Employee Stock Compensation Plans and Market Downturns

There’s a lot of talk going around about a nasty stock market drop and coming recession. Even though the market seems to be less volatile at this point, many market watchers warn there could be a reckoning, especially if we see another wave of COVID-19 infections. The economic implications of even our relatively brief shutdown are also likely to have an impact for at least the next few earnings cycles.

What does it all mean for employee stock plans? The good news is that most equity compensation plans have some protections built in to help participants weather the storm of a down market. If you’re worried about market volatility—or even an outright crash—here are a few things to hang your hat on.

Option Grants

Option grants usually come with a 10-year lifespan. As you might imagine, there’s lots of room in there for market fluctuations. And this form of employee compensation doesn’t need any capital investment from participants until they actually pull the trigger. If shares are underwater, plan participants can wait until the expiration date for the stock to recover.

This can be an advantage. First, options granted during a downturn typically come with a lower exercise price, based on the fair market value at the time. So even if previous grants had a higher exercise price, the newer batch will have a lower threshold. Assuming the stock recovers in short order, it can be like getting shares at a discount.

Also, for vested, nonqualified stock options, there’s a potential tax advantage to a down market. How? At the time of exercise, the net difference between the strike price and the market value of the stock is taxed as W-2 income at the ordinary income tax rate, which can be as high as 37%. But when that stock is eventually sold, any gains over and above that level are taxed at the capital gains rate. If held for the standard one-year period, long-term capital gains tax rates will apply, which top out at 20% as of the 2020 tax year.

Just remember that when you exercise a nonqualified stock option, you’ve essentially made a capital investment in the stock, so you’re now exposed to market volatility.

Restricted Stock

Another type of employee equity compensation is a restricted stock grant. These restricted stock awards also come with a certain amount of flexibility when it comes to choosing your time to meet a tax obligation, which you might be able to use to your advantage during a down market.

With restricted stock, you can make what’s called a Section 83(b) election with the IRS within 30 days after your grant date. With this election, you pay taxes on the value of the stock at the time it’s granted, rather than its value at vesting. Think the stock will rise between the time it’s granted and the time it’s vested? Filing an 83(b) when the market is down—and thus the fair market value of the restricted stock award is low—can potentially lead to a smaller tax bill if a lower amount is taxed as ordinary income versus capital gains.

Your tax advisor can help you determine if a Section 83(b) election is appropriate for your situation. And there are risks. For example, if you quit your job before the vesting date and forfeit the stock grant, you can’t recover the taxes you paid.

Restricted stock is often granted at a nominal cost—and sometimes at no cost—to participants. If you pay nothing or a very small price for the restricted stock, you could realize a substantial gain, even after a stock downturn. Make sure you go through all the tax implications before moving forward. But if you can exercise at a lower price, that gain is going to be smaller—and likely less expensive at tax time.

Employee Stock Purchase Plan

Rather than offering a chance to exercise option grants or get restricted stock awards and take advantage of tax strategies, the employee stock purchase plan is all about managing price volatility. In general, employees can invest in the company stock with their own money.

Most of these stock purchase plans allow for dollar-cost averaging. Each month, you put in the same amount of money and buy however many shares can be purchased at that dollar amount. During a down market, it’s as if the shares are on sale and you can get more for less. Over time, dollar-cost averaging tends to even out, making overall pricing less volatile. 

Another advantage offered by employee stock purchase plans is what’s called a “look-back.” With a look-back, a specific purchase period is designated. Your stock will be purchased at the lower of two prices: either as of the first date of the period or the final date. This can help you buy low even if the price skyrockets by the end of the period.

For example, let’s say you regularly buy shares of company stock with a portion of your paycheck. You enroll in the look-back, and at the beginning of the period, the stock is flying high. But before the end of the look-back period, the price has tanked along with the rest of the market. You don’t miss out on the deal, because your price point will be the lower of the two.

Likewise, suppose you re-enroll while the price is still in the dumps. Later on—as the market recovers and the stock value increases—you still get the lower price from the beginning of the purchase period. This look-back advantage is only available with certain employee stock purchase plans, so you might want to check with your employer. A look-back can provide significant price protection during a volatile market.

Bottom Line

Navigating a market downturn is never fun, but equity compensation can offer a silver lining. Take a look at the employee stock plans your company offers and see what’s available to you. And be sure to discuss your alternatives with your tax advisor. Depending on your individual situation and goals, a down market might actually be an opportunity to consider if this may be a time to exercise your options or buy a little company stock.