Understanding Your Equity Compensation Package

Equity compensation is a valuable component of your employee benefits package. It seems that more and more companies across the world are offering this type of incentive program to their employees, especially U.S. expats. However, with various acronyms like RSU, NSO, ESPP, ISO, and ESOP, it is not uncommon to feel overwhelmed and uncertain about what it entails. Even if you have the necessary documents from human resources, you may still be left wondering about the details and how it works.

It is important to note that equity compensation can take many forms, and offerings may differ from one company to another, even from one employee to another. Equity compensation plans may also vary from one country to another, but for the purpose of this article, we will stick to the basic explanations of how these incentive programs work in the United States. Moreover, equity compensation decisions are often heavily influenced by individual income tax situations, making it challenging to provide generalized advice that applies to all employees, including those with identical equity compensation packages.

Equity Compensation Basics

Companies, both private and public, of various sizes, can provide their employees with the opportunity to gain ownership, also known as equity compensation. By offering equity compensation, employees can feel more invested in their work and in the company itself, as they are rewarded with a stake in ownership for their efforts. However, it is important to note that there are trade-offs to consider when it comes to equity compensation.

If you receive 100% regular salary, you can expect a consistent income without regard to the financial performance of the company. On the other hand, if you receive 100% equity compensation, the value of your equity is directly tied to the company’s financial success.

In some cases, employees may receive a hybrid scenario where they receive a regular salary with equity compensation provided as a bonus. While this can be an attractive option, it’s important to carefully consider the implications.

At times, there are individuals who receive stock options and other forms of equity compensation, and this can result in a top-heavy asset allocation. In such cases, the majority of their financial net worth is linked to the company they work for, through their salary and ownership of company stock. This can be a risky strategy, as the value of the equity compensation may fluctuate based on the company’s performance and can expose the employee to undue financial risk.

Understanding Equity Compensation

Stocks

Equity compensation can include stock options, which give employees the right to purchase a specific number of company shares at a predetermined price, known as the strike or exercise price. Typically, there is a vesting period before options can be exercised.

It’s important to understand that owning stock options doesn’t equate to owning stock. The options simply provide the right to purchase stock.

To maximize the value of stock options, employees may consider a cost analysis to determine if a cashless exercise is appropriate. This approach allows for the exercise of options even when financial resources are limited.

There are two primary types of stock options.

Nonqualified Stock Option (NSO)

A nonqualified stock option (NSO) is the most common type of stock option and may be granted to employees, contractors, and directors of a company. NSOs have relatively straightforward taxation rules.

• • When an NSO is exercised, the difference between the exercise price and the stock price at that time is taxed as ordinary income and reported on a Form W-2.
  • When the stock acquired through the option is sold, the difference between the sale price and the underlying stock price at the time of exercise is taxed as either a short-term or long-term capital gain.

Incentive Stock Option (ISO)

The Incentive Stock Option (ISO) is an employee-exclusive benefit, subject to a yearly vested/exercisable grant value limit of $100,000. It provides a unique tax treatment that requires careful attention due to its intricacies.

• • Upon exercise, ISOs are not taxed as income, yet the difference between the exercise price and the underlying stock price (referred to as the “bargain element”) may be subjected to Alternative Minimum Tax (AMT).
  • The tax implications of selling the stock received from the ISO depend on the holding period, which is relative to both the grant and exercise dates of the option. The holding period determines the tax character and consequences of the stock sale.

Restricted Stock

The concept of Restricted Stock may appear simple, but it is important to understand the specialized terminology associated with it. Restricted Stock and its closely related counterpart, Restricted Stock Units, are two commonly used stock compensation plans that differ significantly.

Restricted Stock involves granting actual shares of stock to an employee with certain restrictions on when the shares may be sold or disposed of. The vesting of these shares is generally based on specific performance objectives or, more commonly, the duration of an employee’s service with the company.

As Restricted Stock involves actual shares of stock, their value can be determined on the date of grant. Consequently, owners of Restricted Stock have the right to vote and receive dividends and may also elect to take advantage of a special tax provision under IRC Section 83(b).

It is advisable to consider filing a Section 83(b) election within 30 days of being granted Restricted Stock.

Section 83(B) Elections a process by which the value of stock is taxed as ordinary income, including Social Security and Medicare payroll taxes, at the time of grant based on the value of the stock on that date. This provides the opportunity to benefit from potentially lower capital gains tax rates on any gain realized after the stock has vested and is sold, assuming that the sale occurs one year and one day after the grant date.

However, there are certain risks associated with making this election.

• First, if the stock never vests due to the employee leaving the company or the company going out of business, the taxes paid on the stock’s value will have been for income that was not realized.
• Second, if the value of the stock significantly declines between the grant and vesting/sale dates, the taxes paid on the stock’s value may be greater than the gain realized.

If an 83(b) election is not made, taxes on restricted stock are paid as ordinary income and payroll tax on the date the stock becomes unrestricted. Any gain realized after that date is taxed as a short- or long-term capital gain, depending on the duration of ownership of the unrestricted stock.

For restricted stock of a pre-IPO company, the potential benefits of an 83(b) election can be significant, but the associated risks should be carefully considered.

Restricted Stock Units (RSU)

An RSU is a commitment made by a company to grant shares of stock to an employee at some future time, which do not yet exist at the time of the grant. This distinguishes RSUs from normal restricted stock.

Since RSUs do not represent actual shares of stock at the time of the grant, holders of RSUs are not entitled to voting rights or dividends, although some companies provide dividend equivalents to RSU holders. Additionally, since the stock does not exist at the time of grant, it is not possible to make a Section 83(b) election on an RSU.

RSUs are taxable, with taxes withheld similarly to wages, when the RSU vests and the actual stock is transferred to the employee. Any gain realized from that point forward is subject to tax as a short- or long-term capital gain, depending on the duration of ownership of the newly issued shares of stock.

However, under certain conditions, RSUs can be deferred under Section 409A, provided the employer sponsors an appropriate plan. The delivery of the actual stock and the associated tax liability can be postponed, even as the RSU vests. This creates a double obligation, as the election must be made within 30 days of the grant and the vesting date must be more than 12 months after the election.

Employee Stock Purchase Program (ESPP)

The stock plans mentioned above are clearly forms of compensation. ESPPs are stock-based retirement plans. There are two categories of people: qualified and unqualified.

Tax-Qualified ESPP

It permits companies to offer their employees the opportunity to purchase the company’s stock at a discount of up to 15%, with an annual limit of $25,000 worth of non-discounted stock per employee.

Taxation of tax-qualified ESPPs is similar in some ways to ISOs, but there are important differences. While there are no AMT implications, whether a sale of tax-qualified ESPP stock is a qualifying or disqualifying disposition depends on the grant date of the plan, the purchase date of the stock, and the sale date of the stock. Regardless of the type of disposition, some amount of ordinary income is recognized upon the sale of tax-qualified ESPP stock.

Even in the case of disqualified dispositions, participating in an ESPP with a 15% discount can yield more after-tax income than not participating at all. However, the primary risk associated with this strategy is the performance of the underlying stock.

Nonqualified ESPP

Nonqualified ESPP plans offer greater flexibility in terms of plan design, allowing for any amount and/or discount level to be offered.

However, nonqualified ESPP plans do not receive any favorable tax treatment. Any discount offered through the plan is taxed as ordinary income, subject to payroll taxes, at the time of exercise. The future sale of the stock is taxed as a short- or long-term capital gain, depending on the number of days the stock is held.

Employee Stock Ownership Plan (ESOP)

An Employee Stock Ownership Plan (ESOP) is a retirement plan in which employees receive shares of company stock that can be held until they are sold without any tax implications. ESOPs are subject to rules regarding vesting and benefit allocation due to their status as retirement plans. Additionally, the original owner of the shares can defer taxable gain through IRC Section 1042.

In conclusion, equity incentives offered by employers, whether locally in the U.S. or abroad, can provide a great benefit to employees who know how to play it smart. It is important to consider the tax ramifications, exit strategies, risks, and how it complements your overall portfolio, among other things. Talk to a qualified professional to help you implement sound strategies for optimization, and to avoid costly mistake