Navigating Equity Compensation: Tax & Portfolio Planning

At the executive level, equity incentives are a common feature of compensation plans. But while equity compensation can offer a valuable financial boost, it can also introduce challenges without proper preparation.

For individuals who expect to receive equity compensation, proactive planning can be helpful in two key areas: portfolio diversification and tax management. Through comprehensive portfolio planning, investors can avoid bearing excessive concentration risk due to equity compensation. Meanwhile, tax planning can help avoid unexpectedly high tax bills now or in the future. 

For individuals who have already received equity compensation, the situation can be more challenging. Attempts to diversify a block of highly appreciated shares can result in an increased tax burden. However, it’s possible to minimize that burden with tax-aware selling and gifting strategies. 

In this article, we’ll explore some of the key factors involved in navigating equity compensation plans. We’ll start by exploring the most common types of equity compensation, followed by some of the main planning considerations they create. 

Common Forms of Equity Compensation

While most types of equity compensation involve similar preparation, the precise form an equity package takes can impact planning details. There are two main kinds of equity compensation executives may receive: equity shares and equity options.
Equity share packages are paid out as actual units of company stock. The most common forms include Restricted Share Units (RSUs) and Performance Share Units (PSUs). While RSUs are received based on a pre-determined vesting schedule, PSUs typically vest according to specific performance criteria, often tied to corporate earnings metrics.

In contrast, equity options are not units of stock. Instead, options offer employees the right to purchase company stock at a fixed price, known as the ‘strike price.’ This right becomes valuable when shares climb above the strike price. Options can come as either Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NQOs), which differ in terms of their tax treatment. 

Portfolio Diversification: Avoiding Concentration Risk

As an executive receiving equity compensation, it’s common to see newly vested shares as a point of pride, reflecting an ownership stake in the company you’re helping lead. Unfortunately, this ownership stake can also be an underappreciated source of portfolio risk.

An employee's personal finances can be closely tied to the performance of the company they work for. For instance, during a downturn, the company may need to reduce salaries, cut bonuses, or even resort to layoffs. If this occurs, it’s also likely that the company’s share price will decline in value too.

As such, equity compensation can dramatically increase the correlation of an individual’s investment portfolio with their overall financial well-being. For this reason, it is generally favorable for employees to liquidate some or most RSUs and PSUs as soon as they vest, using the proceeds to acquire a more diversified pool of assets. As a practical example, an executive may consider selling vested shares and reinvesting the proceeds in a portfolio of index funds designed for long-term holding. 

While diversification is beneficial, it is also important to be aware of any restrictions tied to sales of vested shares. In particular, share-holding requirements and blackout periods can sometimes create hurdles to immediate selling. Working in coordination with your financial advisor and corporate compliance team is key to creating a plan that aligns with employer rules.

Tax Planning for Equity Compensation

Equity compensation doesn’t just create portfolio diversification challenges – it can also create tax challenges. Although equity shares and options are non-cash compensation, they are typically treated as taxable income  in the year they vest. Without proper preparation, this can result in an unanticipated tax bill. 

For this reason, it can be valuable to immediately sell a portion of vested shares in order to cover the income tax obligation. Although companies often withhold a portion of vested shares for taxes, this amount may be insufficient to fully cover the amount due. 

Individuals who already have a block of highly appreciated shares may face challenges liquidating this position. Although it can be beneficial to spread sales over time while aligning them with deductions, these individuals may still face a higher overall tax burden. Avoiding this issue is another reason to consider immediately liquidating and reallocating vested shares.

In certain cases, it may be optimal to pursue a strategy that doesn’t involve sales. For example, gifting appreciated stock to charity can be a tax-efficient way to achieve legacy goals. It may also be possible to borrow against appreciated positions to generate liquidity without incurring sales. 

For equity option packages, tax considerations are more nuanced. While ISOs have more favorable tax treatment than NQOs, recipients generally need to hold exercised shares for at least a year to unlock the lowest tax rate regardless of the option type. For executives anticipating receiving equity options, coordinating a strategy with your financial advisor and tax professional can ensure that both portfolio and tax elements are fully considered. 

Conclusion: An Ounce of Planning

Equity compensation can provide employees with a lucrative boost over their base salary, especially for executives advancing in a company. Thoughtful planning can help ensure that this boost doesn’t turn into an unanticipated portfolio drag.

With a proactive plan designed to address both diversification and tax considerations, investors can avoid potential complications years down the road. By liquidating vested shares, individuals can effectively rebalance their portfolio while also holding cash aside for tax obligations. Although individuals who have already received equity compensation in the past may face more challenges, they can still benefit from a strategy tailored to their unique situation. 

If you’re expecting to receive equity compensation in the future, it’s important to work with an advisor well-versed in these structures to establish a comprehensive plan. At The Fiduciary Group, our experience navigating employee equity packages for our clients allows us to create a thoughtful plan aligned with your overall financial strategy. We appreciate the opportunity to serve our clients and are here to help. We invite you to please reach out to us with any questions.