Stock awards provide corporations a way to pay their executives based on performance so their compensation aligns with the expectations of the shareholders. Companies may also grant stock awards to lower-level employees to incentivize them to take ownership of the company's performance and retain their loyalty. There are four basic types of stock awards:
Stock awards can prove to be a valuable form of compensation. But Australian American employees whose wealth is heavily concentrated in stock awards must proceed carefully. Given the various risks and tax consequences associated with stock awards, and the added complexity brought by a cross-border financial situation, global executives will need to be even more cautious about how they leverage their stock options.
Stock options are essentially a contract between the company and the employee that grants the option’s holder (the employee) the right (or ‘option’) to buy or sell a share of the company’s stock for a set price under certain conditions. This set price is known as the exercise price and is typically equal to the market price of the stock at the date the option is granted.
In most cases, companies implement a vesting schedule that specifies the amount of time that must pass before the Australian/American employee can purchase the stock at the exercise price. Once an employee is vested, they can exercise their stock option, which they typically have to do before the expiration date. Vesting schedules and expiration dates vary by company but commonly we see vesting schedules for four years and expiration periods of ten years.
To purchase stock at the exercise price, an Australian American employee would obtain a loan and pay the loan back when they sell the stock. Alternatively, some companies allow employees to use company stock they already own to pay the exercise price (aka a ‘cashless exercise’).
Ideally, the market price of the stock will be higher than the exercise price when the option’s holder is ready to sell the stock. (The spread between the exercise price and the market price of the stock is known as intrinsic value.) Although this doesn’t always happen due to company performance and market fluctuation, a positive intrinsic value can mean profits for the employee.
As a hypothetical example, imagine a technology company in Silicon Valley offers stock options to their employees with an exercise price of $25 a share. In 5 years once the options are fully vested, the market price of the company’s shares is $80. If the employees exercise their stock options and sell the stocks at that market price, they stand to make a profit of $55 (minus transaction fees). Of course, they will also have to pay taxes on their gain, but the profit is still significant.
As with any investment, stock options can be risky. One only need look back at the dot-com bubble burst of the early 2000s to realize the devastating effects that can result for Australian American employees whose wealth is too heavily invested in their employers’ stock options.
As stated above, market volatility and the inherent instability of start-up companies can result in stock prices that fluctuate significantly. If market prices fall below the exercise price, the investor may lose money. Taking a loss on stock options often results in tax consequences that can be quite expensive.
In a worst-case outcome, the options may expire out-of- the-money (i.e. with the exercise price higher than the market price), meaning the options are worthless, while the employee may still have to pay income taxes on the value of the stock options compensation.
Because of the asymmetric payoff profile, leveraged nature and other risks of stock options, other types of stock awards and deferred compensation have increased in popularity.
Stock options require Australian American employees to purchase the stock at the exercise price once they become vested. This is risky or even unadvisable if the stock price drops. To mitigate against this risk, restricted stock units (RSUs) became a more popular alternative.
Instead of employees having to purchase the stock themselves, employers grant their employees shares of stock (or a cash equivalent) upon vesting or other requirements being met (e.g., meeting certain performance standards).
Depending on the value of the stock at the time it’s granted to the employee, the company may decide whether to grant the value as shares or as a cash equivalent. Sometimes, the employee may be able to make this decision. Either way, RSUs are taxed as ordinary income in the year of vesting even if the employee does not sell the RSUs that year (see more on taxation below).
Stock appreciation rights (SARs) are different once more. Like RSUs, SARs do not require Australian American employees to actually purchase stock options. Instead, SARs are (typically) cash payments to employees based on the company’s stock price from a predetermined period to the stock price at the time of disbursement.
Both the employee and the employer can benefit from this arrangement. Employees don’t have to purchase stock with the risk that the stock value will decrease, and employers don’t have to dilute the share price of company stock by distributing stock to employees as RSUs. In some cases, employers will distribute both SARs and stock options—employees can then use the SAR payments to purchase their stock options at the exercise price.
Like other types of stock awards, SARs are typically subject to a vesting schedule set by the employer. They are also subject to the same taxes as nonqualified stock options (NSOs): The value of the SARs are not taxed as ordinary income on the grant date or when the employee becomes vested. Instead, the spread at the time of exercise is treated as ordinary income.
Synthetic equity provides company employees who will not become equity owners with compensation that looks and feels like equity, but without some of the drawbacks. Essentially, employers grant eligible Australian American employees with ‘phantom’ stock that tracks the movement of the company’s actual stock prices. The employees simply receive cash payments instead of actual shares.
Synthetic stock allows employees to benefit from company growth and increased earnings. However, this type of stock award can protect employers from complications that can arise from having additional shareholders in the company—especially if those shareholder-employees leave the company.
Like stock options, synthetic stock is not taxed as income until the employee redeems their synthetic shares. This typically happens when the employee retires (assuming they are vested) or the company is sold.
Employee stock purchase plans (ESPPs) are the last basic type of stock award we will cover in this article. ESPPs are programs in which employees can purchase company stock at a discounted price. They typically participate in the program by making contributions through payroll deductions between the time they become eligible to participate and the time they become eligible to purchase the discounted stock.
When Australian American employees decide to purchase stock, the employer uses their contributions to purchase shares on behalf of all participating employees at the discounted price.
Taxation of ESPP shares can be quite complex, and taxation depends on whether or not the ESPP is qualified or non-qualified. (Non-qualified plans are subject to fewer restrictions, but do not have as many tax advantages for employees as qualified plans.)
As deferred compensation, all stock awards are taxed differently than wages and bonuses. Even for U.S.-based employees working for U.S. corporations, the tax effects of stock awards can be confusing and depend on a number of factors. For instance, in the case of stock options, taxation will differ depending on whether the option is qualified or non-qualified and the amount of intrinsic value.
Additionally, different types of stock awards are taxed differently. For example, the entire value of an employee’s RSUs is taxed as ordinary income in the year of vesting, unlike traditional stock options. Any income gained from a subsequent sale of RSUs in a later year would be taxed as a capital gain.
Stock options, on the other hand, may be subject to capital gains tax, income tax, and payroll tax, but typically only in the year the options are exercised. (Taxation also depends on the type of stock option granted.) Indeed, one type of stock option—incentive stock options—is not subject to payroll taxes, but is considered a preference item for the alternative minimum tax calculation, which can be complicated to figure out.
For Australian American executives and employees, the tax implications can be even more complex. Tax credits, income exclusions, and tax treaties all come into play. Additionally, deferred compensation may not be realized in a single tax year, and tax years between nations might not align. For individuals who are not U.S. citizens or permanent residents, this is problematic.
Such individuals whose stock options are not granted by a U.S. company, but who spent a certain number of days working in the U.S., must determine how much of their deferred compensation is subject to U.S. tax depending on how many days they lived and/or worked in the U.S. each tax year. Taxes on this type of income are typically assessed on a time basis for the applicable period between which the individual is granted the option and the vesting date.
For U.S. citizens and permanent residents who earn stock options from non-U.S. companies, they will have to strategize how their deferred compensation will be taxed after taking advantage of Foreign Tax Credits or the Foreign Earned Income Exclusion (if applicable).
Many high-earning Australian American executives receive stock awards as part of their compensation package. At Arete Wealth Strategists, we support and serve cross-border executives. We educate on tax implications for their relocation decisions, as well as how to optimize tax mitigation strategies for clients who need them.
We specialize in providing financial advice to globally mobile individuals and families who need us, and it’s never too late to seek advice. To learn more about Arete Wealth and how we can support you, visit www.arete-wa.com or simply click here to visit our get started page.
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