What You Should Know About Equity Compensation
Few other employee benefits stir up more excitement—and anxiety—than an equity compensation grant.
We’ll walk you through the land of RSUs, NQSOs, ISOs, ESPPs, and all those other acronyms you may not be familiar with—yet.
Once you’ve conquered the basics, you’ll find it easier to make sense of what you’ve got and what to do with it.
Equity compensation can be way more than just a longshot “prize” to win or lose.
By thinking of your equity as one among many potential resources for funding your satisfying life (however you define that term) you can make appropriate decisions—for you, your values, and your life.
Part I: What Type of Equity Do You Have?
In this section, we’ll cover the different kinds of equity compensation, as well as things to think about for each type, each step of the way.
Restricted Stock Units
Employee Stock Purchase Plans (ESPPs)
Non-Qualified Stock Options (NQSOs)
Incentive Stock Options (ISOs)
Restricted Stock Units (RSUs)
Here’s the general lifecycle of RSUs:
1
You are awarded an RSU grant.
2
Time passes, and/ or other requirements are met.
3
Your RSUs vest, shares (often) are delivered, and the value is taxed as ordinary income.
4
You can hold or sell your shares as you please.
SUBSTANTIAL RISK OF FORFEITURE
RSUs are generally taxable when they are no longer subject to a risk of forfeiture. This often occurs when RSUs vest, however vesting and the lapse of a risk of forfeiture can occur separately, such as at retirement or with double-trigger RSUs.
Step 1: Receive an RSU grant.
An RSU grant generally starts out as a non-event. You’ll take note of the date you receive the grant and the vest schedule. Other than that, until you reach your vesting date(s), nothing much happens. Think of your pre-vested RSUs as a pledge from your employer: “As long as you remain with our company, you will earn the right to Y shares, after X time has passed.”
Step 2: Your RSUs vest and taxes are (usually) due.
Things start to happen once your RSUs vest and are no longer subject to a substantial risk of forfeiture. This often occurs after a specified time and across a set schedule (such as monthly, quarterly, or yearly). With a few exceptions , the value of your vested units is taxed when they vest. The income is treated much like your salary, with federal, state, local, and payroll income tax due upon vesting at ordinary income tax rates. That’s why you may want to think of your RSUs as being like extra pay.
About Those Taxes
Just as with your salary, your employer will usually withhold some of your vested RSUs to cover the statutory amount of federal tax due, plus other applicable taxes. You’ll still want to calculate whether this automatic withholding is enough for your individual tax brackets.
Step 3: You decide whether to hold or sell your vested RSU shares.
Once your after-tax shares are deposited into your investment account, you own these shares outright. You can now keep them, or sell some or all of them on the open market. But what is best? One idea suggests you should sell your vested RSUs immediately because the primary tax impact has occurred. It’s as if you used your paycheck to buy shares of company stock. If you sell immediately, there shouldn’t be additional tax due. If you wait and sell your shares later for higher or lower than the vesting price, the gain or loss will be subject to short-term capital gains tax treatment if held for a year or less, or long-term capital gains if held for more than a year. Selling RSUs immediately upon vesting may also help mitigate concentration (or single stock) risk, and better align your financial resources with your personal goals.
WHAT IS CONCENTRATION RISK?
Holding a significant portion of assets in a single stock exposes you to concentration risk, or the potential for a significant decline in stock value that may take your overall financial well-being along with it. A diversified investment portfolio is often considered an antidote to concentration risk.
Restricted Stock Units: Additional Resources
The Basics of Restricted Stock Units – And What You Should Know
How to Use Restricted Stock Units to Fund Financial Planning Goals
6 Advanced Planning Ideas to Use When Your Restricted Stock Units Vest
View All RSU Articles
Employee Stock Purchase Plans (ESPPs)
ESPPs are a simple way to acquire company stock through convenient payroll deductions. As a sweetener to encourage participation, some ESPPs offer discounts and/or lookback periods to make them more financially beneficial. In fact, purchasing and selling favorably priced ESPP stock immediately upon purchase may lead to attractive short-term returns, even after-tax.
Broadly, here’s how ESPPs work:
1
You fund your ESPP account through after-tax payroll deductions.
2
The money you’ve set aside is used to purchase company stock at set intervals. The price you pay to buy the shares might be at a discount to the current fair market value, or better.
3
Once shares are purchased, you are free to sell or hold them. Only when you sell do you incur a taxable event.
STEP 1: You usually fund an ESPP with payroll deductions.
Most ESPPs let you specify a set, after-tax percentage or amount to defer out of your paycheck, up to $25,000 per year.
STEP 2: Your employer uses your deferrals to buy company stock for you at set intervals.
Purchases occur on prescribed dates, and follow specific plan rules. For example, a plan may have an offer period of two years with six-month purchase dates. This means you are eligible to participate for two years, during which there will be four stock purchase events (after six months, one year, 18 months, and two years).
DISCOUNTS AND LOOKBACK PERIODS
Read the terms of your ESPP. Many plans offer a discount of up to 15% on company stock purchases. Being able to buy something at a 15% discount that you can immediately sell at full market value means locking in a profit of at least 15%. Your plan also may include a “lookback provision,” which lets you purchase stock at the purchase date price or the offer date price, whichever is lower. Again, especially if you sell immediately upon purchase, an attractive lookback price may be an valuable benefit.
STEP 3: You decide whether to hold or sell your purchased shares.
Again, the decision is guided by your best use of the money. If you sell immediately after each ESPP purchase event, you can use the after-tax cash for discretionary spending, or you can reinvest it into a more diversified portfolio. Either reduces the concentration risk inherent in holding too much of your wealth in a single company stock. There is no taxable event until you sell your shares. But when you do sell, the taxes can be complicated. You’ll likely report a combination of ordinary income, and short- or long-term capital gains income, depending in part on whether the sale is qualified or disqualified.
QUALIFIED / DISQUALIFIED SALES
A qualifying sale is one that meets the following criteria: The final sale occurs at least 2 years after the offer date, AND the final sale occurs at least 1 year after the purchase date. Anything that does not meet these criteria is a disqualifying disposition.
As we’ll cover further on, even if you end up paying more taxes to sell sooner than later, this still may be in your overall best interests.
Employee Stock Purchase Plans (ESPPs): Additional Resources
5 Advantages of a Qualified Employee Stock Purchase Plan
4 Factors to Consider Before Participating in Your ESPP
ESPP Tax Rules – And How They’re Affected by a Qualifying Disposition
View All ESPP Articles
Non Qualified Stock Options (NQSOs)
If your employer offers you a non-qualified stock option (NQSO), they are granting you the right, but not the obligation, to buy a set number of company shares at a set “strike” price. Unlike with an ESPP, there is no limit on the offer size. Plus, participating in the program costs you nothing until and unless you decide to exercise your options.
Broadly, here’s how NQSOs work:
1
You’re granted the option to buy up to XX shares, for $YY per share (the strike price), according to a vesting schedule, such as 20% vesting annually for 5 years.
2
You can exercise your options any time after they vest, through their expiration date.
3
When you exercise a vested option, you’ll buy company stock at your strike price. The difference between your strike price and the stock’s fair market value (FMV) at exercise is taxed as ordinary income.
4
At exercise, you will need to cover the cost of the shares and the tax due. You can do this several ways, including writing a check to cover the cost or executing a cashless exercise (net exercise). These allow you to use some or all of your exercised options to cover the costs of the exercise itself.
5
You can sell exercised shares immediately, or hold them for future sale.
6
If you don’t exercise your options, they eventually expire (often 10 years after grant, or subject to rules of job termination).
Let’s go a little deeper:
STEP 1: You exercise vested NQSOs.
Say you’ve been granted 1,000 options with a strike price of $20/share, all vesting at the same time. By the time the options vest, their FMV has increased to $80/share. If you exercise your options, you’ll pay $20 x 1,000 = $20,000 to buy 1,000 shares worth $80 x 1,000 = $80,000 on the open market, generating a $60,000 profit.
BEING “IN THE MONEY”
When your strike price is less than a stock’s current fair market value, you can exercise and sell the stock for more than you’ll pay for it. This is known as being “in the money.” If your strike price is higher than the stock’s FMV, you are unlikely to want to exercise your options, since it will cost you more to purchase shares via the option than if you go buy them on the open market.
STEP 2: You’ll incur taxable income at exercise.
Whether you exercise and hold, or exercise and sell, the difference between the strike price and FMV is taxable income. In our illustration, that’s $80,000 – $20,000 = $60,000 of taxable income when you exercise your options. You can pay for the shares and taxes out of pocket, or use a net exercise to cover the $20,000 purchase price and estimated taxes. As with RSUs, expect a statutory tax withholding. You may owe additional taxes above and beyond this withholding if you are in a higher tax bracket.
STEP 3: You can sell exercised shares immediately, or hold them indefinitely.
Once you exercise your options, you own the resulting shares outright (assuming you did not exercise and immediately sell all shares). If you sell immediately, there are no additional taxes beyond the ones already incurred at exercise. If you hold the shares, any future gain or loss will be taxed at short- or long-term capital gains rates, depending on how long you hold them. Similar to RSUs, you can mitigate concentration risk by selling sooner than later, especially since you’ll incur taxes at exercise either way.
As we’ll cover further on, even if you end up paying more taxes to sell sooner than later, this still may be in your overall best interests.
Non-Qualified Stock Options (NQSOs): Additional Resources
10 Things to Know About Non-Qualified Stock Options
Evaluating 3 Non-Qualified Stock Option Exercise Strategies
The Basics of How Non-Qualified Stock Options are Taxed
View All NQSOs Articles
Incentive Stock Options (ISOs)
At a glance, there are more similarities than differences between incentive stock options (ISOs) and NQSOs. Both options are granted at a set strike price, and are typically subject to a vesting schedule. Once vested, you can exercise them or not, depending in part on when they are “in the money” for you (i.e., worth more than your strike price). Both are typically subject to expiration after a period of time or if you leave the company, with ISOs being a bit more restrictive post-termination.
Without diving too deep, the biggest difference between NQSOs and ISOs is how they’re taxed. ISOs are the most tax-advantaged if you meet requisite holding requirements, but also the most complicated options to tax-manage. They may entail planning for alternative minimum tax (AMT) and AMT credit, as well as qualified/disqualified sales.
QUALIFIED / DISQUALIFIED SALES
A qualifying sale of ISOs is one that meets the following criteria: The final sale occurs at least 2 years after the grant date, AND the final sale occurs at least 1 year after the exercise date. Anything that does not meet these criteria is a disqualifying disposition.
You’ll follow similar steps in vesting, exercising, holding, and selling grants of either. In our next section, we’ll provide additional comparisons, and take a closer look at ISO’s specific tax treatments. A takeaway here is that personalized tax planning is particularly warranted if you are granted ISOs.
WHAT’S AN 83(B) ELECTION?
Both NQSO and ISO agreements may let you early exercise your option, and file an 83(b) election. This allows you to exercise your option and incur the tax prior to it vesting. Why would you want to do that? If your company is early-stage, with a low share price, you may pay less tax if you exercise early on for NQSOs; or, for ISOs, it may create more favorable AMT tax calculations. However, you risk incurring taxes whether or not a vesting and/or the ability to sell your shares ever occur.
Incentive Stock Options (ISOs): Additional Resources
The Basics of Incentive Stock Options
A Timeline of Events for Your Incentive Stock Options
How to Use a Cashless Exercise of Incentive Stock Options to Manage Cash Flow
View All ISO Articles
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