As a financial planner, I focus on helping veterans transition into the corporate world following their military career. Veterans are often unfamiliar with the many types of compensation and benefits the corporate world offers. An often confusing type of compensation in the private sector is “long-term incentives,” or LTIs. Here’s what veterans need to know about corporate LTIs.
LTIs can take many forms, such as restricted stock, stock options, and profits interests, and tend to vary depending on the type of company. For example, start-ups, privately-owned companies, and public corporations may offer different LTIs suited to their goals and legal structures.
At their core, LTIs are designed to inspire employees to make a long-term commitment by giving them an interest in the company’s success. When employees put in dedicated, collective efforts over time, they earn additional pay as a reward… at least in theory.
But LTIs aren’t guaranteed to yield a significant profit over time. Veterans must understand the LTIs the company is offering in order to effectively evaluate a compensation package and to manage their incentives.
What Veterans Get Wrong About LTIs
Veterans new to the corporate world make three common mistakes.
First, they don’t take the time to fully understand the language surrounding LTIs and how incentive programs work at different companies. Terminology like vesting, strike price, expiration dates, and milestones all have specific effects on when an employee can receive the actual benefit of their LTIs.
Similarly, many veterans confuse stock and stock options. Their potential payoffs can be quite different, and mistaking one for the other can mean a serious loss of opportunity.
Second, these misunderstandings lead veterans to place an unrealistic value on the incentives they receive. In popular culture, people seem to become wildly rich when they receive an award of company stock or stock options. However, that’s not the case for most employees, most of the time.
Instead, it’s important to lay out the potential scenarios for the future value of your LTIs, depending on your specific incentive plan. In some scenarios, incentives can become completely worthless—something for which it makes sense to be prepared.
Lastly, veterans may not understand how taxes work with respect to incentive plans. Taxes can have a major impact on the LTI’s true value. While we tend to avoid focusing on taxes as the dominant factor in how we manage LTIs, it’s also unwise to ignore the tax consequences completely.
Key Terms
The jargon associated with LTIs can make them intimidating, but it’s important to familiarize yourself with the most common terms before diving into how each type of LTI works. If you ever feel lost, refer to this list.
Here’s the basic terminology you need to understand LTIs:
- Stock/Stock shares: Ownership of a small part of the company that issues the stock shares, entitling one to a portion of the assets, earnings, and dividends of that company. Companies can issue different amounts of stock, so it’s not possible to directly compare the stock price of one company to another without referencing other metrics.
- Stock Option: The right (but not the obligation) to purchase a share of the company’s stock at a predetermined price (strike price). Options must be exercised before their expiration date, at which point they are no longer valid and cannot be exercised.
- Strike Price: The predetermined price at which an owner of a stock option can purchase the stock. The strike price for a given option will not change, but the market price can.
- In-the-money: When the market price of a stock is greater than the strike price of the stock option. The employee would profit from exercising a stock option in this situation.
- Out-of-the-money: When the market price of the stock is less than the strike price of the stock option. In this case, the employee would lose money if they exercised their stock option.
- Award/Grant Date: Date that the company gives LTIs to an employee. Employees who stay with a company for a long time may receive multiple awards, each with its own award date.
- Vest/Vesting: The time at which LTIs actually belong to an employee. Vesting occurs on a schedule following the award date, generally giving an employee a percentage of their total awarded LTIs at each stage. An employee who leaves the company before the LTIs vest will likely forfeit them.
- Vesting Schedule: Time frame over which LTIs vest. These schedules vary from company to company, and LTIs rarely vest all at the same time.
- Long-term Capital Gain: An investment return subject to taxation according to the long-term capital gain tax rates. “Long-term” is typically defined as one year or more, with some exceptions to that definition.
- Short-term Capital Gain: An investment return that is not a long-term capital gain. Usually one year or less.
- Disqualifying Disposition: The sale of an asset in a time frame that causes it to lose special tax treatment. For example, selling certain shares too soon and having your profits taxed as earned income instead of capital gains.
- Post-termination Exercise Period: The period of time after an employee terminates their relationship with a company during which they can still exercise their stock options.
Types of LTIs
In this section, we will look at some of the most common types of LTIs, specifically stock options, restricted stock, and profits interests, and examine how they work, how they affect income taxes, and what risks veterans should consider when evaluating offers from companies.
Stock vs. Stock Options
First, let’s clear up the differences between stock and stock options.
Stock is an ownership share in a corporation. It gives you the right to vote in shareholders’ meetings, and may also entitle you to dividends of the company’s profits, either in the form of cash or additional shares. Even if a stock doesn’t provide dividends, you can still potentially sell your shares for a profit.
Stock options, on the other hand, give you the right to purchase shares of a certain stock at a specific price at some point in the future. You aren’t obligated to exercise your options—but if you wait too long, they’ll expire and become unusable.
Restricted Stock vs. Stock Options
Before we get into the details of how restricted stock and stock options work, here’s a quick overview of their differences:
Restricted Stock
- Shares of a company that you own as soon as the stock is awarded
- Cannot sell shares until they vest
- No expiration date
- Taxed when the stock vests and again when sold
Stock Options
- Right to buy shares of stock in the future at a specified price
- Cannot buy shares until the options vest
- Have an expiration date
- May be taxed upon exercise and when you make a profit, depending on the type of stock option and other factors
Restricted Stock and Restricted Stock Units
Restricted stock and restricted stock units (RSUs) are some of the simplest LTIs: they are employee ownership shares granted by a company as further compensation. Beyond that definition, however, they differ in some major ways.
Restricted Stock
Let’s start with restricted stock. Also called a restricted stock award (RSA), this type of incentive is typically associated with executives and can be automatically forfeit if one fails to meet certain corporate expectations.
An individual owns these shares when they are granted, but is restricted from selling the shares until they vest. The vesting schedule of restricted stock will vary by company. Some vesting schedules require you to meet performance milestones, but most vesting schedules are time-based.
A common example is 25% vest per year for four years, giving the employee ownership of a quarter of their awarded stock once per year. Other plans may front-load some of the vesting as a short-term incentive.
Restricted Stock Units (RSUs)
Restricted stock units (RSUs) share many features with restricted stock, including their vesting schedules and taxation. If you’re not an executive or other high-level employee, you’re more likely to be granted RSUs than restricted stock.
The biggest difference: an employee doesn’t own their shares until they vest. This means that you can forfeit those shares if you leave the company before their vesting date. If you stick around until your shares vest, however, you have full ownership and can sell them.
Restricted stock and RSUs provide an employee with extra compensation while encouraging them to stay at the company for at least several years. Hypothetically, this aligns the long-term interests of company and employee—but veterans should remember that a company’s stock is not guaranteed to increase in value.
Taxes on Restricted Stock and Restricted Stock Units
With both restricted stock and RSUs, the employee is taxed when the stock vests. This income is treated as earned income, requiring that you pay federal income tax, state/local income tax (if applicable), as well as Social Security and Medicare (FICA) on the value of the vested stock on the vesting date.
For example, an employee with a $10,000 restricted stock award and 25% vesting would receive 25% of the market value of that stock after 1 year following the award date.
At the award date, that 25% of market value is $2,500. Supposing the market value of the restricted stock remains the same 1 year later, the employee would owe income taxes on that $2,500 of additional income.
Employees can pay those taxes out of pocket or sell some of the vested shares to cover them. How to actually execute those transactions will vary with your employer.
You also have the option to initiate an 83(b) election when your shares are granted. However, that applies to many types of LTIs, so I’ll discuss that in a later section.
Stock Options
Stock options are the right to buy a share of a specific stock at a specific price (the strike price). Similar to restricted stock units, you don’t own any shares when your stock options are awarded and can’t exercise your stock options until they vest.
Like other LTIs, the vesting schedule for stock options may be based on meeting performance goals or just a matter of time.
So your stock options vest, and you can finally buy the stock—but should you? Exercising your stock options will only benefit you if the market price of the stock is higher than the strike price. This is because, relative to other investors, you’re paying less for the same stock.
By contrast, restricted stock has value for an employee as long as the company doesn’t go bankrupt before the stock vests.
Stock options also have an additional feature: an expiration date. This is typically ten years after the award date, after which an employee can no longer use the option to buy company stock.
However, some companies set their options’ expiration date based on when an employee leaves the company, with some as near as 3 months after you leave. This period is known as the post-termination exercise period, and it’s an important thing to consider before leaving your job.
Stock options are often associated with smaller startup companies, but most large companies offer them as well. As you might imagine, startups may bet high on the possibility of their stock price rising, incentivizing employees to stay and work to make that vision a reality.
Taxes on Stock Options – NSOs vs. ISOs
How your options are taxed depends on which kind you have. Employees can receive two types of stock options: non-statutory stock options (NSOs) and incentive stock options (ISOs).
Non-statutory Stock Options
Non-statutory stock options (NSOs) are the ones military veterans are most likely to encounter when transitioning into corporate employment.
NSOs are first taxed upon exercise of the option and taxed again upon the sale of the stock, but only if the employee realizes further profits through that sale.
When the option is first exercised, the difference between the strike price and the market price of the stock is called the “bargain element.” The bargain element is then multiplied by your number of shares:
(Market Price – Strike Price) x Number of Shares = Amount Taxed as Income
This value is taxed as earned income, requiring you pay federal, state/local, and FICA taxes on this amount.
Once you exercise your NSOs, you can hold onto the company stock and sell it later. If you sell your stock later on and realize additional investment profits thanks to an increased stock price, then you will also owe capital gains taxes on this further profit.
If an employee holds the stock for less than one year, this profit would be taxed as a short-term capital gain; profits on stocks held for more than a year would be taxed as long-term capital gains.
Incentive Stock Options
Incentive stock options (ISOs), sometimes also called statutory stock options, are often offered to executives and other high-level employees. They differ from NSOs in how they are taxed.
You won’t pay any income taxes on ISOs when you exercise them. But, you may need to pay alternative minimum tax (AMT) on the bargain element instead. This depends heavily on your financial situation, including your yearly income and the bargain element of your shares.
If you hold your shares for more than a year after you exercise your ISO and more than two years after your ISO’s award date, your profits upon selling them will be taxed as capital gains. You can use the same calculation described above to determine what amount will be taxed.
On the other hand, if you sell your shares early, your profits will be taxed as earned income. This loss of special tax treatment is called a disqualifying disposition, and it’s generally worth making efforts to avoid it.
For some companies, ISOs may be a more valuable long-term incentive because employees need to hold them for longer to pay the least in taxes on their profits. However, AMT can complicate things. Consult a financial planner or tax advisor to help manage tax consequences of your ISOs.
Profits Interests
Profits interests are a relatively unusual type of LTI. They are sometimes issued by private companies (especially in the Private Equity space) instead of issuing stock or stock options. They allow employees to participate in the success of their employer but without taking direct ownership in the company.
Profits interests are structured in many different ways, yielding a variety of benefits for an employee. They may or may not vest. You may have voting rights as a partner, or you may only be entitled to receiving distributions. This makes profits interests difficult to generalize.
Unlike capital interests (such as stock), profits interests do not entitle employees to a distribution if the company liquidates. Capital interests entitle you to a piece of a company’s current value. Profits interests entitle you only to future profits.
If you are awarded or may be awarded profit interest units, closely study the offering documents and presentations. You may also consider consulting with tax planners and financial advisors with experience in profits interests.
The 83(b) Election
The 83(b) election may help an employee reduce tax costs and maximize potential profits of LTIs. This election refers to a provision of the Internal Revenue Code that allows employees to elect to pay taxes on the market value of their equity at the time of award.
Only equity that vests, like restricted stock, RSUs, and stock options, qualify for 83(b) election. In the case of profits interests, you may be required to take an 83(b) election just in case your profits interests don’t qualify under the relevant taxation safe harbor rules.
To take advantage of an 83(b) election, you will file an 83(b) form within 30 days of share grant date. Provide a copy to your employer as well.
The strategic value of taking an 83(b) election relies on the value of your shares increasing in the future. If they do, then you will have paid less in taxes overall on your transactions. But if their value decreases, you will have overpaid—and you can’t get that money back.
Note that you’ll still pay capital gains tax on your profits from selling your shares. Ideally, an 83(b) election allows you to pay income tax on lower-value stock. Then you will pay only capital gains tax when you sell the stock at, hopefully, a higher value.
Don’t Lose Out on Growing Your Wealth with LTIs
Long-term incentives are designed to keep employees at a company for years and motivate them to propel the company’s success. However, the value of corporate LTIs is never guaranteed—a far cry from what you might see on TV.
Veterans who expect to leave a company in the near future may put themselves in a disqualifying disposition by selling early or losing their LTIs entirely. Employees may have some leeway when it comes to managing their shares after they leave a company, frequent job-hoppers are the most likely to lose out on future profits.
Veterans must carefully consider the incentive packages a company offers. That’s why I help veterans evaluate LTIs. With a focus on future goals and tax considerations Veterans are empowered to manage their LTI’s effectively.
If you need help with LTIs or any other financial matter during your transition, reach out to an MFAA advisor that specializes in working with military and veteran families!