Equity compensation is an innovative tool that companies, especially startup companies and private firms, use to reward and incentivize their employees. Through equity compensation plans, employees get a chance to own a slice of the company they work for with an ownership stake. These plans come in different forms, such as restricted stock units, stock options, restricted stock awards, performance shares, or equity management awards.
However, for the inexperienced, this landscape can be complex to tread on as these plans are subject to various federal and state laws, securities regulations, and tax codes. Thus, in this article, we will discuss the things that companies must be aware of regarding legal requirements to ensure they're in compliance and avoid any potential legal and financial troubles.
Equity Compensation and the Law of Securities
Securities law plays a significant role in equity compensation plans. Equity compensation plans are subject to regulations because they involve the issuance of stocks, which are considered investments. The Securities Act of 1933 and the Exchange Act of 1934 are federal rules that regulate the issuance and sale of stocks.
Companies that issue equity compensation must comply with these laws, which require the registration of stocks with the Securities and Exchange Commission (SEC) unless an exemption applies. The SEC provides several exemptions, including Regulation D, which is commonly used by private companies. Under Regulation D, companies can issue stocks to a limited number of accredited investors without registering with the SEC.
State Law and Equity Compensation
In addition to assets legalities, equity compensation plans are also subject to state law. State laws can vary significantly, and business owners need to be aware of the laws in each state in which they have employees. For example, some states require that companies register their equity compensation plans with the state, while others do not. Some states have specific rules regarding the vesting of equity compensation, while others do not.
Employment Laws on Equity Compensation
Employment laws also play a role in equity compensation plans. Business owners must comply with various employment regulations, such as the Fair Labor Standards Act (FLSA) when compensating their employees. They must ensure that their equity compensation plans do not violate these rules. For example, the management must ensure that equity compensation is included in the employee's regular rate of pay for overtime purposes under the FLSA.
Equity Compensation and Taxation
Businesses and employees must also be aware of the tax consequences of equity compensation plans. The taxation of equity compensation plans can be complicated and depend on several factors, such as the type of equity compensation, the purchase price, the exercise price, and the market value of the company stock.
Companies must withhold and pay taxes on equity compensation when it is paid to employees. Additionally, employees may also owe taxes when they exercise their stock options or sell their shares.
Tax Consequences of Restricted Stock Unit (RSU)
RSUs are taxed when they vest. They are treated as ordinary income and require withholding for income taxes, Social Security taxes, and Medicare taxes. The withholding rate for federal income taxes is generally 22%, but employees may elect to have a higher or lower rate withheld. The withholding rate for state income taxes varies by state.
Once the RSUs vest and the employee receive the shares, any future gains or losses on the shares will incur CGT. If the shares are sold within one year of the vesting date, the gain or loss will be treated as short-term gains or losses and will be taxed at the employee's ordinary income rate. If the shares are held for more than one year after vesting, the gain or loss will be treated as long-term gains or losses and will be taxed at a lower rate.
Tax Consequences of Stock Options
Stock options can have different taxation rules depending on whether they are non-qualified stock options (NSOs) or incentive stock options (ISOs).
NSOs are taxed when they are exercised. The difference between the fair market value of the stock during vesting and the strike price (also known as the "spread") is treated as ordinary income for tax purposes and requires withholding for income taxes, Social Security taxes, and Medicare taxes. The withholding rate for federal income taxes is generally 22%, but employees may elect to have a higher or lower rate withheld. The withholding rate for state income taxes varies by state.
Once the stock is acquired through the exercise of NSOs, any future gains or losses on the stock will incur CTG. If the stock is sold within one year of the exercise, the gain or loss will be treated as short-term gains or losses and will be taxed at the employee's ordinary income rate. If the stock is held for more than one year after it vests, the gain or loss will be treated as long-term capital gains or losses and will be taxed at a lower rate.
ISOs are not taxed when they are exercised, but they follow rules different from NSOs. If an employee exercises ISOs and holds the stock for at least two years after the grant date and one year after vesting, any gains on the stock will be treated as long-term capital gains and will be taxed at a lower rate. However, if the employee sells the stock before meeting these holding requirements, the gain will be treated as ordinary income and will require withholding and taxation at the employee's ordinary income tax rate.
Tax Consequences of Restricted Stock Awards
Restricted stock awards are taxed when they vest. The stock when it vests is treated as ordinary income for tax purposes and is subject to withholding for income taxes, Social Security taxes, and Medicare taxes. The withholding rate for federal income taxes is generally 22%, but employees may elect to have a higher or lower rate withheld. The withholding rate for state income taxes varies by state.
the stock vests and the employee receives the shares, any future gains or losses on the shares will be subject to CGT. If the shares are sold within one year of the vesting date, the gain or loss will be treated as short-term capital gains or losses and will be taxed at the employee's ordinary income tax rate. If the shares are held for more than one year after the vesting date, the gain or loss will be treated as long-term gains or losses and will be taxed at a lower tax rate.
In some cases, employees may be able to defer the taxation of restricted stock awards until a later time, such as when the shares are sold. This is known as a Section 83(b) election. To make a Section 83(b) election, the employee must file a written statement with the IRS within 30 days of the grant date of the restricted stock award. The statement must include information about the price of the stock, the purchase price, and other details about the award. By making a Section 83(b) election, the employee can potentially pay less in taxes when the shares are sold.
Advantages of Equity Compensation
Despite the legal considerations and taxation, equity compensation plans offer several advantages to both business owners and employees.
Equity compensation can be an excellent way to compensate employees and incentivize them to work hard and contribute to the organization’s success. Employees who receive equity compensation have a vested interest in its success due to being awarded an ownership stake and are more likely to stay with the company for a more extended period. Equity compensation plans can also be an effective way for entrepreneurs to conserve cash while compensating their employees.
Considerations for Employers
Business owners need to be aware of several considerations when issuing equity compensation. First, owners must determine the value of the equity compensation and ensure that it is fair and reasonable. They must also ensure that the intended recipient of the equity compensation is eligible to receive it under the plan.
Companies must also establish a vesting period, which is the set period during which the employee must remain employed to receive equity compensation. Companies must also establish an exercise price or strike price, which is the predetermined price at which the employee can purchase the company stock.
Legal Compliance Checklist
To ensure compliance with legal requirements, companies should create a legal compliance checklist for their equity compensation plans. The checklist should include:
- Complying with federal, state, and SEC laws when issuing equity compensation
- Ensuring that the equity compensation plan complies with applicable employment laws
- Determining the FMV of the equity compensation
- Establishing the vesting period and strike price
- Withholding and paying taxes on the value of the equity compensation
- Ensuring that the intended recipient of the equity compensation is eligible to receive it under the plan
- Complying with any state registration or filing requirements
- Providing appropriate disclosures to employees about the risks associated with owning company stock
- Ensuring that the equity compensation plan is properly documented and administered
- Employers should also seek the assistance of legal and tax professionals when establishing and administering equity compensation plans to ensure compliance with legalities.
Equity Compensation for Private and Public Companies
Equity compensation plans can differ significantly between private and public companies. Private companies typically issue equity compensation in the form of restricted stock units or stock options. Restricted stock units are equity compensation awards of units that represent a right to receive shares of the company's stock at a later time. Stock options provide employees with the right to purchase shares of the company's stock at a predetermined price.
Public companies also issue equity compensation in the form of restricted stock units and stock options. However, they also issue performance shares, which are awards of stock based on the company's performance. Public companies must comply with additional legal and regulatory requirements when issuing equity compensation. For example, they must comply with the reporting requirements of the SE Act of 1934 and must disclose information about their equity compensation plans in their public filings.
Equity Compensation Doesn’t Have to Look Scary
Equity compensation is a popular way for companies to compensate their employees and share with the company ownership. But just like other financial assets, equity compensation plans are subject to various legal and regulatory requirements, including investment laws, employment laws, and taxation laws.
Companies must be aware of these requirements when establishing and administering equity compensation plans to ensure compliance and avoid legal and financial risks. They should seek the assistance of legal and tax professionals when establishing and administering equity compensation plans.
Despite the legal and tax considerations, equity compensation plans offer several advantages to both the company and its employees and can be an effective way to incentivize employees and conserve cash. Thus, here at Upstock, we make it straightforward and easier for you to manage your employee equity under one platform. Chat with one of our equity experts to see how we can help!
.png){kind=logo}