As an employer, attracting and retaining top talent is essential to the success of your company. Offering competitive compensation packages is a key strategy in achieving this goal, and equity compensation can be a powerful tool in your arsenal.
By offering various types of equity compensation, you can incentivize your employees to work harder and smarter, align their interests with those of the company, and potentially realize gains from the appreciation of the company's stock value.
In this article, we will explore the different types of equity compensation that companies can offer their employees and the benefits and tax implications of each.
Common Types of Equity Compensation Offered to Employees
Employee Stock Purchase Plans (ESPPs)
Employee Stock Purchase Plans (ESPPs) are a type of equity compensation that allows employees to purchase company stock at a discounted price. This discount is usually between 5% and 15% of the stock's fair market value.
ESPPs are usually offered to all employees, and payroll deductions are used to purchase the company's stock. ESPPs can offer several benefits, such as cash flow savings and stock ownership for employees. However, there are some tax rules that employees need to consider when they purchase company stock through an ESPP.
Restricted Stock Units (RSUs)
Restricted stock units (RSUs) are another form of equity compensation. RSUs are awards of company stock that are granted to employees, but the employee does not receive the actual stock until the vesting period is over. During the vesting period, the employee cannot sell, transfer, or pledge the RSUs.
Once the vesting period is over, the employee receives the company's shares or the cash equivalent of the company's shares. RSUs are usually subject to a vesting schedule, which is a predetermined period during which the employee must work for the company to receive the RSUs. Vesting schedules can be based on time or particular performance targets.
RSUs and the Fair Market Value (FMV)
Restricted stock units (RSUs) are often granted to employees as a form of equity compensation. RSUs represent a promise from the company to deliver company stock to the employee at a future date or upon the occurrence of certain conditions, such as vesting. The value of RSUs is typically determined by the fair market value (FMV) of the company shares on the award date.
The FMV of the company shares is important because it determines the value of the RSUs when they are granted to the employee. For example, if an employee is granted 100 RSUs and the FMV of the company's shares on the award date is $10 per share, then the RSUs are worth $1,000 in total. However, if the FMV of the company's share on the award date is $20 per share, then the RSUs are worth $2,000 in total.
It's worth noting that if the FMV of the company shares increases between the award date and the date the RSUs are delivered to the employee, the value of the RSUs will also increase. However, if the FMV of the company shares decreases during this period, the value of the RSUs will also decrease.
Stock Options
Stock options are a type of equity compensation that gives employees the right to purchase stock at a predetermined price, known as the exercise price. They are usually granted to employees at the award date and have an expiration date, which is the last date the employee can exercise the option. The exercise or strike price is usually the FMV of the stock on the award date. Stock options can be further divided into two categories: incentive stock options (ISOs) and non qualified stock options (NQSOs).
1. Incentive Stock Options (ISOs)
ISOs are employee stock options that meet certain requirements under the Internal Revenue Code. ISOs are usually granted to employees as part of their compensation package, and the employee does not pay tax on the option when it is granted or exercised. Instead, the employee pays tax on the difference between the exercise price and the stock's fair market value when they sell the stock.
If the employee holds the company shares for more than a year after exercising the option, they will pay long-term capital gains tax on the difference between the exercise or strike price and the fair market value of the stock at the time of sale.
2. Non Qualified Stock Options (NQSOs)
Non qualified stock options (NQSOs) are employee stock options that do not meet the requirements of ISOs. NQSOs are usually granted to employees as part of their compensation package, and the employee pays tax on the difference between the strike price and the stock's FMV when they exercise the option. NQSOs do not have the same tax benefits as ISOs, but they offer more flexibility in terms of how they can be used.
Stock Appreciation Rights (SARs)
SARs are a type of equity compensation that gives employees the right to receive a payment based on the appreciation of the company's stock over a predetermined period. SARs are usually granted to employees at the grant date and have an expiration date, which is the last date the employee can exercise the right. SARs can be settled in cash or company stock, depending on the terms of the SAR agreement. Like stock options, SARs have an exercise or strike price and are subject to vesting schedules. However, SARs do not require employees to purchase company stock, and they can be a useful way for companies to offer equity compensation plans without diluting the company's equity.
Restricted Stock Awards
Restricted stock awards (RSAs) are similar to RSUs, but the employee receives the actual stock at the award date, subject to a vesting schedule. The employee pays tax on the stock's FMV when they receive it, and the stock is subject to the same transfer restrictions as RSUs during the vesting period. RSAs are less common than RSUs, but they offer some of the same equity compensation benefits, such as stock ownership and the potential for capital gains.
Phantom Stock
Phantom stock is a type of employee equity compensation that does not involve the actual company stock. Instead, the employee receives a payment based on the company's share value over a predetermined period.
Phantom stock can be settled in cash or company stock, depending on the terms of the phantom stock option agreement. Phantom stock can be a useful way for private companies to offer equity compensation without disclosing sensitive information to employees or the Securities and Exchange Commission (SEC).
Tax Consequences and Benefits of Receiving Equity Compensation
Receiving company equity compensation plans can have tax consequences and benefits that employees need to consider when they receive equity compensation. The tax consequences and benefits depend on the type of equity compensation and the employee's tax situation.
A. Employee Stock Purchase Plans (ESPPs)
Employees who purchase company stock through an ESPP are subject to ordinary income tax rates on the discount they receive when they purchase the stock. The discount is usually considered compensation income, and the employee pays tax on it in the year they purchase the stock. However, if the employee holds the stock for more than two years after the purchase date and more than one year after the offer date, they may be eligible for a tax credit.
B. Restricted Stock Units (RSUs)
Employees who receive RSUs are subject to income tax on the FMV of the stock when the RSUs vest. The FMV is usually considered compensation income, and the employee pays tax on it in the year the RSUs vest. However, if the employee holds the stock for more than one year after the vesting date, they may be eligible for long-term capital gains tax on any appreciation in the stock's value.
C. Stock Options
Employees who exercise stock options are subject to ordinary income taxes on the difference between the exercise price and the stock's FMV when they exercise the option. The difference is usually considered compensation income, and the employee pays tax on it in the year they exercise the option. However, if the employee holds the stock for more than one year after exercising the option and more than two years after the award date, they may be eligible for long-term capital gains tax (CGT) on any appreciation in the stock's value.
D. ISOs
Employees who exercise ISOs are not subject to income tax when they exercise the option or when they sell the stock. Instead, they pay long-term CGT on any appreciation in the stock's value if they hold the stock for more than one year after exercising the option and more than two years after the grant date.
E. NQSOs
Employees who exercise NQSOs are subject to income tax on the difference between the strike price and the stock's FMV when they exercise the option. The difference is usually considered compensation income, and the employee pays tax on it in the year they exercise the option.
F. Stock Appreciation Rights (SARs)
Employees who receive SARs are subject to income tax on the amount they receive when they exercise the SAR. The amount is usually considered compensation income, and the employee pays tax on it in the year they exercise the SAR.
G. RSAs
Employees who receive RSAs are subject to income tax on the FMV of the stock when they receive it. The FMV is usually considered compensation income, and the employee pays tax on it in the year they receive the stock. However, if the employee holds the stock for more than one year after the vesting date, they may be eligible for long-term capital gains tax on any appreciation in the stock's value.
F. Phantom Stock
Employees who receive phantom stock are subject to income tax on the amount they receive when this stock vests. The amount is usually considered compensation income, and the employee pays tax on it in the year they receive the payment.
Tax Benefits of Receiving Equity Compensation
Employees who were awarded equity compensation may be eligible for certain tax benefits, depending on the type of equity compensation and the employee's tax situation.
For Employee Stock Purchase Plans (ESPPs)
Employees who purchase company stock through an ESPP may be eligible for a tax credit if they hold the stock for more than two years after the purchase date and more than one year after the offer date.
For RSUs
Employees who receive RSUs may be eligible for long-term CGT on any appreciation in the stock's value if they hold the stock for more than one year after the vesting date.
For Stock Options
Employees who exercise stock options may be eligible for long-term capital gains tax on any appreciation in the stock's value if they hold the stock for more than one year after exercising the option and more than two years after the award date.
For Incentive Stock Options (ISOs)
Employees who exercise ISOs may be eligible for long-term CGT on any appreciation in the stock's value if they hold the stock for more than one year after exercising the option and more than two years after the grant date.
For Non-Qualified Stock Options (NQSOs)
Employees who exercise NQSOs may be eligible for long-term CGT on any appreciation in the stock's value if they hold the stock for more than one year after exercising the option.
Bottom Line
Equity-based compensation is a valuable tool that companies can use to attract and retain employees. There are several types of equity compensation plans, including employee stock purchase plans, restricted stock units, stock options, SARs, restricted stock awards, and phantom stock. Each type of equity-based compensation plan has its own benefits and drawbacks, and employees need to consider the tax responsibilities and benefits when they receive equity compensation.
But just like other financial instruments, employee equity compensation is subject to tax rules under the Internal Revenue Code, and employees need to pay attention to the state, federal, and income tax liability of receiving equity compensation. Tax obligations can include paying tax on the fair market value of the stock when the equity compensation vests, paying income tax on any compensation income, and paying long-term CGT on any appreciation in the stock's value.
Employees who were given equity compensation may be eligible for certain tax benefits, depending on the type of equity compensation and the employee's tax situation. Tax benefits can include a tax deduction for holding company stock purchased through an employee stock purchase plan for more than two years, long-term CGT on any appreciation in the stock's value for certain types of stock options, and long-term capital gains tax on any appreciation in the stock's value for certain types of equity compensation.
Overall, employee equity compensation can be a valuable benefit for both employees and companies. Established companies and startups can use employee equity compensation to attract and retain employees, while employees can benefit from owning a stake in the company and potentially
If you’re looking for an all-in-one equity management solution for your employee compensation, you can tap Upstock to do the groundwork. All you have to do is onboard your employees and we’ll take care of the rest. Chat with us to know more about this cost-efficient equity platform that Upstock offers!
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