Equity compensation- what you need to know

There’s a reason your employer offers you equity comprensation: it’s an incentive for you to stay with the company and a reward for your hard work and loyalty. Additionally, if your employer can align your financial well-being with that of the company, it’s a win-win for everyone. 

Unfortunately, receiving equity isn’t as simple as getting a paycheck. There are many forms of equity compensation and each one has different rules and benefits. Each type might play a different role in your overall financial picture.

Because the different types of equity compensation can be complicated, this article will give an overview of each kind and how they work.

But first, let’s back up a step, and talk about the larger picture of equity compensation. What is it, and how can it benefit you and your employer?

What is equity compensation?

Equity compensation is a form of non-cash compensation that companies offer to all types of employees. But you might be wondering, “What does it mean to have equity in a company?” or “What is equity in a company?”

Compensation in this form allows employees to share in the profits of the company via appreciation in the stock price. This encourages retention, as there are generally vesting periods associated with the equity compensation.

While equity compensation was once primarily offered to executives and upper-level management, it has now become more common for many types of employees to receive a portion of their remuneration, particularly bonuses, in the form of company stock or stock options.

Equity compensation programs can be an excellent tool for employers attempting to keep certain key employees and attract top talent. Stock based compensation plans can also help companies offset below-market salaries.

Providing employees with equity compensation can be especially beneficial for smaller companies and startups. By offering equity in place of high salaries, businesses can manage their cash flow more effectively. Additionally, companies that offer equity-based compensation may be eligible for a tax credit, which can help minimize their federal tax liability.

The different types of equity compensation include employee stock options (ESOs), Restricted Stock Units (RSUs) and Employee Stock Purchase Plans (ESPPs). We’ll dig into the details of each type below.

Maximize the benefits of your equity compensation with our free tax strategies guide.

Employee Stock Options

ESOs are a type of equity compensation plan in which an employee is given the right to purchase shares of the company’s stock at a set price for a specific period of time. If the price of the company’s stock rises above the ESO price, the employee can make a profit by buying stock at the discounted price and then selling it in the open market.

Types of ESOs

A company can grant two types of ESOs: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). 

Incentive Stock Options are the more complicated type of option, generally only offered to key employees and senior management. ISOs can sometimes offer tax advantages over other types of stock options, but with some restrictions. If an employee exercises an ISO and then doesn’t sell the stock until one year after exercising the option and two years after the grant date, the profit will qualify for capital gains tax treatment. Additionally, the exercise of an ISO can potentially cause certain high-income earners to incur liability for alternative minimum tax, so you will need to consult your tax professional to determine if this applies in your case.

Non-Qualified Stock Options are the most common type of option offered by employers, but they do not offer the same tax advantages as ISOs. Upon exercising NSOs, the employee pays ordinary income tax on the difference between the exercise price and the current market price (the bargain element). 

The exercise price is the predetermined price at which an employee can buy the stock, while the current market price is the stock’s actual value at the time of exercise.

Since ordinary income is taxed at a higher rate than long-term capital gains, this can make NSOs less attractive for individuals with higher income levels, but the simplicity of NSOs allows employers to offer this type of option more broadly. In addition to income taxes, Social Security and Medicare, taxes will also be withheld when NSOs are exercised. 

Restricted Stock Units (RSUs)

RSUs are granted to employees but are subject to a vesting schedule, meaning you can’t benefit from them until a set time that is determined by your company and the conditions they place on the stock. It is usually time-based, requiring you to remain with the company until becoming fully vested.

Like any form of equity compensation, RSUs have unique tax treatment. Since RSUs are shares granted to an employee as a form of compensation, the shares are taxed at the time of vesting, with the current market price of the shares taxed as ordinary income. Typically, when RSUs vest, some shares are immediately sold for tax withholding (i.e., federal, state income tax, Medicare and Social Security), and the remaining shares are moved to a brokerage account.

For example, if $100,000 worth of RSUs vest, the company might sell $30,000 worth of shares for tax withholding, and the remaining $70,000 worth of shares would move to your brokerage account. The full $100,000 is taxable and will appear on your W-2.

If you immediately sell the remaining $70,000 in shares, there will be no additional tax liability. However, if you hold the shares and they increase in value — for instance, to $80,000 after three months — and then sell them all, you’ll have additional taxable income of $10,000.

In terms of capital gains tax, if you hold your RSUs for more than a year after they vest, your gain on the stock will be taxed as a long-term capital gain instead of a short-term capital gain, which is taxed at the same rate as ordinary income.

Maximize the benefits of your equity compensation with our free tax strategies guide.

Employee Stock Purchase Plans (ESPPs)

In an ESPP, your employer allows you to purchase company stock, usually at a discounted price. Your employer will make it easy for you by automatically and regularly withdrawing money from your paycheck to finance your purchases of company stock.

There are four phases to the ESPP. In the “grant phase,” the company gives the option to purchase. During the “offering period,” you accumulate after-tax payroll deductions; then during the “transfer period,” those deductions are used to effectively purchase company stock at a discount. Finally, in the “disposition phase,” you sell your shares and face tax implications. During a given year, the maximum amount of capital an employee can invest in their company stock through their ESPP is capped at $25,000.

ESPPs can get even more complicated because the income from the stock can be considered compensation income (the amount the stock was discounted) and capital gains income (the increase or decrease of the value of the shares). Like the other forms of equity compensation, holding on to the stock for at least two years from the offering phase and one year from the purchase date will help minimize tax liability.

Key considerations for equity compensation recipients

If you are offered equity compensation, it’s crucial to consider the following three factors:

• Cash flow needs: Assess your current cash flow requirements and determine how much you’ll need to fund near-term and long-term financial goals or obligations. This is especially important if you will be receiving equity compensation coupled with a lower cash compensation than you’re accustomed to.

• Tax implications: Understand the tax implications of your equity compensation. Know how it is taxed (if at all) when granted, when it vests and later — when you choose to sell. Be aware of any holding periods that may impact the taxes you’ll pay. Additionally, make sure that you’re withholding enough to cover these taxes to avoid surprises during tax season.

• Stock performance expectations: Evaluate how the company’s stock may perform and set realistic expectations for potential upside or downside. Consider how these movements may affect your ability to meet your short-term needs or savings goals, and plan accordingly.

How does equity compensation fit into my financial plan? 

Equity compensation can be a valuable addition to your overall financial plan, but navigating the complexities and tax implications can be challenging. 

To help you make the most of your equity compensation, we’ve created a comprehensive e-book, Equity Compensation Tax Strategies: A Quick Start Guide. Download your free copy today to learn expert strategies for optimizing your tax situation and getting what you need from your equity compensation benefits.

If you need personalized guidance on incorporating equity compensation into your financial plan, KFA Private Wealth Group can help. Our equity compensation approach focuses on developing tailored strategies that maximize benefits while minimizing tax liabilities. Schedule a call with one of our experienced advisors to discuss your unique situation and learn how our expertise can help you build long-term wealth.