Take Advantage of Your Equity Compensation Plan in a Down Market
When markets are down, it’s easy to panic as you see the value of your investment account declining. Although such volatile times may cause some uncertainty, it’s important to keep a long-term perspective and remember that unique opportunities often arise when markets are down. For those with an equity compensation plan through their employer, which may consist of restricted stock units (RSUs), non-qualified stock options (NQSOs), incentive stock options (ISOs) and employee stock purchase plans (ESPPs), there will likely be compelling opportunities to make the most of “discounted” stock values during a down market.
While RSUs are typically taxed when the shares vest – and are subject to a pre-determined vesting schedule – NQSOs, ISOs and ESPPs are typically taxed when the shares are exercised and/or sold. Given the ability to strategize around the timing of their exercise/sale, let’s focus on potential opportunities for NQSOs, ISOs and ESPPs when market are in decline.
Non-qualified stock options
When NQSOs are exercised, the difference between the fair market value (FMV) and the exercise price is taxed as W-2 income. If the FMV drops during a down market, the amount of taxable income you’re liable for at the time of exercise would also lower as a result. Assuming the FMV stays above the exercise price (i.e., your NQSOs are not “underwater”), this presents the chance to exercise a larger number of shares for the same amount of taxable income.
For example, let’s assume the exercise price of a stock is $5 per share and the FMV at exercise is $10 per share. If you exercised the NQSO, it would result in $5 per share of W-2 income. In a scenario where the stock price dropped to $6 per share, exercising the NQSO would result in $1 per share of W-2 income. At a FMV of $6 per share, you would be able to exercise five shares for the same amount of taxable income as exercising one share at a FMV of $10 per share.
For those with a concentrated stock position, this may allow you to tax-efficiently exercise/sell out of the stock to help better diversify your portfolio in a shorter period of time. In addition, for those who plan to exercise their NQSOs and hold them for a while, exercising shares at a lower FMV can help you lock in a lower tax basis and save on taxes in the long run. By exercising at a lower FMV, a smaller portion of the growth is taxed at higher W-2 income tax rates (which establishes the tax basis), while a larger portion of any future growth will be taxed at lower long-term capital gains rates when sold (assuming you hold the stock for at least one year after exercising).
Incentive stock options
Similar to NQSOs, a drop in the stock price provides an opportunity to exercise a larger number of ISOs for the same amount of taxable income. The main difference with ISOs revolves around how they’re taxed. When ISOs are exercised, the difference between the FMV and the exercise price is taxed as Alternative Minimum Tax (AMT) income. When ISOs are sold, they qualify for specific tax treatment. When they are held for at least one year after the exercise and two years after the grant, the difference between the sale price and the exercise price is taxed at long-term capital gains rates when sold. Since you only pay AMT if it’s higher than your regular tax, it’s important to confirm your projected AMT calculation with your tax accountant before exercising larger amounts of ISOs. Assuming your AMT projection doesn’t exceed your regular tax for the year, there’s a chance to exercise more ISOs without owing any additional tax.
Similar to NQSOs, for those who hold a concentrated stock position, the benefit of being able to tax-efficiently diversify it in a shorter period may help mitigate the overall risk in your portfolio. These diversification benefits that ISOs provide, along with their special tax treatment, make them an appealing opportunity to seize during a down market.
Employee stock purchase plans
There are two main types of ESPPs: Qualified ESPPs and Non-Qualified ESPPs. This section will focus on Qualified ESPPs, which are the more common of the two types. For Qualified ESPPs, after-tax contributions are deducted from your paycheck during a given purchase period (e.g., six or 12 months), starting with the offering date and ending with the purchase date. At the purchase date, the stock is purchased at a discounted price (e.g., 15% discount) relative to the stock’s FMV. If the stock price declines and ends up at a lower FMV on the purchase date, the discounted price you pay is based on that lower FMV. When you hold the stock for at least one year after the purchase date and two years after the offering date, you’re not taxed until the stock is sold. When you sell the stock, the discount portion (i.e., the difference between the FMV on the purchase date and the discounted purchase price) is taxed as ordinary income, and any gain above the FMV on the purchase date is taxed at long-term capital gains rates.
For example, let’s assume the price of a stock is $20 per share on the offering date and it drops to $10 per share on the purchase date. If your employer offers you a 15% discount, you would be able to purchase the shares at a 15% discount from the lower $10 per share price. In this scenario, you’d purchase the shares at $8.50 per share, instead of at $17 per share (15% discount from the $20 per share price). If you sold the shares at $25 per share, $1.50 per share would be taxed as ordinary income and $15 per share would be taxed at long-term capital gains rates (assuming you sell the stock at least one year after the purchase date and two years after the offering date).
For those who believe in the long-term value of their employer’s stock, a decline in the stock price provides a unique opportunity for you to purchase shares in an ESPP at a double discount. Taking advantage of this double discount gives you more “bang for your buck” and can allow you to maximize the benefit you receive from any future growth.
Bottom line
During a down market, many things may be beyond your control. Focusing on the things within your control and taking advantage of the opportunities that arise can help set you up for long-term financial success. For those with an equity compensation plan through their employer, unique scenarios typically arise in a down market that can provide diversification benefits, long-term tax benefits and even “double discount” benefits. If you’re interested in pursuing these opportunities or would like to learn more, please contact your Corient Wealth Advisor. Our team would be happy to assist you.
ABOUT THE AUTHOR
Erik Nelson
Erik joined legacy firm Dowling & Yahnke in 2019 as a Financial Planner and now is the firm's Director of Financial Planning. He manages the financial planning team and serves as a technical leader for complex planning issues and initiatives. Prior to joining Dowling & Yahnke, he served in financial planning and advisory roles over the last five years with two local investment management firms in San Diego.
Erik holds a CERTIFIED FINANCIAL PLANNER™ designation and Certified Private Wealth Advisor® (CPWA®) certification. He has a Master of Science in Business Administration (MsBA) in Financial & Tax Planning from San Diego State University. Erik completed his undergraduate work in Business Administration and Finance at San Diego State University.
Erik is a native San Diegan who currently resides in La Jolla and is an avid sports fan.
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