, restricted stock, and RSUs (Restricted Stock Units), is obvious for both employers and employees. For employers, these plans prove effective in keeping talent and incentivizing employee production, albeit with conditional “golden handcuffs”.  For employees, these plans represent an opportunity to build corporate ownership over one’s career.

While the popularity and appeal of company stock plans are obvious, the tax repercussions of ownership are not always so. In fact, in any given tax year, it is all too easy to unknowingly trigger ordinary income and AMT (Alternative Minimum Tax) – both of which could be avoided, reduced, or planned more effectively. While tax season is officially behind us, one does not have to wait until next year in order to reduce the tax bite involved in ownership and or sale in company stock. In fact, throughout the year, it is possible to implement strategies which can serve to both limit concentration risk and reduce the tax impact of company stock ownership.

Strategy One

One strategy that could prove effective is to exercise ISOs (Incentive Stock Options) at an early stage and before the fair market value appreciates. This strategy is applicable to individuals working at a “start-up” company or one in the early growth stage.

There are two benefits in executing this strategy:

  1. An early exercise will get the clock ticking on long-term capital gain treatment. If held two years from the grant date and one year from the exercise date, ISOs will receive favorable long-term capital gains treatment upon sale as opposed to ordinary income.
  2. The earlier in the company’s growth that one exercises the option, the less the spread will be between the grant price and the fair market value at exercise. Why is a reduced spread important? While owners don’t pay income tax when exercising ISOs, the difference between the grant price and fair market value at option (AKA spread) is added back when calculating AMT. Thus, the lower the spread, the less potential there will be in triggering AMT.

The one downside to this strategy is that you will be out the “purchase cost” and must commit to holding the stock for the required two year holding period lest you trigger a disqualifying disposition. If your company goes south, you may never recoup the cost to buy the option. However, for those working at “start-ups” and companies in the early growth phase, exercising shares at a low cost (some even pennies on the dollar) may be worth the risk. Additionally, this strategy could prove effective in reducing the potential AMT exposure.

Strategy Two

Another strategy to consider is filing an early 83(b) election with the IRS for your restricted company stock. This strategy is most applicable to individuals who have been granted very low to nominally priced restricted stock. Before discussing the benefits of filing this esoteric election, it is first important to discuss the implication of filing the 83(b) election in the first place. In essence, filing the 83(b) will give you permission to pay early income tax on the restricted stock value that you don’t yet fully own. What?!? Why would anyone in their right mind voluntarily pay ordinary income tax if they don’t have to? Believe it or not, paying income tax early can actually be strategically beneficial under certain circumstances. Ordinarily, employees who are granted restricted stock would only be mandated to pay income tax when their shares are fully vested and are owned outright. The majority of restricted stock plans vest over a “graded” four year schedule (25% per year). However, for those employees granted restricted stock with a low to nominal value, it may make sense to accelerate the payment of ordinary income tax before becoming fully vested. Filing an 83(b) election with the IRS within 30 days of the grant date will accomplish this tax acceleration. I can demonstrate the efficacy of the 83(b) election by presenting an example of what could happen in two different circumstances.

In circumstance one, Mrs. Garcia is granted 5,000 shares of restricted company stock on April 15th, 2016. The stock is valued at $5 per share and has a four year vesting schedule. For the sake of simplicity, let’s also assume that she is in the 35% marginal tax bracket. Upon the grant, Mrs. Garcia decides not to file an 83(b) election. Let’s fast-forward four years later to April 15th, 2020. Each of the 5,000 shares is now valued at $20 and Mrs. Garcia has become fully vested. At the point of full vest, she owes ordinary income tax of $35,000 ($100,000 x 35%). One year later (April 15th, 2021), she decides to take her profits and sell all 5,000 shares which have now increased to $25 per share. She will owe capital gains on the difference between the sales price ($25) and cost basis at vest ($20), which ends up being $3,750 ($5 x 5,000 x 15%). The economic gain after tax? $86,250 (e.g. $125,000 minus $35,000 minus $3,750)

In circumstance two, let’s assume that everything is the exact same as in the above paragraph. The only difference is that Mrs. Garcia files an 83(b) election with the IRS within the 30 days of the grant. Consequently, she immediately owes ordinary income tax of $8,750 ($25,000 x 35%) without officially owning said shares. Now, let’s fast-forward four years later to April 15th, 2020. The stock is now valued at $20 per share and Mrs. Garcia has become fully vested. With the boon in the stock price, she decides to sell all 5,000 shares one year later (April 15th, 2021) at $25 per share. However, because she had filed the 83(b) election four years prior, she already paid the ordinary income tax early. Consequently, upon sale of the shares, she only owes the advantageous long-term capital gains rate between the sales price ($25) and cost basis ($5). This tax amounts to $15,000 ($20 x 5,000 x 15%). The economic gain after tax? $101,250 (e.g. $125,000 minus $8,750 minus $15,000).

While an 83(b) election can be beneficial, there is a downside to consider. There is the possibility that you file an 83(b) to pay early income taxes only to see your company lose share value by the time you become 100% vested. In the case of a down-market, electing to pay taxes early through 83(b) filing can actually expose you to greater taxes than waiting until becoming fully vested. Bottom-line, an 83(b) election should generally be considered a viable strategy if you have been granted restricted stock with low to nominal value and for which there are long-term appreciation prospects. Paying income taxes on the value of relatively low priced stock ahead of time could result in lower income tax exposure in a rising market.

Strategy Three

A third strategy is to accelerate itemized deductions in years when RSU vesting income is high, and postpone itemized deductions when AMT is high. The strategy of accelerating deductions can be applicable to individuals who expect a large chunk of RSUs to vest in a given year. When RSUs vest, they become taxable as ordinary income. During years when large blocks of RSUs vest, ordinary income will usually exceed AMT. In this case, you can accelerate the payment of items like property taxes, state taxes, and charitable gifts – all of which can be used as deductions against higher income. However, postponing deductions can also be an effective strategy for the opposite reason. For instance, if fewer RSUs vest the following year, you may find yourself in a situation where AMT is actually higher than ordinary income. However, in calculating AMT, many itemized deductions like property taxes, state taxes, and charitable gifts are actually added back and aren’t allowable. Thus, they can be wasted. In years when AMT is greater (e.g. less RSUs vesting), it may make sense to postpone certain itemized expenses until the following year when they can be utilized more effectively.

In conclusion, if you are an employee who has stock options, restricted stock, or RSUs (Restricted Stock Units), it may be worth exploring how implementing one of these strategies could improve your overall tax plan. However, as with anything tax-related, please consult your tax-attorney or CPA before making any decisions. Osborne Partners Capital Management is not a tax advisor but is happy to work with your team of professionals.