Stock Awards, Part 2: Mechanics and Taxation of Three Common Types

Equity or share-based compensation can be a significant source of wealth for many employees. However, among 86,000 participants in Morgan Stanley’s 2022 Annual Stock Plan Participant Survey, only 39% understood the taxation of their stock awards.¹ This article is part of a series on how to make the most of your equity compensation.

Stock awards can be a powerful way to incentivize employees. It gives them an owner’s perspective, so they approve and execute projects that add shareholder value and lets them participate directly in the value that is created.

Knowing the type of stock awards to which you are entitled and how they are treated from a tax perspective are important considerations when evaluating your overall financial plan. Here’s a closer look at the mechanics and taxation of three common types of stock awards.

Stock Options

Incentive stock options and non-qualified stock options give employees the right to purchase stock directly from the company at a set price. Once the vesting date passes, you can exercise the option by paying the strike or exercise price for the shares.² Ideally, the stock option is exercised when the share price is higher than the strike or exercise price. However, it might make sense to delay exercising depending on your situation.

1. Incentive stock option (ISO)— ISOs qualify for preferential tax treatment if certain holding period requirements are met. There are two holding periods to be met for the sale of shares from an ISO to be deemed a “qualifying” disposition. The shares must be sold:

• at least one year after the option is exercised, and
• at least two years after the grant date

If you sell the shares before either of the required holding periods, you are making a “disqualifying” disposition.³ ISOs can impact the alternative minimum tax (AMT). You should work with your tax advisor to determine the best timing.

Below are examples of how each type of disposition is taxed.

In the above scenario, let’s assume the employee pays 37% ordinary income tax and holds the shares long enough to qualify for long-term capital gains treatment. If a qualifying disposition is made, the employee will pay $12,935 to exercise the option and $654 in long-term capital gains taxes, as shown below:

If a disqualifying disposition is made, the employee will still pay the same $12,935 to exercise the option, but will pay $997.15 in ordinary income taxes, as shown below:

*Since the stock price on the date of exercise is lower than the stock price on the date of sale, the taxable income is the difference between the strike or exercise price and the stock price on the date of exercise

2. Non-qualified stock option (NQSO)—Unlike ISOs, NQSOs do not receive preferential tax treatment. Using the same assumptions, the employee will pay the same $12,935 to exercise the option, but $1,246.90 in ordinary income and long-term capital gains taxes, as shown below:

2. Restricted Stock

Restricted stock units (RSUs) and performance stock units (PSUs) are stock awards where the shares of a company’s stock are delivered to the employee on the date they vest. With restricted stock awards (RSAs), the employee receives the award/shares at the outset, but they are “restricted” and cannot be sold until after the restriction period expires.⁴ RSAs vest or can be sold after either a “time trigger” or “performance trigger” has been met.

• A time trigger requires the employee to work at the company for a certain amount of time
• A performance trigger requires a specific event to take place, such as going public or achieving an earnings goal

After a time trigger or performance trigger is satisfied, the stock award automatically vests or becomes unrestricted, and the shares of stock are delivered to the employee.

Below are examples of how restricted stock awards are taxed.

In addition to the information above, let’s assume the employee pays 37% ordinary income tax and holds the shares long enough to qualify for long-term capital gains treatment.

*Income taxes are due in the year vesting occurs.
**Ordinary gains taxes are due in the year the stock is sold.

As shown above, the employee will pay $8,684.64 when the shares vest and $1,084.50 when the shares are sold. Unlike options, RSAs do not require the employee to exercise the option. Instead, when the shares vest, they are automatically delivered to the employee without requiring the employee to do anything.

3. Stock appreciation rights (SAR)

SARs offer the employee the right to the cash equivalent of a stock's price gains over a predetermined time interval.⁵ The mechanics of SARs are similar to stock options since it is at the employee’s discretion to exercise the right. However, SARs usually do not require payment to exercise the right. When exercised, SARs can either be settled with cash, shares of the company’s stock or a combination of both.

Below are examples of how SARs are taxed.

In addition to the information above, let’s assume the employee pays 37% ordinary income tax and the SARs are settled in cash.

As shown above, the employee will pay $6,930.84 when the shares vest. If the SAR was settled with shares of the company’s stock instead, then the stock price on the date of vesting would become the tax basis for the shares received.

Stock awards have the potential to generate significant wealth for employees. If you are an executive or other insider of the company you receive the stock award from, we recommend you check with your company’s legal department before exercising or selling any stock received. And, to make the most of your stock awards, we believe it is wise to work with tax and wealth advisors who can help develop strategies to increase the chances of achieving your long-term financial goals.

¹ 2022 Annual Stock Plan Participant Survey, Morgan Stanley
² Incentive Stock Options (ISO): Definition and Meaning, Investopedia
³ Internal Revenue Code – Title 26 U.S. Code § 422 – Incentive stock options
⁴ Restricted Stock Unit (RSU): How It Works and Pros and Cons, Investopedia
⁵ What Are Stock Appreciation Rights (SARs), and How Do They Work?, Investopedia