Employee equity compensation is a common benefit provided by public companies and some private companies (especially startups) but one that is often misunderstood by employees. It’s a non-cash compensation that gives employees a form of ownership of the company. Companies offer these options for a myriad of reasons, such as retaining and motivating employees, aligning their interests with those of the company, and freeing up cash flow by offering an alternative form of compensation. Employee equity compensation comes in several different forms, and given the rise in popularity, it’s important to know the basics of how they work.
The most common form of equity compensation awarded to employees is through stock options. Stock options are contracts that give an employee the right to buy, or “exercise,” a set number of shares of company stock at a pre-set price, known as the grant price. The contract specifies a set amount of time that the employee has to purchase the shares, starting with the grant date. There is typically a vesting period for stock options, meaning the employee doesn’t have the right to exercise the options until they worked for the company long enough to satisfy the vesting schedule specified. When the options vest and the employee decides to exercise the options, they buy the company stock at the price specified in the contract, which is intended to be below the current market value of the stock.
There are two forms of stock options – non-qualified stock options (NSOs, which are more common) and incentive stock options (ISOs). While the fundamentals of both forms work the same, the main difference between an ISO and an NSO is how they are treated for tax purposes.
For NSOs, the first taxable event comes after the options have been vested and the employee exercises them to purchase shares. Once the option is exercised and shares are purchased, the difference between the fair market price of the stock and the exercise price is immediately taxable to the employee as ordinary income. In simplified terms, the discount received at purchase is considered taxable ordinary income. The employee’s cost basis in the shares is the amount paid for the shares + the discount the employee paid taxes on. For example, if one share of stock was purchased at an exercise price of $10 when the stock was trading for $20, the employee pays $10 per share and is taxed on the $10 discount received. The cost basis established for this share is $20. Going forward, if the share is sold, standard capital gains tax rules apply to any appreciation above the cost basis.
ISOs are more advantageous to the employee in terms of tax treatment. For ISOs, outside of alternative minimum tax rules, exercising the option by buying the shares is not a taxable event as it is for NSOs. The preferential tax treatment of ISOs comes into play with what is called a qualified position. For shares to be considered a qualified position, they must be held for at least one year after exercising them and at least two years after the grant date. For a qualifying position, the cost basis in the shares includes what was paid for them based on the exercise price. When a qualifying position is sold, the employee has the advantage of being taxed at the preferential capital gains rate for any appreciation in the shares above the exercise price. It differs from NSO treatment since the gain on the shares due to the discount is taxed at the lower capital gains rate rather than at ordinary income tax rates. If the waiting period requirements for a qualified position are not met, then the discount received on the shares will be taxed at ordinary income tax rates, with the remainder of the appreciation subject to capital gains tax rates. As a result, the employee will pay less in taxes on a qualified position of an ISO than they would on an NSO.
EMPLOYEE STOCK PURCHASE PLANS
Another form of equity compensation is an Employee Stock Purchase Plan (ESPP), which allow participating employees to buy shares of their employer’s stock at a discounted price by using after-tax payroll deductions. Employees who want to participate in an ESPP can only do so after the offering period begins, similar to the grant date for stock options. Offering periods can last anywhere from six to 18 months, during which your payroll deductions accumulate. There are set purchase dates, at which point the accumulated funds are used to buy shares of stock at a discount to the current market price. In other words, after-tax funds are withheld from an employee’s paycheck, they are then used to buy shares of company stock at defined intervals. The amount an employee is allowed to deduct from their paychecks for ESPPs is determined by the plan, subject to an IRS limit of $25,000 per year.
Like stock options, ESPPs can be qualified or nonqualified. The difference comes down to how your shares are taxed if and when you sell them at a profit later. With a qualified plan, if you hold the stock for at least one year after the purchase date and two years after the offering date, you realize ordinary income in the amount of the discount you received in purchasing the stock as well as long-term capital gain income for any gain above the discount. However, if you meet the holding requirements, none of this income is reported until the year you sell the shares. For a nonqualified ESPP, you will owe ordinary income tax on the discount amount in the year you purchase the stock, and capital gains taxes on any appreciation thereafter.
RESTRICTED STOCK PLANS
Restricted Stock Plans are another form of equity compensation in which stock is granted to an executive of the company. The restricted stock units (RSUs) are “restricted” because they are subject to a vesting schedule and governed by other limits on transfers or sales that your company can impose. The vesting schedule can be based on several factors, such as length of employment or performance goals. When RSUs are issued, there is no value to the employee, therefore it is not a taxable event. When the shares are vested and delivered to you, they are taxable income. The shares are considered compensation subject to federal and employment tax (Social Security and Medicare) and any state and local tax. A company may offer different options to pay taxes at vesting, or it may use a mandatory method. The most common method is withholding the amount of taxes from the newly delivered shares by surrendering stock back to the company. When you later sell the shares, you will pay capital gains tax on any appreciation over the market price of the shares on the vesting date.
STOCK APPRECIATION RIGHTS
Stock Appreciation Rights (SARs), another form of equity compensation, is an award that provides the holder with the ability to profit from the appreciation in the value of a set number of shares of company stock over a set period of time. They offer the right to the cash equivalent of a stock’s price gains over this predetermined period. This compensation is most commonly paid in cash, however, the company may pay the employee in shares as well. Like the other forms of equity compensation covered, SARs are granted at a set price and generally come with a vesting period and expiration date. Once a SAR vests, the employee can choose to exercise it at any point before the expiration date, collecting the gain of the stock price over that time in either cash or shares. Once exercised, you recognize ordinary income in the amount of cash or shares received at vesting.
PERFORMANCE UNIT OR SHARE PLANS
Performance Unit Plans (PUPs) are a form of equity compensation common to small businesses. The company can select a goal that makes sense for an employee or executive, such as increased sales revenue. These goals are attached to specific numbers, in this example a percentage increase in sales revenue, over a specified period of time. When the PUP document is drawn up, the employee is given a number of performance units, with no value at first. The document will state that if the employee achieves his or her PUP goal over a defined period, each unit will increase in value until it can be redeemed for its new value. The plan document will specify how much the value of the performance units would grow upon achievement of the specified goals. At the end of the defined period, if the employee meets their goal, they collect a cash payment.
PHANTOM STOCK PLANS
Phantom Stock Plans are a form of equity compensation that gives selected employees many of the benefits of owning company stock without actually issuing any stock. Shares of mock stock are issued to the employees that track the price movements of the company’s actual stock, paying out any resulting profits. The plan document will specify the number of phantom shares issued, their starting value, and if there is any dividend availability. The document can also state a vesting schedule, requiring an employee to stay with the company for a specified amount of time before collecting any benefits, or if there are goals that the employees must accomplish in order to vest. Payment events will also be stated in the plan document, at which point the cash value of the phantom stock is distributed to the participating employees.
Whether you are an employee or a business owner, understanding the different forms of equity compensation plans and their value can be an important piece in financial planning. Have more questions about equity compensation? Reach out to us and we’ll walk you through it.
Presented by Elizabeth Schleifer