Looking to Benchmark Pay?
Types of Equity Compensation
There are two common types of equity compensation plans:
-
Options Awards
- Incentive Stock Options (ISOs), which are qualified plans
- Non-Qualified Stock Options (NSOs), which are non-qualified plans
-
Stock Awards
- Restricted Stock Plans
- Performance Share Plans
Option Awards
Option Awards usually involve granting an employee the right to purchase a specified number of shares of company stock at a set price subject to a vesting schedule and term limit of the option. If the company does well in the future, the stock options may gain significant value over the life of the award.
How stock options work:
Judy, COO of ABC Corporation, is offered 5,000 options to purchase company stock at a price of $5 a share (the closing stock price on the date of grant). She may purchase that stock according to the vesting schedule specified by the plan.
Upon 100% vesting, the stock price is $15 per share. Judy exercises the options, buying the shares for $25,000 and then selling them for $75,000. She makes a profit of $50,000 (less taxes).
(This example is shown to illustrate the economic dynamics of an option. Where real shares are used, there are different tax scenarios.)
ISOs. The Incentive Stock Option is a tax-favored plan in the U.S. that does not result in taxable income to employees at the date of grant or time of exercise if certain conditions are met. One limitation is a $100,000 cap on the annual value of ISOs that vest. Any options that exceed this cap do not have tax-favored treatment. ISOs are found in large, publicly traded organizations as their value is readily ascertainable applying an option pricing model. In privately held organizations, the value of closely held shares is not readily ascertainable because the stock is not traded and hence their use is less prevalent. ISOs may only be used for employees.
How ISOs work:
The exercise of an ISO does not require income to be reported on a tax return, but it may give rise to the alternative minimum tax (AMT). The AMT is equal to the amount by which the fair market value of the stock exceeds the amount paid for it. All the taxes paid can be on the capital gain when the stock is sold as long as the holding period is satisfied (e.g., sold more than two years after the date the option was granted and more than one year after the ISO was exercised).
John Smith on June 30, 2022, received ISOs with a right to purchase 100 shares of employer stock for $10 a share. On July 2, 2023, when the market price is $16, he exercised the ISOs at the stated $10 exercise price. He then sold on Aug. 2, 2024, for $25 a share. The sale date was more than two years after the June 30, 2022 grant date and more than 12 months after the July 2, 2023, exercise date. Therefore, the entire $1,500 profit was taxed at the long-term capital gains tax rate.
NSOs. The Non-Qualified Stock Option is a popular form of stock option for those organizations with a readily ascertainable stock price. They are also popular due to the flexibility they allow companies in plan design and can be granted to anyone, whether they are an employee or not. This can include outside consultants and non-employee directors, etc. However, they do not satisfy the IRS requirements for preferential tax treatment.
The person receiving the options does not pay any income tax on them when they are granted. However, when the option is exercised, the employee will pay ordinary income tax on the difference between the fair market value of the stock and the exercise price. When the stock obtained from the exercise is sold, a capital gain or loss will be incurred on the difference between what the stock is sold for and the fair market value at the time of the exercise of the option. The type of capital gain (long term or short term) would depend on the length of time the shares were held after exercise.
Here's generally how NSOs work:
Ethan is granted 100,000 options to purchase his company's stock at $1 per share (which is the fair market value of the stock on grant date). When the stock rises to $15 per share, he exercises, buying the stock for $100,000.
Taxation: On exercise, he must pay taxes at the ordinary income rate on the difference between the exercise price and the current market value, even if he doesn't sell the stock right away. So even if Ethan doesn't sell his stock immediately for $1.5 million, he owes ordinary income tax on the $1,400,000 gain. (Note, tax rules change and both federal and state income taxation exist so any exercising plan participant should seek advice from a tax accountant or lawyer.)