Types of Equity Compensation and Tax Considerations | By Reagan A. Hamilton, ChFC®
Employee stock awards come in various forms, each with its unique features and benefits. Whether through stock options, restricted stock units, employee stock purchase plans, performance stock awards, or phantom stock, companies have a range of tools at their disposal to motivate and reward their workforce. Understanding the different types of employee stock awards empowers both employers and employees to make informed decisions that align with their long-term goals and aspirations. As companies strive to attract and retain top talent, employee stock awards have become a popular tool to incentivize and potentially reward employees. These awards not only align the interests of employees with the success of the company, but also provide a valuable incentive for long-term commitment. In this article, we will explore the different types of equity compensation, and briefly explain some of their tax considerations.
Phantom Stock:
Phantom stock awards are a cash-based alternative to traditional stock awards. Employees receive notional units that track the value of company stock. When the units vest, employees are paid a cash equivalent to the stock's value. Phantom stock allows employees to benefit from the company's performance without actual ownership of shares. In some cases, the compensation is calculated based on the positive difference of a stock’s value over a given timeframe. This type of phantom stock is usually referred to as a stock appreciation right. A company might offer this type of equity compensation to provide the employee an opportunity to participate in company stock appreciation, without any of the costs related o traditional investing.
For phantom stock, taxation occurs when the units vest, and the employee receives a cash payment equivalent to the stock's value. This cash payment is considered ordinary income and is subject to income tax.
Stock Options:
Stock options are perhaps the most well-known form of employee stock awards. They grant employees the right to purchase company stock at a predetermined price, known as the exercise or strike price. The hope is that the market value of the stock will exceed this price, allowing employees to buy shares at a discount. Stock options often come with a vesting period, encouraging employees to stay with the company for a certain duration before exercising their options. There are two main types of stock options:
In the realm of employee stock options, two common types stand out: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs). Both serve as powerful tools for companies to attract and retain talent, but they differ in their tax treatment and eligibility criteria. Let's delve into the distinctions between Incentive Stock Options and Non-Qualified Stock Options.
Incentive Stock Options (ISOs):
ISOs are typically reserved for key employees, including executives and other high-ranking personnel. Employees must adhere to specific criteria outlined in the company's stock option plan and meet IRS eligibility requirements.
ISOs can offer a more favorable tax treatment. Employees do not incur regular income tax upon exercise or the sale of shares. Instead, potential tax liability arises when the employee sells the shares, and the gain is subject to capital gains tax.
To benefit from long term capital gains rates, employees must hold the shares for at least two years from the grant date and one year from the exercise date.
It is also important to note that owning incentive stock options at the end of the year can contribute to triggering alternative minimum tax on your tax return. Alternative minimum tax, or AMT, is an alternative way of calculating your tax rate than the standard method and can have significant tax ramifications.
Non-Qualified Stock Options (NSOs):
NSOs are generally more broadly available and can be offered to all employees, directors, and consultants.
NSOs are subject to ordinary income tax on the difference between the exercise price and the fair market value of the stock at the time of exercise. Employers are also required to withhold applicable payroll taxes at the time of exercise.
IRS form 83(b) is relevant when an individual chooses to exercise their stock options before the options have fully vested. This means they are willing to pay for and own the stock, even if they could potentially forfeit it later if they don't meet certain conditions (such as continued employment). By filing Form 83(b), the individual is essentially opting for early taxation on the difference between the fair market value of the stock at the time of exercise and the exercise price. This can have potential tax advantages if the stock appreciates in value over time. The decision to file Form 83(b) involves some level of risk. If the individual ends up forfeiting the stock due to not meeting vesting requirements, they will not be entitled to a refund for the taxes paid on the stock's value at the time of exercise.
If the stock is held after the option is exercised, any appreciation in value is considered short term or long term capital gain (or loss), based on the typical one year holding requirement for long term rates.
Restricted Stock Units (RSUs):
RSUs are another common type of employee stock award. Unlike stock options, RSUs grant employees the actual shares of stock, but they typically come with a vesting schedule. Once the vesting period is complete, employees receive the shares outright. RSUs provide employees with a sense of ownership and are often used as a retention tool, as they require employees to stay with the company to receive full benefit.
RSUs, on the other hand, are taxed differently. The taxable event occurs when the RSUs vest, and the shares are delivered to the employee. The value of the vested RSUs are treated as ordinary income and is subject to income tax and, in some cases, payroll taxes. Once the RSUs are converted to actual shares, any future gain or loss is considered a capital gain or loss upon sale. Whether the gain (or loss) is considered long term or short term, depends on if the shares were sold at least one year after the vesting date.
Despite there being mandatory federal tax withholding on RSU vesting, it could potentially be less than the actual amount of taxes owed on the tax return.
Employee Stock Purchase Plans (ESPPs):
ESPPs allow employees to purchase company stock at a discounted price, often through payroll deductions. These plans are typically offered to all employees, providing an inclusive way for staff members to become shareholders. ESPPs can be advantageous for both employees and employers, fostering a sense of ownership and shared success.
ESPPs provide employees with the opportunity to purchase company stock at a discounted price. The discount offered is considered ordinary income and is subject to taxation. If the employee sells the shares any additional gain or loss will be treated as a capital gain or loss. To achieve long term capital gain (or loss) tax treatment, the employee is required to hold the stock for at least two years after the offering date and one year after the purchase date.
Performance Stock Awards:
Performance stock awards tie the distribution of shares to specific performance criteria, such as achieving certain financial targets or meeting key business milestones. These awards are designed to reward employees for contributing to the company's success and align their interests with the overall goals of the organization.
Taxation for performance stock awards varies based on the specific conditions set for the award. In most cases, the value of the shares received upon meeting performance criteria is considered ordinary income and subject to taxation. The taxable event is usually when some pre-defined performance metric is accomplished, and shares are delivered to the employee. It may also require a meeting of the board of directors or upper management in order to certify the grant of shares to the employee. Subsequent gains or losses upon selling the shares are treated as capital gains or losses.
Similar to an inherent risk with RSUs, despite the mandatory federal tax withholding, there is potential that the actual tax impact of the grant could be much higher than the mandatory withholding amount.
Navigating the taxation of employee stock awards requires a clear understanding of the specific type of award and the timing of taxable events. Employees and employers alike should be aware of the potential tax implications associated with stock options, RSUs, ESPPs, performance stock awards, and phantom stock. Seeking advice from tax and investment professionals can be instrumental in making informed decisions that maximize the benefits of employee stock awards while minimizing tax liabilities and portfolio overconcentration risk. As the landscape of taxation and investment continues to evolve, staying informed and proactive is key to ensuring a smooth financial journey for both employees and employers.
All investments involve the risk of potential investment losses and no strategy can assure a profit. The opinions and forecasts expressed are those of the author, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. Past performance does not guarantee future results.