Written by: Blake Pinyan | Anchor Bay Capital
2023 has been a year of company layoffs, with behemoths such as Amazon, Google, Microsoft, Meta, and others publicly announcing thousands of cuts to their workforces. With the uncertainty ahead, many more employers are considering or enacting similar plans. If you have clients who have been let go, it’s critical that you step up and be their guide during this difficult time in their life.
As advisors, we serve our clients through every stage of their life, through all the highs and the lows. It’s during the low points that we can really make a difference by providing sympathy, a shoulder to cry on, and developing a game plan that prioritizes what steps they should take and when. For clients who have been laid off, we generally speak with them first about unemployment compensation and their options for employer-provided insurance (health, life, disability, etc.). But what may not be top of mind is advising them on what to do with their equity compensation plans.
Before getting into the details of the common forms, you will want to take a step back and define the two ingredients that accompany equity compensation plans:
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Grant Sheet and
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Plan Agreement
The grant sheet is your north star. It is essentially a shorter, customized snapshot of the key facts of your client’s equity compensation. The important data to look out for on this sheet, which varies based on the type, may include:
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Type of Grant
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Quantity Granted
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Vesting Dates
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Exercise Price
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Grant Date and Price
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Expiration Date, and
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Conditional Events. Conditional events would be what happens to your stock in the event of death, disability, retirement, and most importantly: layoffs!
A plan agreement is the company’s stock plan prospectus. The document is more general in nature and highlights the mechanics of what awards are offered and what the company’s policies and procedures are for them. Think of the grant sheet as your client’s 401(k) statement, whereas the plan agreement is their summary plan description.
Although there are more variations, some of the most well-known types of equity comp plans are:
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Stock Options (Non-Qualified and Qualified)
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Restricted Stock and Restricted Stock Units (RSUs)
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Employee Stock Purchase Plans (ESPPs)
Stock Options (Non-Qualified and Qualified)
A Stock Option gives your client the right to purchase shares of their company stock at a discount. It’s their “right” to buy shares or not, because the action of exercising costs them money.
Stock Options are defined as either Non-Qualified (NQSOs) or Qualified/Incentive (ISOs). The grant sheet generally defines which type your client has, and it’s possible that they could have been awarded both. In addition to the other important details (significant dates, exercise price, etc.), it should be your cheat sheet for what happens to your client’s stock in the event of termination.
For Stock Options in particular, this typically comes in the form of how many days or months your client has to exercise their vested options before they expire. It’s key to note that this refers to options available to be exercised at the time of your client’s termination of employment. Options that have not been vested may not be eligible.
The grant sheet should specify the number of days or months in reference to the method of termination, specifically whether the end of your client’s employment was voluntary (they quit), involuntary (they were laid off), or it was termination for cause (they were terminated for a particular reason). For example, your client may have 90 days from the date of their termination to exercise their vested options. If they didn’t exercise in time, the options would expire.
Termination for cause can have varying outcomes, including an immediate revocation of any existing or future grants, depending on the company's plan design and their intention to benefit former employees. It is not a one-size-fits-all approach, so it is recommended that you review your client's grant sheet and/or stock plan agreement to determine what they allow.
On the surface, the primary difference between NQSOs and ISOs is the tax treatment. For NQSOs, taxes are recognized upon exercise, and the difference between the exercise price and the stock's price per share on the day of purchase is taxed as compensation income, known as the bargain element. Because exercising NQSOs is considered compensation, taxes are generally withheld, and the income and withholdings appear on their W-2. These same rules apply even after your client's termination.
The amount subject to taxes (bargain element) is added to your client's original exercise price, and the result becomes his/her adjusted cost basis. From there, the standard capital gains rules are used to determine the tax implications of future short-term or long-term capital gain taxes (if any).
Exercising ISOs does not trigger an ordinary income tax hit, but rather a positive adjustment for Alternative Minimum Taxes (AMT). When shares are held for at least 2 years from the grant date and one year from the exercise date, they are in the qualifying disposition period, and future sales get treated with preferential, long-term capital gain rates. Exercising starts the holding period clock for both ISOs and NQSOs.
From a planning perspective, if your client has been granted both NQSOs and ISOs and was laid off, you could consider a tandem exercise. This is where you exercise ISOs in the same calendar year as NQSOs. The rationale behind this is that exercising ISOs alone can potentially create an AMT problem if the AMT liability exceeds the ordinary income tax liability. By exercising NQSOs in the same calendar year, you could attempt to neutralize the AMT liability since the NQSO exercise would increase the ordinary income taxes. The year your client is laid off could be an optimal time for this strategy, assuming their income is projected to be lower.
The year that your client is laid off can be an attractive year for selling company stock. For NQSOs, you'll need to wait a year from exercise to achieve long-term capital gain rates. As far as ISOs, at least two years from the grant date and one year from the exercise date will meet the qualifying disposition rules. If the tax projection confirms it, now may be an opportunity to harvest capital gains and reduce single-stock concentration.
Restricted Stock and Restricted Stock Units (RSUs)
Restricted Stock and RSU awards are shares of company stock given to your client as part of his/her compensation package. The two are very similar in their makeup, and the primary differences are that RSUs do not give your client voting rights, dividends, the power to do an 83(b) election, nor have physical shares associated with the award. RSUs are phantom compensation, and no physical shares are issued to your client at grant. They are released at specified dates determined by the vesting schedule. The stock is considered "Restricted" during the period before its vested, which is known as the "Restricted Period."
Like Stock Options, the grant sheet is your blueprint for understanding the vesting provisions and other key facts, such as the type (Restricted Stock or RSUs), grant date, and the quantity awarded. As for what happens to the award(s) in the event of termination, the grant sheet and/or full stock plan agreement should provide you with the answer.
One of the widely known characteristics of Restricted Stock/RSUs is that they come with forfeiture provisions. This means that the company can nullify the shares pledged to an employee if their employment is not going well, such as failing to meet performance metrics. This would result in the employee not receiving the shares promised to them. Upon termination, the unvested Restricted Stock/RSUs are not granted to the employee. The vested stock, however, belongs to them. For instance, a client’s RSU plan agreement may state that “Restricted Stock Units will automatically be forfeited in full on the date of termination of employment.” Each company has its own bylaws about what happens during this transition, but it’s customary for these forfeiture provisions to be applied.
From a tax standpoint, the fair market value of shares granted to the client on the day of vesting is taxed as compensation income. Like NQSOs, the employer will likely withhold taxes, and the taxes paid will impact the cost basis. The cost basis for Restricted Stock/RSUs is the fair market value of the shares on the vesting date (ordinary income taxes paid). Additionally, the holding period clock starts on the vesting date, which determines the nature of the tax paid upon a stock sale. This is the standard short-term vs. long-term capital gains (or loss) calculation.
If the client is terminated, there is likely no wiggle room to act on Restricted Stock/RSUs. However, as mentioned before, selling some vested shares in the year of layoff may be a good strategy, as it may be a low-income year for them. It should be straightforward to track all the shares that have met the long-term holding period vs. the short-term.
Employee Stock Purchase Plans (ESPPs)
Employee Stock Purchase Plans (ESPPs) allow clients to defer a portion of their salary into an account that subsequently purchases company stock. Contributions are typically recognized on an after-tax basis, and the ability to buy in is non-exclusive. Companies usually don't place many restrictions on who can participate in the plan, unlike some of the other equity compensation plans, which might be more restricted to directors, executives, etc.
The incentive for employees is that they may be able to buy the stock at a discount. The discounts can range from 0%-15%, but most companies settle on 15%. This is likely because it is the biggest discount that the IRS allows under a tax-qualified ESPP plan. The answer will ultimately lie within the client’s stock plan agreement. With ESPPs, the stock plan agreement is the go-to for answers, and there won’t be a grant sheet. This is because ESPPs are not awards granted but rather an employee benefit.
ESPPs are unique in the structure of how the company stock is purchased. The client’s salary deferrals get pooled together in an account, and the aggregate is used to purchase stock on the designated purchase date, which is generally the last business day of the offering/purchase period. The client’s stock plan agreement will provide more clarity.
If your client is laid off, his eligibility for participation in the ESPP will end. The shares that have already been purchased will not be impacted and will still be held by your client. However, the money that is sitting in the intermediary account, waiting for the designated stock purchase date, will be affected. Funds withheld from your client's salary that haven't been used to purchase shares will be returned to them within a reasonable period. This return of contribution is non-taxable as their deferrals were after-tax.
Regarding tax ramifications, tax-qualified ESPPs are treated similarly to ISOs. Ordinary income taxes are not triggered until the stock is sold, and your client can partially qualify for the long-term preferential tax rates. This is known as a qualifying disposition if the stock is sold two years after the start of the offering period and one year from the date of purchase. This is because ordinary income taxes are paid on the lesser of the stock discount granted by the company or the capital gain from the stock sale. Any remaining gain after adjusting the cost basis for ordinary income taxes paid will be taxed at preferential rates, assuming the qualifying disposition period is met.
It may be advantageous to evaluate the tax impact of selling ESPP shares that have met the qualifying disposition period during the year that your client is laid off. Analyze which shares are eligible for preferential tax rates and collaborate with your client on the decision to sell if a low-income year is expected.
Experiencing a layoff is a challenging time for clients, and it's crucial to be there for them to relieve as much stress as possible during their transition. Guiding them on the implications of their equity compensation is an additional way to add value to the relationship and further establish yourself as their trusted partner. Give them the silver lining!
Related: Creating a Service Calendar Around Value Adds and Client Touchpoints