What is Equity Compensation? Why Does it Matter to You?
Equity-based compensation is an additional non-cash method companies use to pay employees by issuing them stock as part of an overall compensation package. Equity compensation comes in many forms, but in all cases, it provides employees a financial stake in the success of the company. If the company’s profits grow, employees can share in that growth
If you’re a recipient of equity compensation, these benefits represent one of your best wealth accumulation opportunities. However, not all equity compensation plans are created equal. Each comes with their own unique considerations when it comes to things like tax, investing strategy, and regulatory requirements.
In this article, we will provide an overview of the five most common types of equity compensation plans, along with the key distinctions between each plan type. To maximize the value of your equity compensation plan, it’s important to understand and incorporate these considerations into your financial plan, both of which can be accomplished with the help of a financial advisor with expertise in equity compensation.
1) Non-qualified Stock Options (NQSOs)
Non-qualified stock options are the most common type of equity compensation. NQSOs give employees the right to buy shares of company stock at a preset price (known as the “strike price” during a certain period of time. NQSOs don’t qualify for favorable tax treatment for the recipient but allow the company to take a tax deduction when the options are exercised.
For employees, tax treatment depends on your holding period. The capital gain or loss is considered long-term if the recipient holds the stock for more than one year. If the options are exercised with a holding period of less than one year, the gains or losses are considered short-term.
2) Incentive Stock Options (ISOs)
Like NQSOs, incentive stock options (ISOs) offer employees the right to buy shares of company stock at a set price. The biggest advantage of ISOs is their tax treatment, assuming two criteria are met:
- The options are held for at least two years the date of issuance
- The options are held for at least one year after the date of exercise
If these conditions are satisfied, ISOs are taxed as ordinary income as opposed to the higher capital gains rate. You do not have to pay taxes when you receive or exercise ISOs. Instead, ISOs are reported as taxable income only when you sell the stock.
Because you can choose when to exercise your options, and how much to sell, there is flexibility in avoiding or minimizing your taxes with careful planning. A financial advisor can help you plan and model various scenarios to select the proper one.
3) Employee Stock Purchase Plans (ESPP)
Employee Stock Purchase Plans allow employees to buy shares of their employer’s stock at a discount. Employees usually have the opportunity to enroll twice a year in the plans and choose how much to contribute, typically up to 15% of their annual salary or $25,000.
Once enrolled, the company will create a personal ESPP account, often with a brokerage company, and transfer funds from the employee’s paycheck into the account to buy shares. With most plans, the program enables employees to sign up for a 12-month offering period, the official start of ESPP participation. The offering period is the beginning date for tax purposes and helps to set the price for the lookback benefit.
ESPPs can also include an extra benefit called the “look back period.” With this feature, the employee still obtains a 15% discount, but used for the lower of two prices — the stock price on the first day the employee began to set aside money or the stock price on the day it’s purchased. The discount is the key advantage of the plan.
4) Restricted Stock (RSUs)
Unlike stock options, grants of restricted stock/RSUs have value at vesting even if the stock price has not moved since the grant (or even dropped). One distinct difference is that RSUs have less general upside than options and, as a consequence, less risk.
Restricted stock units are commonly awarded to executives and key employees. In short, RSUs are a promise from your employer that you will receive shares of company stock in the future. There are two primary types of RSUs:
- Service-based – units received after a defined period of service
- Performance-based – units received once specific goals are met
From a tax standpoint, RSUs are considered part of your compensation and taxed as ordinary income once fully vested. Thereafter, any gains or losses from the sale of your RSUs will be taxed at the capital gains rate, again subject to holding period.
Filing an 83(b) election can help reduce the taxes you pay on your RSUs. Effectively, an 83(b) election provides employees the option to pay taxes on the value of RSUs at the time of issuance as opposed to the value when fully vested. Assuming the value of your company stock increases over time, an 83(b) election allows your tax rate to applied to the lower of the two valuations.
If you work for a public company, it’s also important be aware of any trading blackout periods, as you will be prohibited from selling company stock during these times.
5) Stock Appreciation Rights (SARs)
A Stock Appreciation Right is an equity award that enables you to profit from the appreciation of a set number of number of your company’s shares during a defined period of time.
There are two types of SARs:
- Stand-alone stock appreciation rights are granted independently of any other stock options.
- Tandem stock appreciation rights are granted in conjunction with a Non-Qualified Stock Option or an Incentive Stock Option, which entitles the holder to exercise it as an option or as a SAR. The election of one type of exercise prevents it from being exercised as another.
There are no tax consequences when SARs are granted or fully vested. If you exercise your SAR for cash proceeds, you must pay income tax on the fair market value of the amount received at the time of vesting. If you elect to receive stock options at the time of exercise, you will pay capital gains tax subject the gain or loss on the sale of those options.
Equity based compensation enables you to share in your company’s success and profits. Obtaining the maximum from your equity compensation requires a fundamental understanding of your plan’s terms, structure, and tax obligations.