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Wealthyist, the podcast that discusses the lifestyles, choices, and strategies of the wealthy. Each week, the Annex Private Client team talks to experts in a variety of areas to discuss trends and paths visited by people who have built or are in the process of building significant wealth.
You're listening to Wealthiest, the podcast that takes a look at the lifestyles, choices, and strategies of the wealthy. I'm Brian Jacobson, Chief Economic Strategist at Annex Wealthy Management, and joining me is Tom Burkholt, Senior Financial Planner and Team Lead for the Financial Planning team here.
Speaker 2:Thanks for having me.
Speaker 1:Yeah. So I think this is gonna be a really interesting discussion, all sorts of different directions that we can go with it. And my main motivation here was thinking about the extent to which people sometimes get compensated, not just with a paycheck. Mhmm. But there's all sorts of different ways in which people can get compensation, and there's so many acronyms.
Speaker 1:Right. Right? There's like ISO, RSU, all sorts of different things. And I'm hoping that you can unpack that for us. Of course.
Speaker 1:Excellent. So let's get into it. So what exactly is equity compensation?
Speaker 2:Yeah. Equity compensation to me is an umbrella term. So like you mentioned, it encompasses a variety of different types of stock options. But the theme is that a company can pay you in many different forms. So usually, it's wages, like Mhmm.
Speaker 2:Cash wages, or they could pay you a bonus, like quarterly bonuses throughout the year. But another way that a company can compensate an employee is equity compensation, and there's a lot of different flavors of that, and there's advantages, disadvantages, and strings attached with every type of equity compensation, and it can get complicated very fast.
Speaker 1:Sure. So maybe get into some of the economics behind it about why do companies do this. Is it because they don't have the cash, but they still wanna pay? Is it other reasons?
Speaker 2:Of course. Yeah. There's all sorts of reasons why a company would. Primarily though, it's to attract, retain, and recruit talent, because obviously, there's a huge talent war out there for the best and brightest employees, and especially depending on what industry you're in. So certainly in the tech industry right now, with the monster companies, Google, Apple, Nvidia, all of those companies in their race for AI dominance are trying to attract the best AI engineers out there, and of course, equity compensation is a huge part of that.
Speaker 2:They're offering huge pay packages, essentially, to recruit talent and keep them there. Because usually, you gotta follow a vesting schedule as well, or you got to work there for a period of time in order to receive the the benefits.
Speaker 1:Sure. So the vesting schedule, the idea there is it creates I think they used to refer to those as, like, golden handcuffs, where it's not just what you're getting paid, but it's also about if you don't do your time, spend enough time there, you basically forfeit.
Speaker 2:Anything unvested, it's typical to forfeit anything. So you see different types of vesting schedules. So one, you might see a graded vesting schedule, where it's like 25% a year over four years, or you may see a cliff vesting, where you gotta work there for three years, and then on the end of that third year, you might get it all at once.
Speaker 1:Sure. Now, in terms of the types of companies that offer these, you had listed a few that everybody has probably heard of, publicly traded companies. Right. But is it restricted to just publicly traded companies that offer equity compensation?
Speaker 2:Yeah. That's a good question. So we see both, Annex. A lot of our clients come to us with both private and public companies. Certainly more common on the public side just because there's a a liquid market for it.
Speaker 2:There's a ticker out there that you can buy and sell freely in the open exchange or secondary market. More common on private or public companies. And we have a variety of public companies in our Milwaukee area around our office. So we see employees from, you know, companies that everyone would recognize. Mhmm.
Speaker 2:But we also see it on the private side. So many companies you've never even heard of are offering this type of compensation, and it can get much more complicated when it's on the private side, just because they can be end up being worthless if the company if there's not a liquidity event. Sure. Right? Like, if the company doesn't go public, or if they don't offer a secondary offering, or some sort of liquidity event for employees while you work there, then there's risk involved with that.
Speaker 1:Yeah. I know that oftentimes, there has to then be some sort of, like, buyout agreement of the way how do you value the shares if there is not a publicly traded market, where you can just look up the ticker and see what the price is. So some some complications there. What are the different types of equity compensation? I started off with some of the acronyms that are out there.
Speaker 1:Do you mind maybe going through what the common ones are Yep. And define them? Of course.
Speaker 2:Yeah. The most common type of the most common form of equity compensation that we see is restricted stock units, or RSUs. So this is also the most easy to understand from the normal person out there. So really, it's just, instead of your company paying you cash, they're just paying you stock. They're paying you in the form of their employer's stock, and generally, it's subject to a vesting requirement over, you know, three or four years.
Speaker 2:So it stacks right on top of your ordinary income, so you get it on your pay stub, essentially. Mhmm. It's right on your pay stub, it's on your w two when you report your taxes, and then you're free to do with it. As soon as it vests and it arrives in your account, you can do with it as you please.
Speaker 1:Interesting. Now, if there is that restriction, and it shows up on your w two, in a way, are there interesting tax dimensions to RSUs that people kind of need to be aware of?
Speaker 2:There are. So it there it is subject to ordinary income tax, just like cash wages. So there's no, like, tax benefit of receiving RSUs. However, the withholding can get interesting, because a lot of time with companies, they're gonna subject a 22% default withholding. It's like the supplemental wage withholding.
Speaker 2:And if you're in a higher marginal rate, like if you're in a 37% rate, but they withheld taxes at a 22 rate, usually you can end up with a tax surprise, where you received all these RSUs throughout the year, you file your taxes, and then you owe in thousands of dollars. So if you're someone out there who is receiving RSUs and commonly is paying into their taxes year after year, and they're like, why do I always owe into my taxes? This could be a culprit for sure. Could it
Speaker 1:also create issues of, is it called under withholding, where you ultimately owe, like, at the end of the year, a penalty?
Speaker 2:Right. Yeah. It, commonly, it can result in a penalty, because if you're not hitting safe harbor, then you essentially didn't pay in enough to your taxes. Yeah. And you get dinged when you do that.
Speaker 2:So usually, a a workaround is either you gotta dial up your withholding throughout the year, or you have to make quarterly estimated tax payments, and kinda get up to that safe harbor level.
Speaker 1:Yeah. For some reason, I don't know why, but people are hesitant to make those quarterly payments. I think we like the ease with which it just comes right out of the paycheck. My employer does it. They have to do it as well on the side.
Speaker 1:Just seems like it it makes the almost tax paying a little bit too visceral, too real.
Speaker 2:Right. Yeah. And another challenge with quarterly estimates is that these are dynamic. So you one year, you may have a a huge grant be invested, where the following year, it might be, slightly less. So it's somewhat difficult to retrofit your withholding and future proof it, and be like, I'm just gonna withhold this amount and be good.
Speaker 2:It changes year to year, so you really have to proactively stay on top of it, and and kind of project out, like, hey, what is my vesting? Where are my upcoming vesting going to be, and am I withholding the proper taxes for it?
Speaker 1:So to maybe wrap it up with the RSUs, are there any other interesting things, whether alternative minimum tax, or the possibility that when you get it on your pay stub, right, the price fluctuates. Mhmm. What if eventually the price goes down? Is that then a capital loss?
Speaker 2:Right. Yeah. So there's conventional wisdom out there with restricted stock units, where when they vest, so when you legally receive them, you pay the taxes, usually, a lot of financial advisors out there recommend to just sell immediately because you already pay the taxes. And to your point, if the tax or if the stock pulls back, you already paid taxes at that higher price, so it can create issues there. But I I don't think conventional wisdom is necessarily a good fit for everyone, because me, personally, if I was working at a company with RSUs, I'd wanna develop some skin in the game and just allow the stock to vest, and if I believe in the company, I might hold on to some shares strategically, and especially if it doesn't represent, like, an overwhelming amount of my net worth.
Speaker 2:Right? So the risk isn't there as much, where you can kind of ride it out with the company, and I think it's it's kind of fun to have some skin in the game at the company that you work for.
Speaker 1:That's true. Well, that is one of the things that we always look at on the investing side, is the concentration risk, right, of these RSUs. If all of a sudden, your portfolio, when you look at everything all inclusive, where that's all of a sudden now a massive part of your portfolio, that's something to be a little aware of. In terms of now the maybe to pivot a little bit to other types besides RSUs, used to be much more common. I always heard about these stock options like ISOs, incentive stock options.
Speaker 1:There's qualified, non qualified. Can you maybe unpack those a little bit for us?
Speaker 2:Yeah. Sure. So behind RSUs, there's, to your point, the nonqualified stock options, or NQSOs, or NSOs. There's all these different names out there for them. But these are interesting too, because this is essentially the company giving you the right, not the obligation though, but the right to buy shares in the the company's stock at a strike price.
Speaker 2:And usually, it's over a ten year window, and then it expires. So for example, you may be given an award for a thousand shares at $50, right, at the company you work for, and then if the stock price goes up to a 100 or 150, you can basically raise your hand and say, hey, wanna exercise my non qualified stock option you awarded me, and I wanna purchase those shares at the $50 strike price, and then from there, you can immediately turn them turn around and sell them on the liquid open market, and lock in that that difference.
Speaker 1:Okay. So that makes a lot of sense. Now, explain to me the difference between qualified and nonqualified. Like, are they taxed differently? Is there a motivation behind a company to give one over the other?
Speaker 2:Yeah. So so ISOs, incentive stock options, is another kind of flavor of nonqualified stock options, and we don't see those as much anymore. We certainly have clients who have ISOs, but we don't see them anymore because the employers no longer receive tax benefits. So with non qualified stock options, when you lock in that price, it's deduction for the business, but the business doesn't get that for ISOs. So there's this whole transition in out there that away from ISOs and over to things like RSUs and PSUs, which we haven't talked about.
Speaker 1:Oh. Oh, well, maybe before we get to the PSUs, I was curious about some of the things that I had been reading about the alternative minimum tax, and how perhaps there's a motivation with the one big beautiful bill Yeah. To either exercise them in 2025, or maybe 2026. I'm not sure which one it is. It seems like some of the information out there is a little confusing.
Speaker 1:Maybe you can unconfuse it
Speaker 2:for us. Sure. Yeah. So with ISOs, it it it's an add back item for AMT. So I'll break down AMT.
Speaker 2:So AMT is this parallel tax system that's right next to the regular income tax system. So side by side, every year as an American taxpayer, you're either paying one or the two. 99% of people out there are just the regular income tax. They've never even heard of AMT, they'll never see it. Sure.
Speaker 2:But there are certain high generally high income earners who are make over a threshold amount who have ISOs, because ISOs are actually an add back into AMT So what's what we see is someone exercises their ISOs, and then it actually pushes them into the AMT side, where now they are subject to AMT tax, because ISOs are an add back item there.
Speaker 1:Okay. Yeah. It's fascinating because actually, companies have been experiencing that as well with all of the deductions for like, depreciation, research, and development, where under the normal tax code, they calculate their taxes. But under the parallel one with the corporate alternative minimum tax, they're finding that they're getting hit there. Right.
Speaker 1:And so they're not able to fully take advantage of some of the incentives in the one big beautiful bill for investing in property, plant, and equipment. So it applies not just corporations, but individuals who they can get caught in that trap too.
Speaker 2:Because right now, we're under the Tax Cuts and Jobs Act environment, which dramatically increased the AMT exemptions, and not many Americans are subject to AMT right now. So to your point, there could be a strategy where you could strategically exercise ISOs this year instead of next year to take advantage of some AMT.
Speaker 1:Oh, yeah. Alright. And does it boil down to just doing the math, really? And using the software, look at the scenarios, should you or shouldn't you, is Yeah.
Speaker 2:AMT is highly complex, so you really wanna rely on a really good software to basically project it out side by side. So what we do with clients is, we we run the projection with and without, and say, we actually retrofit and figure out how much AMT, or how many ISOs can you exercise to avoid AMT. So there's this break over, or break even point, where you can actually strategically exercise a certain amount of ISOs and stay right under AMT, and maybe exercise the remaining amount the next year.
Speaker 1:Oh, fascinating. Well, yeah. It definitely pays to work with the professional then to kinda go through those scenarios. So maybe let's finish then with you had mentioned another acronym, the PSUs. Mhmm.
Speaker 1:What are those?
Speaker 2:Yeah. Performance share units. So generally, the vesting is tied to a three year measurement period where the it's kind of like a sliding scale for the payout. So it's not like, oh, a thousand shares. It is you might get a thousand or 1,200 or 800 shares depending on the performance of the company.
Speaker 2:So usually, tied to some sort of like EBITDA calculation, it can it can get complex, but shareholders love it, of course, because they're now, the award or the payout is directly tied usually to kind of like the stock performance. Sure. So if the stock and the company's performing well, then everyone gets their PSUs. But if things are not going well, then maybe the sliding scale kind of moves back that amount
Speaker 1:Mhmm.
Speaker 2:That people receive.
Speaker 1:Yeah. Well, I know that Elon Musk, it's not a PSU, but he was in the news lately for this new pay package that they he negotiated, and very aggressive performance targets, where it's like, well, if he creates $7,000,000,000,000 in shareholder value, and they wanna give him a trillion dollars for it, maybe that's not that bad of a trade. But it kinda sounds like it's similar. You hit if they hit these performance targets, you basically get rewarded for it.
Speaker 2:Exactly. You're really aligning the incentives with the company and the employee, where everyone is working towards the same goal. We all wanna drive shareholder value, and of course, employees selfishly wanna get the highest equity compensation payouts possible, but then the companies and their board and whatnot want, obviously, the performance to do well as well, so
Speaker 1:Yeah. And I think from a business perspective as well, it highlights why it is that some employees might be eligible for these versus others, because if you are in a position, an executive Right. Clearly, your decisions, the actions you take, probably have a really direct linear bearing on the performance of the company. Now, everybody obviously is contributing, but sometimes it can be very indirect. And it's like, well, what sort of alignment of incentives is there needed for, perhaps, one person who is, you know, in in some other position, entry level.
Speaker 1:Right. Maybe they're not making a direct contribution to it, so does it really align those incentives? Exactly. So question for you in terms of maybe the amount that people are making, whether it's from their base salary, other income, or that they could exercise, is there a difference in approach if you are making, say, you know, above a million dollars versus below a million dollars or whatever that threshold might be?
Speaker 2:Right. Yeah. So high income earners, there's a lot more implications around stock options because you're in the highest marginal tax rate usually, 37%. So anytime that you receive RSUs or you exercise your NQSOs, you're taxed at ordinary income of the highest marginal tax rate. So one interesting strategy for higher affluent individuals is to align your equity compensation with your charitable giving intent.
Speaker 2:So you can take vested stock options that you received over the years that you, you know, you own and have appreciated, maybe have a built up capital gain underlying in there, and if you're in the highest marginal tax rate, you could just turn around and gift stock to a nonprofit, or you can open a donor advised fund, a DAF, and bunch multiple years of charitable giving into one to coincide with a high income tax year.
Speaker 1:Oh, interesting. So that would be don't sell it, gift it instead.
Speaker 2:Exactly. And if you were already gonna give cash to charity, why not give a highly appreciated position that you can get multiple tax benefits at the same time? You can get a deduction for the contribution, but you could also avoid the tax when you
Speaker 1:realize the gain. Yeah. That's really a win win right there. Right. Yeah.
Speaker 1:Now, is there anything else, now that we're approaching the end of the year here, tax planning season, anything words of wisdom that you would like to share with people as far as anything to maybe consider to do, like, dos before the end of the year, especially if it relates to you have equity compensation to look at?
Speaker 2:Yeah. Equity compensation's interesting because it requires more proactivity from the the shareholders, right? So you wanna stay on top of that instead of, like, other investments, you're like, you know, set it and forget it, and I'll check it on it every one or two years, where equity comp, you wanna be on it every single year, because every year at the end of the calendar year, there's an opportunity to potentially exercise some nonqualified stock options. You you could fill up strategically certain marginal tax rates, and or you could sell stock, obviously, and offset winners and losers, and and really just right size your tax situation for that year. So there's a lot to do, and at this time of the year, we're really busy with doing that.
Speaker 2:So we have a lot of clients with equity compensation that are doing these types of things, especially when the stock market's at an all time high. Sure. Because when do you wanna sell stock? Like, when a buyer down low, like, at all time highs, we're seeing a lot more people starting to take action, especially since we're at the end the year.
Speaker 1:Makes a ton of sense. Well, Tom Burkholz, thank you so much for joining. My pleasure.
Speaker 3:Annex Wealth Management LLC is a registered investment adviser. For more information about our firm, please visit annexwealth.com. The information in this podcast is for educational and entertainment purposes only and is subject to change without notice. The opinions expressed are those of the participants and don't necessarily reflect those of Annex Wealth Management LLC. Information presented should not be construed as tax, legal, or investment advice or a recommendation or solicitation for the sale of any product or strategy.
Speaker 3:Listeners are encouraged to seek advice from qualified professional to determine whether any information presented may be suitable for their specific situation. Investments involve risk. Neither Annex Wealth Management LLC nor its podcast participants shall be liable for losses resulting from decisions based on information or viewpoints presented on this podcast.