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Have you been offered equity compensation as part of your benefits package? Understanding the types of equity compensation and your specific benefits can help you maximize your compensation potential. Also called share-based or stock-based compensation, equity compensation’s purpose is to align employee interests with the company’s shareholders. In a perfect world, it motivates employees beyond standard cash-based compensation, like salaries and bonuses. 

But whether or not you should opt in depends on your personal financial situation. And it all starts with getting to know the benefits and drawbacks of equity compensation. Here, we’ll provide a comprehensive overview of equity comp, including taxation, common issues and associated risks you may run into, and the various forms of equity compensation that can be applied.

Contents

The Common Types of Equity Compensation

Equity compensation plans come in many forms, and each has its own set of contractual guidelines for employees to follow.

Employee Stock Purchase Plans (ESPPs)

Employers often provide perks like employee stock purchase plans to retain and attract top talent. With ESPPs, employees get the chance to buy company stock through payroll deductions made after taxes have been withdrawn.

It is possible for the plan to stipulate that employees will pay less than the stock's fair market value per share. If the ESPP meets the Internal Revenue Code section 423, it can offer discounts of up to 15 percent off the stock's purchase price.

Stock Options

Employees with stock options have the right to purchase a specified number of shares in a company at a specified price and date. Stock options are not stock ownership but a contract granting you the right to buy the stock at a specified price and date.

For example, a company may give you stock options stating that you can purchase 1000 shares in the company for 60 cents per share after a specific date. That means that after the specified date, regardless of the current stock price, you can buy 1,000 shares for 60 cents each, for a total of $600. If the shares are worth $2.50 per share when you exercise the options, you still pay only 60 cents per share and make an immediate profit of $1.90 per share, or a total of $1,900.

Restricted Stock

Restricted stock is company stock that is granted to employees with certain restrictions until the vesting date. There are a couple of key differences between certain restricted stock offerings companies will offer as part of their equity compensation packages. 

Restricted Stock Units (RSUs)

Stocks granted to an employee with limited ownership rights are known as restricted stock units. In most cases involving RSUs, an employee is not entitled to full ownership of the stock until they have worked for the company for a certain number of years or achieved a certain level of performance. After receiving their shares in full, the employee can enjoy all the voting rights and dividends those shares offer.

Restricted Stock Awards (RSAs)

Despite similar titles, restricted stock awards and restricted stock units carry different stipulations. The key difference between them is that, unlike RSUs, RSAs are granted up front, potentially giving employees voting rights and dividends without having to wait for shares to vest. They also allow employees to take advantage of the 83(b) election.

Stock Appreciation Rights

Employees who receive Stock Appreciation Rights (SARs) can participate in the upside potential of a stock, similar to a stock option. When you exercise a SAR, you receive the increase in the value of the company’s stock shares above the predetermined price of the award.

Understanding Taxes on Equity Compensation

Tax considerations vary depending on the type of equity compensation you hold.

Taxing Stock Options

  •  Incentive Stock Options (ISOs): Incentive stock options (ISOs) give you the right to buy company shares. ISOs generally receive favorable tax treatment upon selling their shares if certain holding period requirements are met. For shares that are sold at least two years from the grant date and one year after exercise, any gain above the exercise price will be taxed at the lower long term capital gains rate rather than at ordinary income tax rates. It is important to note that when you exercise an ISO, the difference between the price you pay for the shares and their fair market value is considered an add-back item for Alternative Minimum Tax.  In certain cases, it may make more sense to not meet the above holding period requirements and instead be subject to ordinary income tax. Thus, it is important to consult with a tax professional or financial advisor.
  • Non-Qualified Stock Options (NSOs): Non-qualified stock options are not eligible for tax benefits like ISOs. The difference between the stock's fair market value  at exercise and the strike price will be subject to ordinary income tax. When the shares are sold, the gain will be taxed as short-term or long-term gain depending on how long the shares are held after the options are exercised.

Taxing Restricted Stock Units

Ordinary income tax on the fair market value of the shares is due when the RSUs vest and your employer will likely withhold a certain percentage from your paycheck at the time of vesting and delivery for taxes. The amount withheld may or may not be enough to cover any tax liability due before filing your return. When the shares are sold, the gain will be taxed as short-term or long-term gain depending on how long the shares are held after the RSUs have vested.

What Is an 83(b) Election and Why Is It Important?

Understanding 83(b) Election

Employees who receive Restricted Stock Awards or RSAs as compensation do not have to immediately pay taxes on the shares upon receipt because of the "substantial risk of forfeiture" the IRS assigns to such awards. That is to say, there is a possibility that the shares won't become yours until you meet some stipulation, like a minimum number of years of service or a certain level of performance. As a result, when the employee's shares vest, they must report and pay income taxes on the shares' total fair market value.

If an 83(b) election is available for RSAs, then employees have 30 days from the initial grant date to make the election and pay income tax when the shares are granted.

Consider the following scenario: an employee receives 1,000 shares of a stock priced at 50 cents per share for a total current fair market value of $500. Assume the shares fully vest in 4 years when the stock is trading at $5 per share.

She will pay income tax on $500 if she files an 83(b) election. No ordinary income taxes will be due if the shares are worth $5,000 at the time of vesting. When the shares are sold, any gain above the initial basis of $500 will be taxed at the more favorable long term capital gains rate.

If she does not file an 83(b) election, she will have to pay ordinary income tax on $5,000 when they vest.

Benefits and Risks of 83(b) Election

Filing an 83(b) election can have several advantages, including the potential reduction of ordinary income taxes and the acceleration of the start of the capital gains tax holding period. Holding the shares for at least one year allows you to take advantage of the lower long-term capital gains tax rate. By selecting the 83(b) method, the period for calculating capital gains begins on the grant date rather than the year in which the shares vest. If you file an 83(b) election, you may be able to sell your stock upon vesting and be eligible for long-term capital gains tax treatment without having to wait the entire year after the vesting date.

Filing an 83(b) election carries the risk of already paying tax on something that doesn't come to fruition because the stock price drops or the shares don't vest. That means the 83(b) election could result in a complete loss if you voluntarily leave the company before they vest (and you would not be eligible for a tax refund).

No one can predict with absolute certainty whether a share price will rise or fall. Which begs the question: how do you settle on whether or not to file an 83(b) election?

Considerations like your own risk tolerance should play a role in this choice. Consider questions like:

  • What is your level of familiarity with the company?
  • Do you have enough cash on hand to cover the tax payment?
  • How does the stock fit into your overall financial goals?

Lastly, consider your tax situation, investment goals, and current tax rates.

Events That Affect Equity Compensation

Like any other asset, equity compensation can be impacted by life or business events. However, unlike other forms of payment, the rules surrounding equity compensation aren't always black and white.

It is important to understand your company’s stock options and grant agreement as these documents dictate specifically what will happen in each of the following circumstances. Here are some situations that can impact your equity compensation and the steps you can take in response.



Death

Depending on the company's plan specifics, they may modify the current vesting rules in case of a participant's death. In most cases, the employee's estate or beneficiaries will be responsible for paying taxes on restricted stock compensation that vests upon the employee's death.

Stock options are generally exercisable by the estate or beneficiaries for a certain period of time following the option holder's death, assuming the options do not expire before then. After the death of an employee, the estate or heirs are responsible for paying taxes on any profit made from the stock option's exercise.

Divorce

Property settlements in a divorce often address the treatment of stock options or equity awards. The non-employee ex-spouse is generally subject to income taxation upon the exercise of any vested stock options transferred to them. The employee, however, must shoulder the burden of paying employment taxes.

However, the tax consequences of incentive stock options are very different from those of non-qualified stock options. If ISOs are transferred to the non-employee ex-spouse before they are exercised, they become non-qualified options. However, the employee can exercise the ISO and then transfer the stock to the ex-spouse after holding periods are met in order to receive favorable long term capital gains tax treatment.

Company Merger or Acquisition

A change in management may impact your company's equity plan. Here are two potential ways your equity compensation could be impacted.

  • Accelerated vesting: Accelerated vesting allows you to receive stock-based compensation ahead of the typical vesting schedule, sometimes up to 100 percent of your award. Tax payments that usually would have been paid over several years as shares vested could end up needing to be made all at once. Stock options with accelerated vesting typically have a short exercise window, sometimes as little as 30 days.
  • Adjustments to your stock option: A merger or acquisition agreement may provide that the granted shares will automatically convert into shares of another company. If your company is the one being acquired, the acquiring company may convert any outstanding equity shares into unvested equity shares.

Leave of Absence

Different plans have different approaches to handling company leaves. Again, it is important to understand the company’s stock options and grant agreement as these documents dictate specifically what will happen, but here are some common scenarios:

  • Depending on the circumstances, a leave of absence could amount to a termination of employment, and you usually have 90 days from your termination date to exercise any options. Authorized unpaid leaves (sabbaticals, parental leaves) may count toward vesting under some plans but not others.
  • Paid or statutory (legally required) leaves may continue vesting under some plans, but disability leaves may not. Typically, you have up to 12 months to exercise any options if you leave due to disability. 
  • While on leave, you might not be able to cash in on your stock options or have your restricted stock units vest and payout to you. If you have RSUs and your employer allows them to continue vesting during your leave but does not release the shares until you return to work full time, this can be a source of frustration.
  • Special rules may apply to restricted stock not yet vested if the employee is on disability leave. While on leave, stock options may continue to vest, or the company may adjust the vesting schedule.

Risks Involved in Equity Compensation Planning

Blackout Periods

Certain individuals, such as executives or high level employees, may be barred from buying or selling shares of stock in their company during a blackout period. Black out periods are intended to prevent insider trading based on information not generally available to the public.

Understand when your company’s blackout period is. Make sure you exercise any options before they expire when you are no longer in a blackout period. Otherwise, you could unintentionally forfeit any unexercised options.

Insider Trading and 10b5-1 Plans

Rule 10b5-1 allows insiders to make planned trades in compliance with insider trading regulations. When executives are granted permission to trade securities, the best practice is to allow them to adopt a 10b5-1 plan. If an insider has access to material non-public information (MNPI), they are barred from making plan modifications or implementations under Rule 10b5-1.

Under Rule 10b5-1, directors and other insiders in the company (including large shareholders, officers, and others with MNPI) may establish a written plan detailing the times and dates on which they may buy or sell shares on a predetermined and scheduled basis regardless of blackout periods. 

Concentrated Stock Position

When an employee has a high percentage of their wealth invested in a single company, they are said to have a concentrated stock position. It can occur when long-term employees and executives have a disproportionately high amount of their investable assets "locked up" in a single stock.

The risks of having a sizable portion of your wealth invested in a single company are evident during times of increased market volatility. For instance, acquiring shares of a company through the vesting of restricted stock units, the exercise of stock options, or the acquisition of founders' stock in a rapidly expanding startup quickly can lead to a concentrated stock position. While it can generate enormous wealth if the price of that stock increases, it can also backfire if the shares drop significantly.

If you have a concentrated stock position, it is encouraged that you speak to a financial advisor and put together a plan to unwind your position while taking taxes into consideration.

How to Exercise Equity Compensation Options

You may have a few different ways to exercise your option depending on what your company’s option or plan agreement offers. 

Cash Exercise

In a cash exercise, you will exercise your options at the strike price (also known as the exercise price) and pay for them with your own money. When exercising your options, the total amount owed consists of the cost of the options being exercised, including any taxes owed at the time of the exercise.

Cashless Exercise

This transaction allows you to buy shares of your company and use some of the shares to cover the cost of exercise.

You will receive the difference between the stock's fair market value and the exercise price, less any taxes and brokerage fees.

The challenge with a cash exercise is having the funds needed to exercise the option and pay the tax. This is why most opt for a cashless exercise.

Regardless of whether you choose a cash or cashless exercise, it is important to work with a financial advisor and understand what your potential cash needs are and plan ahead. If you receive net shares after you exercise, you will need to determine how best to diversify your single stock position.

Equity Compensation Stories from WSA Clients

Example 1: John

A Wealthstream Advisors client, whom we will call John, has been working for a special-purpose acquisition company. Before joining the company, he spent close to a decade as a senior executive in another company, where he was first introduced to WSA. A financial correspondent recommended the firm.

The Process

When John first joined his current company, he was offered equity compensation as part of the initial offer. His Wealthstream advisor was present throughout the financial planning process. They tracked his equity, guided him on the pros and cons of an 83(b) election and assisted him in deciding whether to sell or keep it. He appreciated that the WSA team was hands-on and always available to accompany him. They kept the lines of communication open and continued to make suggestions to him.

Lessons Learned

The most valuable advice John received from WSA was how to view his entire portfolio holistically and identify when the equity in one company is too significant in the context of the whole portfolio. That helped him in properly reducing risk and diversifying his portfolio.

John advises his colleagues making equity compensation decisions to consider the vesting period carefully. He believes people should consider where they work and career advancements before making decisions that could impact their taxes or long term financial planning goals.

Example 2: Jane

Our second client, whom we will call Jane, is a senior medical professional at a pharmaceutical company. She needed assistance and professional guidance, so she contacted WSA for information on equity compensation.

The Process

She regularly sought the opinions of her trusted advisors before making any major choices. Her advisors tracked the stock price and proactively reached out when her options became “in-the-money” and helped her cash out when she considered leaving the company. Because this was a foundational part of a larger financial picture, Jane appreciated that the WSA team helped her navigate all the intricacies of a rather complex topic.

Lessons Learned

One piece of advice that stuck with Jane was to "not wait too long when the opportunity presents itself". This advice and countless others from her advisors helped her make the most out of her equity compensation.

Equity compensation is a complex topic that requires proper management for optimal outcomes. However, there is no one-size-fits-all approach when handling this form of equity. You must seek the advice of seasoned professionals to ensure you’re getting the best deal. Contact Wealthstream Advisors for a consultation about your equity compensation package. 

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