When employees find out they're getting equity compensation from their employer, their first reaction is typically, "Great!" Their second reaction is often, "How does this work?"
Both reactions are understandable. In most cases, equity compensation is a net win for employees. It rewards you for a job well done and gives you a chance to take ownership—literally—in the company you work for. Managed wisely, it can be a powerful way to build wealth.
On the other hand, equity compensation can be confusing. The tax implications can be tricky to sort out and most forms of equity compensation come with their own rules and restrictions. The first step toward making the most of your equity compensation is to understand what type of equity compensation you’ve been offered so you can focus on the most important considerations that will affect the potential value of your equity award.
Understanding Equity Compensation
Equity compensation programs provide employees a chance to own company stock, often at a discounted price. The value of equity compensation grows when the company does well, which means employees’ interests are aligned with company goals and can provide a meaningful way for employees to participate in their company’s financial success.
To reap those rewards, however, you typically must meet certain procedural and/or performance requirements. These often include vesting schedules (which consists of a waiting period before you can take ownership of company shares or even performance goals that you or the company must achieve) or time limitations on when you can exchange your award for stock. Some types of equity compensation require you to purchase company stock—often straight from your payroll—while others operate more like a cash bonus.
Four Common Types of Equity Compensation
If you are receiving equity compensation for the first time, you may find that becoming familiar with equity compensation terminology can be challenging! The types of equity compensation you're most likely to encounter fall into four categories: incentive stock options (ISOs), non-qualified stock options (NSOs), restricted stock or restricted stock units (RSUs) and employee stock purchase plans (ESPPs).
Stock options give you a right to buy company stock at a discount price, known as the strike price, after waiting out the vesting schedule. Restricted stock units are a promise to award you shares at a later date, while employee stock purchase plans are managed programs that allow you to buy shares at a discounted rate through payroll deductions.
Incentive Stock Options (ISOs)
ISOs are one of the two main types of stock options and can be particularly attractive because of the tax-favored status.
With ISOs, rather than being given company shares right away, initially you are given the potential opportunity—or “option”—to acquire shares at a set price at a later date. The date you are given the options is known as the “grant date” and the fixed price at which you can purchase shares is known as the “strike price” or “exercise price.”
Options are generally not exercisable right away, but rather subject to a vesting schedule providing different dates on which you can choose to exercise your option to purchase company shares. Vesting schedules vary by employer, with three to five years being common vesting periods. A “graded” vesting schedule provides for incremental vesting over a period of years while with “cliff” vesting all options will become exercisable at the end of the period. While the vesting structure may differ substantially from employer-to-employer, it is imperative to understand how your options vest as you will generally forfeit options that have not vested should you decide to leave your company.
Once your stock options vest, you may decide to exercise some or all of your options if the strike price is less than the fair market value of the stock. You have some flexibility in choosing to purchase stock, as under tax regulations give you up to ten years from the grant date to exercise the options. When you exercise your ISOs, you don’t owe regular income or payroll taxes on the difference between your strike price and the stock’s fair market value as long as you hold those shares for the longer of (1) one year after exercise and (2) two years from the grant date. Instead, you can defer taxes until you sell those shares, at which point any gain will be taxed at the long-term capital gains tax rate—which is often much lower than your income tax rate.
However, while the option exercise is disregarded for regular income tax purposes, the difference between what you paid for the shares and the stock's fair market value on the date of exercise must be included in your alternative minimum taxable income (AMTI), and you could be subject to the alternative minimum tax (AMT). To the extent that you owe AMT due to the exercise, you may have a tax credit that can be carried forward to offset tax in a future year, such as the year in which you sell the shares. The AMT rules are complex, and it is important to understand and plan for the tax implications prior to exercising your options and ensure accurate reporting of the exercise—and later sales—on your income tax return.
Non-Qualified Stock Options (NSOs)
Although nonqualified stock options (NSOs) do not provide the tax-favored treatment of the ISOs, they can still be a meaningful way to enhance your compensation package.
Similar to the ISOs described above, NSOs provide you the option to purchase company stock at a set price according to a vesting schedule. While the operation of the NSOs and ISOs may be similar, the tax consequences are quite different. With NSOs, the difference between the option exercise price and the fair market value of the stock at exercise is considered compensation income and is subject to both income and payroll taxes. It is also included with your taxable wages on your Form W-2 for the year of exercise.
Because of the tax impact upon exercise, your cost basis in the shares you acquire when exercising your options will equal the fair market value of the stock at exercise. This means that if you sell shares immediately upon exercise, your gain or loss will be minimal if the daily stock fluctuation is not significant. If you decide to hold your shares, keep in mind that your acquisition date is the date of exercise (not the date of grant) and so in order to have any future gains taxed at the lower long-term capital gains rate you will need to hold the shares for at least one year after the exercise date.
Restricted Stock and Restricted Stock Units (RSUs)
With a traditional restricted stock plan, a company issues actual shares of stock to an employee; however, while the employee has stock voting rights and dividends are generally paid, the stock is nontransferable and is subject to forfeiture until the shares vest. As with options, the vesting schedule can be based on graded or cliff vesting and will usually also include requirements that certain company or employee performance goals are met as a condition of vesting.
To avoid immediately issuing shares of stock, many companies offer restricted stock units (RSUs) instead. Prior to vesting, RSUs are simply an unfunded promise to issue shares in the future, and the employee will not be able to vote the shares or have a right to dividends during this time (although some plans do provide for dividend equivalent payments).
For tax purposes, both restricted stock and RSUs are not taxed at the time of grant. But the full fair market value of the shares is treated as compensation income (and subject to federal income tax and payroll tax withholding) at the time of vesting. This income inclusion means the cost basis of the shares you acquire will equal the fair market value of the stock on the date of vesting.
While restricted stock and RSUs are nearly identical in many regards—including the tax consequences discussed above—a major difference is the ability to make an election under Internal Revenue Code Section 83(b) to accelerate the deemed income that usually occurs at vesting. Under Section 83(b), an employee elects to be taxed on the share value at the date of grant rather than upon vesting. Why would an employee elect this treatment? If the value of the stock rises significantly from the date of grant until the date of vesting, the Section 83(b) election minimizes the amount of compensation income on which the employee must pay tax. But this election is not without risk! If vesting does not occur and the shares are forfeited, the employee is not entitled to a refund or credit for taxes paid, and in most cases will also not be allowed to claim a capital loss.
In some ways restricted stock and RSUs are one of the most straightforward forms of equity compensation in that you don't have to make any hard decisions about when to exercise your shares. That's because they're essentially purchased for you as part of your compensation. But as with any equity compensation, it is important to know when your shares or RSUs will vest, to understand your options to pay for income and payroll tax withholding and to review how the related income will affect your overall tax situation.
Employee Stock Purchase Plans (ESPPs)
A qualified employee stock purchase plan, or ESPP, allows employees to buy company stock with contributions made through payroll deductions. In contrast to stock options, the shares you buy through an ESPP come at a preset discount—typically 5%-15% lower than the stock's market price. Some plans even have a “look back” provision which bases the purchase price on the lower of the stock price at the beginning of the offering period or the end of the purchase period, essentially locking in the most beneficial price for the employee during the period.
As with ISOs, qualified ESPPs enjoy tax-favored treatment under the Internal Revenue Code. Shares that are acquired through an ESPP are never subject to payroll taxes, regardless of when the shares are sold. Although at purchase there are no income tax consequences, when you sell your shares at a later date you will face income taxes on the discount you received, as well as capital gains taxes if the share price has risen since the purchase date.
Generally, in order to maximize the tax benefits of the ESPP you will need to meet the holding period requirements for a “qualifying disposition,” which requires that you hold the shares for at least two years after the offering date and one year from the date the shares were purchased. The tax rules related to an ESPP can be complicated and rely on the employee for accurate and timely reporting, so it is important to work with your financial advisor to ensure you meet these obligations.
Including Equity Compensation in Your Wealth Management Plan
Equity compensation can provide you with a valuable opportunity to participate in the financial success and growth of your company and build additional wealth for meeting your personal goals. That’s why it’s so important to understand the specific restrictions, timelines and tax implications of your particular equity award.
While equity compensation can provide another reason to feel loyalty and optimism toward your employer—and for some higher-level executives can create actual or perceived pressures on selling shares—be careful about being too confident. No matter what kind of equity compensation your company offers or your position with the company, you'll want to integrate your equity compensation into your overall financial plan and maintain a smart balance between your personal goals and corporate concerns. This means taking into account the potential risks of overexposure to your company and the benefits of investment diversification.
Receiving equity compensation might be a good reason to seek out professional guidance if you aren’t already working with a financial advisor. An advisor can help you develop a strategy for equity compensation in the context of your current financial situation and long-term goals, so you’re in the best position to take full advantage of these valuable benefits.
This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.
Plancorp is a registered investment advisor with the Securities and Exchange Commission ("SEC") and only transacts business in states where it is properly registered or is excluded or exempted from registration requirements. SEC registration does not imply a certain level of skill or training. Please refer to our Form ADV Part 2A disclosure brochure and our Form CRS for additional information regarding the qualifications and business practices of Plancorp.