Recently, more new clients have come to us holding not just one type of equity compensation, but two or three types, including incentive stock options (ISOs), non-qualified stock options (NSOs), and restricted stock units (RSUs). A common question they have around what to do with it is: “What should I sell first: my ISOs, NSOs, or RSUs?”
It sounds like such a simple question. And occasionally, the answer is straightforward. However, most of the time deciding which shares to sell requires a lot of analysis, paired with a clear understanding of what you’re trying to accomplish. It requires thoughtful equity compensation planning.
This is best done by creating a complete equity compensation plan, which typically involves a carefully laid out sequence of exercises and sales from a mixture of portions of different grants from the various types of equity compensation: ISOs, NSOs, and RSUs.
For a quick refresher on stock options and RSUs, you can read earlier posts:
Equity compensation plan considerations
Crafting an equity compensation plan requires considering several interrelated factors, such as:
What types of equity compensation do you have?
What is the total value of each type (i.e., the percentage value of each)?
How many different grants do you have for each type?
How far into the vesting schedule are you for each type and each specific grant?
Have you early exercised any stock options?
Have you exercised any vested stock options (i.e., regular, not early exercised)?
Are any of your exercised shares eligible for Qualified Small Business Stock (QSBS) tax treatment?
Is your company public or private?
If your company is still private, how long before you expect a liquidity event?
If your company is public, are you subject to trading restrictions such as a post-IPO lock-up period, trading windows, or a 10b5-1 trading plan for corporate insiders?
If you are holding shares from stock options you previously exercised or from RSUs that vested and shares were delivered to you, how long have you held those shares and how much taxable gain would be realized per share if they were sold?
What will your income and tax rates be over the next few years before any extra income from equity compensation stock exercises or sales?
Do you have an alternative minimum tax (AMT) credit from ISO exercises in prior tax years?
What tax law changes are in the works? (This is getting a lot of our attention right now.)
Are you considering donating any of the appreciated shares to charity (which brings a charitable tax deduction)?
What is the current stock price and how volatile has the stock price been?
What is the current stock price in relation to the strike price of your unexercised stock options?
Do you have financial goals that require raising cash from your equity compensation—for example, buying a new home or funding the kids’ college savings accounts?
How quickly would you like to diversify your holdings?
How much of your stock do you need to sell now to be sure you’re set for retirement?
The first step to creating an equity compensation plan is understanding a client’s financial goals and diversification objectives, and then developing various scenarios for the exercise of options and sale of options and RSU shares that meet those goals and objectives.
The second step is determining the total tax cost of the various scenarios over a three to four tax-year window. For most clients, a key goal is minimizing the amount of tax they’ll pay when selling their stock from equity compensation and thereby maximizing the amount of after-tax proceeds they’ll receive.
The final step is adjusting and iterating to find a good balance between minimizing tax and achieving their financial goals and diversification objectives.
An earlier post covered important post-IPO equity compensation planning issues with multiple types of equity compensation and included a useful scenario to consider. Here’s another scenario that highlights some of what needs to be considered in this essential type of planning.
New scenario: Exercise ISOs, sell NSOs, later sell RSUs
Let’s say you have ISOs from the early start-up days at your company, NSOs from a few years later, and RSUs that you were granted more recently after the company went public. All of your ISOs and NSOs are fully vested, and you can exercise them anytime—no trading restrictions apply to you. You have not exercised any of your ISOs or NSOs yet. Some of your RSUs have vested, and the shares were delivered to you in your company stock plan account. You haven’t sold any of those RSU shares yet, and you’ve held them for 11 months.
You want to raise cash to buy a new home. You also want to diversify out of one-half of the total value of your stock in two years because your financial plan says moving that amount of money to a more reliable investment portfolio will secure your retirement. You don’t expect any large bonuses or other changes in income for the next several years—you expect your income to be steady. The stock has appreciated substantially, and you’re ready to start cashing it out. So, how should you go about it?
Since you’ve done a good job clarifying your financial goals and diversification objectives, the next step is to develop scenarios for the exercise and sale of your stock options and RSU shares. One scenario that could possibly meet your goals and objectives while minimizing taxes might be this: exercise ISOs now, sell NSOs now to raise cash for ISO exercise, and hold RSUs for another month.
In this scenario, you will exercise some or all of your ISOs to get the clock started on the one-year holding period required to qualify for the favorable long-term capital gains tax rates when you sell your shares (you’ve already met the two-year-from-date-of-grant requirement because you received your ISOs many years ago). You’ll need to come up with cash to pay the exercise price for the shares (you’re going to be buying the shares and holding them for at least one year).
You may also need cash to pay any AMT on the ISO shares. Remember, exercising ISOs doesn’t create any tax under the regular tax system, but it can create tax under the AMT system. Any AMT you pay this year will give you an AMT credit you may be able to use to offset the regular tax you pay when you sell the ISO shares after one year.
Continuing the scenario, you will same-day exercise and sell enough of your NSOs to raise cash to cover the total cost to exercise the ISO shares. You’ll need to sell enough NSOs to pay the strike price per share multiplied by the number of ISO shares you plan to exercise.
The company will withhold federal tax on your NSO sales, probably at a 22% tax rate. The company will also withhold state income tax and federal and state payroll taxes. This means you’ll need to sell enough NSOs such that the after-tax proceeds (including federal and state income and payroll taxes) will be enough to pay for the ISO exercise. You won’t sell NSOs to cover the AMT generated by the ISO exercise.
Because the AMT won’t be due until next year’s tax filing due date, and assuming no estimated tax payments will be due this year because your income will be higher than it was last year, you don’t need to raise cash immediately for the extra tax owed. You can wait a bit. You will wait for at least one month and possibly longer, until you’ve held your RSU shares for at least one year. That way, the gain on RSU share sales will qualify for long-term capital treatment, and you’ll pay tax on those sales at the lower federal long-term capital gains tax rate.
Once the RSU shares qualify for long-term capital gains tax treatment, you will sell enough held RSU shares to raise cash to cover the tax on the ISO exercises and any tax due on the NSO sales as a result of tax under-withholding (a common problem). You may also sell additional RSU shares to raise cash for your home purchase and to make progress on your diversification goals. You paid most of the tax due on the RSUs when they vested, but you will need to set aside cash to pay for the additional tax on RSU sales as a result of RSU share appreciation after vesting with this year’s tax return.
Next year, once a full year has passed since exercise, you will sell the ISO shares that you exercised this year. You will have “pre-paid” much of the tax on those shares during this year, and you will use your AMT credit next year to offset the tax owed on the ISO share sales. The proceeds from the ISO share sales will move you closer to your diversification objective of selling half of your stock within two years.
This is one scenario, one particular pattern of option exercises and stock sales, that could meet these hypothetical financial goals and diversification objectives. Of course, how well it works—the amount of tax saved, the amount of cash raised, and the diversification achieved—would depend on the specific facts and circumstances. The devil is in the details. In the same way, the specific facts and circumstances of your particular situation will be important in your decisions about what to sell when. There is no one-size-fits-all answer.
As you can appreciate with this example, many factors must be considered to create a workable plan and answer the question, “What should I sell first?”
Parkworth Wealth Management provides holistic wealth management services including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. If you’re thinking about the best way to sell your company stock and would like to understand how an equity compensation plan can help you build net worth, schedule a complimentary consultation.
