Characteristics of Equity Securities

Characteristics of Equity Securities

Owning common stock isn't just a title to a share — it's a bundle of distribution rights, corporate-action exposures, and employee-compensation features that play out over the life of the holding. Companies distribute earnings through cash dividends, occasionally through stock dividends or special one-time payments, and increasingly through share buybacks. They restructure their share count through forward and reverse splits. They compensate employees through options (ISOs and NQSOs), purchase plans (ESPPs), and restricted stock units (RSUs). And they impose resale restrictions on stock acquired outside public markets, governed by Rule 144. This chapter covers the mechanics, timing, and tax consequences of each.

Restricted Stock and Dividends

Restricted stock is typically granted to insiders and employees, subject to resale restrictions under SEC Rule 144:

• Minimum holding period before resale
• Volume limitations on sales
• Must file Form 144 with the SEC

Dividends are distributions of corporate earnings:

• Declared by the board of directors — not guaranteed
• Cash dividends, stock dividends, or stock splits
• Key dates: declaration date, ex-dividend date, record date, payable date

Three forms of dividend distributions

A dividend is a distribution of corporate earnings to shareholders, declared by the board of directors at its discretion. Companies use three main forms:

Three things every shareholder should know about dividends:

• Dividends are not guaranteed. The board can cut, suspend, or eliminate the dividend at any time. Skipping a common dividend is not a default and creates no legal liability.
• Dividend payments reduce shareholders' equity by the cash paid out. The stock typically drops by roughly the dividend amount on the ex-dividend date (covered in §2).
• Companies generally try to maintain or grow dividends because cutting a dividend is a strong negative signal to the market and to income-oriented shareholders.

Qualified vs. ordinary dividend taxation

Federal tax law splits dividend income into two categories. The distinction matters a lot for high-bracket investors.

The Series 66 expects you to know the categorical split and the rough rate differential, not the exact bracket thresholds. The practical implication: for high-bracket investors, the same dollar of dividend income can have wildly different after-tax value depending on whether the holding qualifies. REIT investors and short-term traders in particular should be aware their distributions don't qualify for the preferential rate even though they look like ordinary dividends.

Dividend Reinvestment Plans (DRIPs)

A Dividend Reinvestment Plan automatically reinvests cash dividends into additional shares of the same stock instead of paying out cash. Many large public companies offer DRIPs directly; brokerages typically offer the equivalent at the account level.

Three features worth knowing:

• Compounding. Reinvested dividends purchase additional shares, which then earn dividends themselves — classic compounding over long horizons.
• Often discounted prices and zero commissions. Some company-sponsored DRIPs purchase shares at a small discount (1-5%) to market price or with no transaction cost.
• Tax still applies. Reinvested dividends are taxable in the year received, even though no cash hits the shareholder's account. This catches investors off-guard — they receive a 1099-DIV showing taxable income they never saw in cash.

DRIPs are well-suited to long-horizon investors building positions in dividend-paying companies. They are less appropriate for income-needs investors who require the cash distributions for living expenses.

The four dates in the dividend process

Each declared dividend follows a four-stage timeline. The Series 66 tests the sequence and especially the role of the ex-dividend date, which determines who gets paid.

The critical relationship to remember: Under current T+1 settlement, the ex-dividend date is one business day before the record date. To receive the dividend, an investor must buy the stock before the ex-dividend date (so settlement clears them as a shareholder of record by the record date). Buy on the ex-date or after and the seller keeps the dividend.

Why the stock price drops on the ex-dividend date

On the morning of the ex-dividend date, the stock typically opens at a price roughly equal to the previous close minus the dividend amount. This is not a coincidence and not market manipulation — it reflects the economic reality that the cash dividend is leaving the company.

The mechanics:

• Before ex-date, the stock trades "cum dividend" — the buyer will receive the upcoming dividend. The stock price implicitly includes the value of that dividend.
• On the ex-date, the stock trades "ex-dividend" — the buyer will NOT receive the dividend. The price drops by approximately the dividend amount to reflect the lost cash flow.
• The price drop is mechanical, not bearish. Investors who held through the ex-date receive the cash; the stock is worth less because the cash will leave the company.

An everyday example: a stock closes at $50.00 the day before ex-date with a $0.50 dividend pending. It typically opens at roughly $49.50 on the ex-date. Combined with the dividend a few weeks later, the total economic position is preserved: $0.50 in cash plus $49.50 in stock equals $50.00.

The Series 66 tests this concept indirectly through "tax loss" questions: an investor cannot create a tax loss simply by buying just before ex-date and selling immediately after — the post-ex price drop, after dividend tax, generally leaves the investor worse off, not ahead.

Forward stock splits

A forward stock split increases the number of shares outstanding and proportionally decreases the price per share. The total economic value of the company — market capitalization — is unchanged.

Common ratios: 2-for-1 (each share becomes 2), 3-for-1 (each share becomes 3), 4-for-1, even 10-for-1.

Why companies do forward splits:

• Lower share price improves perceived affordability for retail investors. A $40 stock feels accessible in a way a $1,000 stock doesn't, even though the economic claim is mathematically equivalent.
• Improved liquidity. Lower prices mean more shares trade hands per dollar of market cap, tightening bid-ask spreads.
• Index inclusion and option chain accommodation. Some indexes have price-weighted methodologies that disfavor very high prices; option markets work better with moderate share prices.

Reverse stock splits

A reverse split reduces the number of shares outstanding and proportionally increases the price per share. Like forward splits, total market capitalization is unchanged.

Common ratios: 1-for-5 (5 shares become 1), 1-for-10, 1-for-20.

Reverse splits typically signal stress and have a different motivation than forward splits:

• Comply with exchange listing requirements. NYSE and Nasdaq require a minimum bid price (typically $1.00 or $4.00) for continued listing. Companies with depressed prices use reverse splits to climb back above the threshold.
• Improve institutional acceptance. Many institutional funds have charter restrictions against holding stocks below $5 or $10 per share. A reverse split makes the stock eligible.
• Combat the "penny stock" perception. Stocks under $1-2 carry a low-quality stigma; bringing the price up is partly cosmetic.

The Series 66 tests recognition of the directional opposites: forward splits increase share count and decrease price; reverse splits decrease share count and increase price. The economic value of each shareholder's holding doesn't change in either case.

Share buybacks

A share buyback (or repurchase) is the company purchasing its own shares from the open market or from existing shareholders. Buybacks have become a primary mechanism for distributing cash to shareholders, often exceeding dividend payouts at large public companies.

Three structural approaches:

• Open-market repurchase. The company buys shares on the public exchanges over an extended period, typically authorized by the board for a multi-year window with a dollar cap. Most common method.
• Tender offer. The company offers to buy back a specified number of shares at a stated price (usually a premium to market), with shareholders submitting their shares for redemption. Used for larger one-time buybacks.
• Accelerated share repurchase (ASR). The company purchases a large block from an investment bank, which then buys shares in the open market over time to cover its position. Effectively front-loads the buyback.

Effects of buybacks:

• Share count decreases — the repurchased shares become treasury stock (or are retired).
• EPS increases mechanically because the same earnings are divided by fewer shares.
• Ownership percentage of remaining shareholders rises proportionally — each share now represents a larger fraction of the company.
• Tax efficiency — non-tendering shareholders have no taxable event, unlike a dividend. Buybacks are generally more tax-efficient than dividends for most shareholders.

Employee stock options — ISOs and NQSOs

Companies grant employee stock options as part of compensation packages, particularly at growth-stage and technology companies. Two main flavors:

• Incentive Stock Options (ISOs) — favorable tax treatment: no ordinary income tax at exercise (but may trigger Alternative Minimum Tax). Gains taxed as long-term capital gains if holding period requirements are met. Available only to W-2 employees.
• Nonqualified Stock Options (NQSOs) — the spread at exercise (market price minus exercise price) is taxed as ordinary income immediately. More flexible: can be granted to employees, directors, consultants, and independent contractors.

The next subsections cover each in detail, including the specific holding periods, AMT mechanics, and the choice trade-offs employees face. Beyond options, ESPPs and RSUs round out the modern equity-compensation toolkit.

Incentive Stock Options (ISOs) — mechanics and AMT

Incentive Stock Options are a tax-advantaged form of employee stock option. The key advantages are deferred taxation and the potential for the entire gain to qualify for long-term capital gains rates.

Three-stage tax life of an ISO:

• Grant. No tax consequence to the employee. The option is granted at a stated exercise price (typically equal to the stock's current market value).
• Exercise. Employee pays the exercise price and receives the shares. No regular income tax on the spread (the difference between market price and exercise price) — this is the main ISO advantage. However, the spread IS an Alternative Minimum Tax (AMT) preference item, which can create unexpected tax bills for high-spread exercises in years where AMT applies.
• Sale. If the employee holds the shares for at least 2 years from grant AND 1 year from exercise, the entire gain (from exercise price to sale price) qualifies for long-term capital gains treatment. If either holding period is missed, it's a "disqualifying disposition" and the spread becomes ordinary income.

Nonqualified Stock Options (NQSOs)

Nonqualified Stock Options are the more flexible, more common form of employer stock option. They lack the tax advantages of ISOs but compensate with broader applicability and simpler tax treatment.

Three-stage tax life of an NQSO:

• Grant. No tax consequence (same as ISOs).
• Exercise. The spread (market price minus exercise price) is immediately taxable as ordinary income in the year of exercise. Subject to federal income tax withholding, FICA, and Medicare just like regular wages. The employer gets a deduction for the same amount.
• Sale. Any additional appreciation between exercise and sale is taxed as capital gain (long-term if held more than 1 year after exercise; short-term otherwise).

Key contrast with ISOs:

• Recipients. NQSOs can be granted to employees, directors, consultants, and independent contractors. ISOs are restricted to W-2 employees.
• Tax timing. NQSO tax hits at exercise (cash needed); ISO tax (for regular income tax) is deferred until sale.
• Employer treatment. Employer gets a tax deduction equal to the ordinary income recognized by the NQSO recipient. ISOs generally produce no employer deduction unless there's a disqualifying disposition.

Employee Stock Purchase Plans (ESPPs)

An Employee Stock Purchase Plan lets eligible employees purchase company stock at a discount from market price, typically through payroll deductions over a 6-month "offering period."

The classic structure:

• Payroll deductions accumulate during the offering period. Employees elect a percentage (often 1-15%) of pay to contribute. Contributions accrue but no purchase happens yet.
• At the end of the offering period, the accumulated cash buys shares at a discount. Standard discount is 15% off the lower of the offering-period start price or end price (the "lookback").
• Section 423 qualified ESPPs get favorable tax treatment: the discount is taxed as ordinary income at sale (not at purchase), and gains above purchase price can be capital gains if holding periods are met (similar to ISOs — 2 years from offering-period start, 1 year from purchase).

ESPPs are popular employee benefits because of the discount: a 15% discount with no immediate tax effectively delivers a guaranteed 17.6% return on the purchase price, assuming the employee sells immediately (qualifying versions have specific holding rules to consider). They're frequently overlooked by employees who don't enroll, leaving meaningful compensation on the table.

Restricted Stock Units (RSUs)

Restricted Stock Units are a promise to deliver actual shares of stock to the employee on a future vesting date, subject to continued employment and any performance conditions. RSUs have largely replaced stock options as the dominant form of employee equity compensation at large public companies.

Key mechanics:

• Grant. The employee receives a contingent right to a specified number of shares. No tax consequence at grant.
• Vesting. Shares are delivered on the vesting date if the employee is still employed and any performance conditions are met. Most RSU grants vest over 4 years with various schedules ("cliff" vesting, monthly vesting, or graded vesting).
• Tax at vest. The full market value of shares delivered is taxed as ordinary income at vest. Employers typically withhold shares (or cash) to cover the tax liability.
• Sale. Any further appreciation after vesting is capital gain.

RSUs differ from stock options in two important ways: they always have intrinsic value (unless the stock goes to zero), and they don't require the employee to pay an exercise price. From the company's perspective, RSUs are simpler and more reliable as compensation tools; from the employee's perspective, they're less leveraged to stock price increases but more reliable in flat or down markets.

Restricted stock vs. control stock

The Series 66 tests two related categories of stock subject to special resale restrictions under Rule 144. They look similar but apply for different reasons.

Key distinction in practice: restricted stock requires a holding period before any sale; control stock can be sold immediately but only subject to volume limits and Form 144 filing requirements. A single individual can hold BOTH categories — an officer who acquires shares through a private placement holds restricted stock (subject to the holding period) AND, once acquired, those shares are also control stock (subject to volume limits).

Rule 144 resale mechanics

Rule 144 provides a safe harbor for resale of restricted and control stock without full SEC registration. Four operational requirements:

Non-affiliate fast lane: a non-affiliate holding restricted stock can sell without any Rule 144 restrictions — no volume limit, no Form 144 — once they've held the shares for the required period (6 months reporting / 12 months non-reporting). This is the Series 66's favorite trap: many candidates assume the volume limits and filing requirement apply to everyone, but they apply only to affiliates.