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SUMMARY
Equity compensation has become widely used to attract, motivate, and retain employees as well as align interests through stock price appreciation.
Stock Options
Although they have declined in popularity, stock options are still used to compensate senior management and are popular with startup companies that do not have a strong cash flow.
There are 2 main types of employee stock option programs:
Incentive stock options (ISOs) are only offered to employees. They receive favorable tax treatment. If the stock is held for one year after exercise and two years after the grant date, any increase in stock value from the exercise date to the time of sale is only subject to long-term capital gains taxes.
Nonqualified stock options (NSOs) may be offered to employees, board members, and consultants. These options are taxable as soon as you exercise your options, even if you don't sell the stock right away.
Vesting
Companies typically grant employee stock options with the right to purchase the stock at a set exercise price (fair market value on the grant date) after a period of time has elapsed, and service to the company has been performed. Known as vesting, this practice helps to achieve employee retention (at least during that period). Accelerated vesting can and does occur, especially if an employee dies or becomes disabled.
Early exercise is a practice that lets you pay for the options right away. However, this stock becomes restricted, meaning the company reserves the right to buy it back if you leave the company before the grant has actually vested.
Employees who leave the company or are fired for cause may lose their stock options entirely.
Exercising
Employees should get financial advice to determine when to exercise and when to sell their shares. Plans usually allow 10, 7, or 5 years to purchase stock. However, it may be advisable to exercise options sooner rather than later to diversify investments or if the current stock price has peaked.
Taxes
Selling stock options raises total income. This may even bump a portion of the income from the sale of stock into a higher income tax bracket. To avoid this, it may be a good idea to spread out exercising and selling stock options over several years. This will keep total income within a lower tax bracket. NSOs and ISOs differ in their tax requirements, so it is important to understand how these equity programs work.
The table below summarizes the tax treatment for both qualified and non-qualified plans:
| ISO | NSO | |
|---|---|---|
| Employee exercises options |
No Tax Subject to Alternative Minimum Tax |
Ordinary income tax (10-37%) |
| Employee sells options before 1 year (from exercise) | ISO is disqualified, taxed as NSO | Short-term capital gains tax (same as ordinary income tax rate) |
| Employee sells options after 1 year or more (from exercise) | Long-term capital gains tax (0-20%) | Long-term capital gains tax |
Ordinary income and short-term capital gains taxes have the same range of tax rates, which are higher than the long-term capital gains tax rates. Most participants in equity compensation plans would be looking for a plan that would minimize the higher rates in favor of the long-term capital gains rate.
Restricted Stock
This class of equity compensation is a grant of stock to participating employees, usually senior management, with vesting requirements that encourage tenure or performance. As stock options have declined in popularity, restricted stock awards have become more widespread, especially in established companies. They have less risk than stock options, almost always having some value. Taxes may be paid at the time of the grant and then on any capital gains when the stock is sold, or on the full value of the grant when vesting requirements are met.
Restricted Stock Units
A popular form of equity compensation that may be granted to all levels of employees, RSUs have vesting restrictions based on time in service or performance. When the shares are vested, they are then owned by the employee and subject to ordinary income tax. Like restricted stock, they almost always have some value.
Stock Appreciation Rights
SARs are rights to any increase in value that a company’s shares gain over a predetermined time period. They are most often granted to company leadership as a performance incentive. Payout is usually in cash. Since there is no purchase of stock, SARs are taxed at exercise, the tax being on the gain of the assigned number of shares from the date of the grant to the date of exercise.
Phantom Stock
These are grants of units having a value that mirrors the market price of an organization’s stock. A plan participant may hold the units for a defined period of time and then receives a payout equivalent to the value of the stock price increase over that time, or they may be given a “full value” payout which is the amount the stock is worth at the time of the grant plus any appreciation. The payout is taxed as ordinary income.
Employee Stock Purchase Plans
With certain exceptions, an ESPP must be made available to all employees if such a plan is offered. These plans may be tax-qualified if they meet Section 423 requirements and have the specified holding period. If these requirements are not met, for tax purposes, a plan will be treated as non-qualified. For qualified plans, the discount is not taxed at the time of purchase, only when the stock is sold, but for non-qualified plans the discount is taxed when the stock is purchased.