Congratulations! You’ve climbed the corporate ladder to the point where you now qualify for equity compensation. Whether a start-up company or well-established corporation, your organization recognizes that your success impacts the company’s success. Granting stock ownership is a great way to align an employee’s personal financial interests with the organization’s long-term profitability.

Equity-based compensation also is a great way to build personal wealth over time if carefully managed. These plans are layered with complexities and understanding the financial decisions that accompany these awards are necessary to harness the value toward the achievement of your individual goals. To have a thorough understanding the benefit you’ve received, it is essential to know how the plan is structured and the accompanying tax impacts.

Let’s take a look at some common types of equity compensation:

 

Employee Stock Options

Stock options give an employee the right, but not the obligation, to buy shares of company stock at a predetermined (or “exercise”) price. A typical grant is defined for a set period of time and a waiting, (or vesting) period must pass before an employee can exercise their right. Although vesting periods can vary by plan, the term of an option grant typically expires after 10 years, but all of the details are outlined in the Stock Option Award or Grant Agreement. 

In order for an option to have value, the current market price of the stock must be greater than the exercise price of the option.

Option Value = # of shares granted X (current FMV of the stock – the exercise price).

(To put it in mathematical terms: If you are granted 100 options to purchase XYZ company at an exercise price of $10/share, and XYZ is currently trading at $15/share, your options, if vested, would have a value of $500). 

Options are often separated into 2 types: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs). Although the option value has the same calculation, each type has a distinct tax treatment.  

  

NQSOs are the more common of the 2 option types and have a more straightforward tax calculation. At exercise, the option value is taxed as ordinary income and subject to federal, state, and local income taxes, in addition to payroll taxes. Subsequently, when the shares are eventually sold, they will be taxed again, subject to capital gains taxes.

 

ISOs are typically considered more favorable if they have a qualifying disposition. There would be no tax due on the exercise, and all shares would be subject to capital gain treatment if 2 factors are present: 

  • The options must be held for at least 2 years after they are granted.
  • Once exercised, the shares must be held for at least one year.

It is important to note that if these factors are not met it is considered a disqualifying disposition and ordinary income taxes would be due on the difference between the exercise price and the lesser of the option value as described above, or the sale price of the stock. (Additionally, it is important to understand that although not taxed at exercise, if the stock is being held, the difference between the exercise price and the fair market price will be included as a preference item when calculating the Alternative Minimum Tax (AMT)).

 

Restricted Stock 

A Restricted Stock Award (RSA) is a grant of company stock in which the recipient’s rights are restricted during a specified period.  Although the shares are restricted, RSAs offer the advantage of immediate stock ownership as compared to stock options or phantom-stock arrangements. Like an RSA, a Restricted Stock Unit (RSU) is a grant valued in terms of company stock. Unlike an RSA, no company stock is issued at the time of an RSU grant, Vesting can simply be based on an amount of time lapsed or based on performance metrics as outlined by the company. (Often RSUs that are based on company metrics are known as Performance Stock Units, or PSUs). Depending on the rules of the plan, the employee receives unrestricted shares of company stock or the cash equivalent after vesting. This amount is taxed as ordinary income. Depending on the company, the amount of shares delivered may be adjusted by the amount of taxes due. These differ from options in that the employee is not required to “buy” the shares. Upon eventual sale of the company shares, they will be taxed again at applicable short or long-term capital gain rates. 

 

Stock Appreciation Rights

SARs or Stock Appreciation Rights are a blend between stock options and restricted stock. Similar to options in that the employee will benefit from the growth of the stock value from the time granted through the point at which the SAR is exercised. Similar to RSUs in that the employee is not required to purchase the shares. A SAR can deliver a cash payment or shares of company stock, depending on preference, but will be taxed as ordinary income when exercised.

 

Employee Stock Purchas Plans (ESPP)

These plans offer an optional benefit that allow after-tax payroll deductions to be used to purchase shares of company stock at a discount. If offered participation in the plan, an employee can simply decide how much they would like to invest per pay period. Often there are holding requirements on purchased shares that are specific to the plan and outlined in the document.

The plan explanations shared above are a high-level introduction to the different types of equity compensation. Although there are complexities, these plans can be a great benefit that can positively impact your cash flow and overall financial independence. Understanding your options and the details of your company’s specific plans are the key to success over time. Working with a financial advisor who is able to help interpret the plan nuances while helping you manage the single company stock concentration, and the various tax impacts will be beneficial to your long-term outcomes. Your Sequoia Wealth Advisor can help you understand how to maximize your equity compensation benefits and devise strategies specific to your goals.

The views expressed represent the opinion of Sequoia Financial Group. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Sequoia believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Sequoia’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. Past performance is not an indication of future results. Investment advisory services offered through Sequoia Financial Advisors, LLC, an SEC Registered Investment Advisor. Registration as an investment advisor does not imply a certain level of skill or training.

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Investment advisory services offered through Sequoia Financial Advisors, LLC, an SEC Registered Investment Advisor. Registration as an investment advisor does not imply a certain level of skill or training.

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