Does equity compensation make up the employee benefit package? With acronyms such as RSU, NSO, ESPP, ISO, and ESOP Your package could look more like an alphabet soup than benefits. You have documents from human resources, but you may be wondering what exactly it does and the way it operates.
The most straightforward way to describe it simply is that equity compensation can be described as an amount of compensation. It comes in various types, and the offerings differ not just from one business to business, but also between employees. Therefore, Joe in the accounting’s plan of action could be based on an equity compensation offer which is distinct from the one you’re using.
Many of the comp package choices are heavily influenced by individual specific tax situation. Therefore, there’s rarely “blanket” advice on offerings that apply to every employee, not even those who have the same equity compensation packages.
If you’re interested in digging deeper into the various types of equity comp, or even how you could manage yours following your initial public offerings (IPO) go through our archive of equity compensation. This is our 100-level overview of equity compensation where you’ll be able to learn what words on your equity compensation packages are and how to get a better understanding of this type of employee benefit.
EQUITY COMPENSATION BASICS
Small, medium and large public and private businesses can provide ways employees to take ownership, also known as equity. Equity compensation is a way to help employees feel more investedliterally and figuratively and committed toward their companies. It’s because it enables employees to gain ownership in the company by their work.
But there are trade-offs.If you …
- Get a 100% salary on a regular basis You know exactly what you’re getting.
- Get 100% equity in your compensation. its worth — and consequently, your pay is contingent on the financial performance of the company.
- Are paid according to the hybrid model, which means you are paid a salary on a regular basis and equity compensation as an incentive.
It is not uncommon to see clients who are receiving stock options or other types of equity compensation start to have high-value asset allocations. This means that the bulk of their net worth will be tied to the business they work for by their salaries and the owning shares in the business.
Pro Tips: Diversify your investments to ensure that you don’t rely too much on your business’s financial success for your own economic success.
UNDERSTANDING EQUITY COMPENSATION
STOCK OPTIONS
This type of reward grants the ability to purchase the specified number of shares of the company’s stock at a set price, also known as the exercise price or strike price. It’s typically a waiting period until these options become fully vested (i.e. they are that they’re available to use).
- It’s crucial to realize that you don’t have stocks until you exercise your options. Stock options simply give you the option to buy stock.
Pro Tip: If it is appropriate, conduct an analysis of costs to determine the benefits of an exercise that is cashless. This approach allows employees to exercise their options even when they don’t have the money to pay for the shares.
There are two main types of stock options.
> NONQUALIFIED STOCK OPTION (NSO)
The most popular type of stock options NSOs are given to a variety of stakeholders, including contractors, employees directors, and contractors of a business.
— NSOs have taxation that is relatively simple.
- If the stock is exercised in a manner, the difference between value of the exercise and price of the stock is taxed as normal income. The most common way to report it is on an Form W-2.
- If the stock purchased with this option sells any difference in price between price of the stock at the date of exercise and the price of sale is taxed as a smallor long-term capital gain.
> INCENTIVE STOCK OPTION (ISO)
— ISOs are only available to employees. They are only available to $100,000 in granted value that can be exercised or vested per calendar year.
Their tax treatment isn’t so easy to understand.
- If exercised ISOs do not have to be taxed in the form of income. However that difference between exercise prices and actual price of the stock (aka “the bargain element”) is subject to Alternative Minimum Tax (AMT).
- When the option stock purchased with an option sale the period of holding relative to the date of the grant date and exercising date on the ISO determines the tax classification and ramifications of the stock sale.
Are you looking for more information about stock options? Take a look at our article about NSOs in generaland ISOs, As Well!.
RESTRICTED STOCK
The name is fairly straightforward. However, the terminology associated with restricted stock may create confusion quickly. Restricted stock, as well as its closely related counterpart that is restricted stock units are both very well-known, yet clearly different plans for stock compensation.
> RESTRICTED STOCK
Stock shares are given to employees, but with limitations regarding when the employee can sell or take the shares away. It is usually dependent on specific goals for performance or, more often the length of time that an employee works for the company.
The reason for this is that restricted stock is actually shares of stock, the value of which can be determined on the date of grant the owners of restricted stock have voting rights and dividend rights. They also have the option to make a tax-specific choice in accordance with Internal Revenue Code (IRC) Section 83(b).
Pro Tip: You should consider making an Section 83(b) option within 30 days after receiving an award in restricted stock.
SECTION 83(B) ELECTION
The option will make the amount of the stock tax-deductible to you as normal revenue (including Social Security and Medicare payroll taxes) in accordance with the value at the date of grant. This gives you the possibility of a benefit of a lower capital gain tax rates for the gain when the stock is vesting and you decide to sell it (assuming that the date is at least one calendar year and one day following the date of grant).
The main risk is:
- The stock is never vested since you have left the business or shuts down.
- A substantial decrease in the value of the stock between the date of grant and vesting/sale.
In both of these risk scenarios you will end up having to recognize tax-free income that you didn’t realize.
Without making an 83(b) choice you’ll pay regular taxes on your income and pay for the restricted stock at the date that the stock is granted in you (aka the day it becomes non-restricted). The gain you earn from this date forward will be taxed as a small as well as a long-term capital loss dependent on the length of time you own the subsequently unrestricted stock.
If you have restricted stock in companies that are pre-IPO The rewards of the Section 83(b) decision could be impressive … however, the risk is substantial.
> RESTRICTED STOCK UNIT (RSU)
When granted, an RSU is a promise made by a business to provide an employee with stocks in the near future that aren’t in existence at the moment. The fact that the stock was not in existence in the moment of grant is a key distinction between ordinary limited stock as well as RSUs.
Since RSUs aren’t actual stocks at the date of grant, those who hold RSUs do not have dividends or voting rights (although certain companies pay dividend equivalents RSU shareholders).
The lack of shares in the period of grant means it’s not feasible for holders of RSUs to exercise election under Section 83(b) choice for their RSUs.
- RSUs are tax-deductible with tax withholding similar to wages at the time the RSU becomes a part of your portfolio and the shares are given to you. The gain you earn from this date forward can be taxed as a small and long-term capital gain according to how long you hold the shares that you have just issued of stock.
However, Section 409A deferral is feasible through RSUs when the employer sponsors a suitable plan of the appropriate type.
- In certain situations, the delivery actually held could be delayed (along with tax liabilities) in the meantime that the RSU itself is vested.
- This is then converted into an IOU within an IOU. The RSU owner must submit the 409A decision within 30 days after the award, and the date for vesting is not less than 12 months following the date of the election.
Want to know more about restricted stocks? We have a blog for you! Check out All About RSUs — and RSAs, Too.
EMPLOYEE STOCK PURCHASE PROGRAM (ESPP)
The plans for stock above are clearly examples of compensation. The ESPPs, on the contrary side, are savings programs that involve the company’s stock. There are two kinds of ESPP plans which are tax-qualified as well as non-qualified.
> TAX-QUALIFIED ESPP
The ESPP is subject to a maximum annual limit of $25,000 in non-discounted stock per employee Tax-qualified ESPPs allow businesses to offer discounts that can be as high as 15% on the purchase of stock owned by the company through the plan.
Taxation is in a few ways like ISOs however there are some key differences.
- While there aren’t any AMT-related implications, there is an association with the ESPP plan’s date of grant and the date on which it was purchased the stock, as well as the sale date when determining whether a sale qualifies as qualified or not.
- In each case there will be a portion of normal income that is recognized as the disposal of tax-exempt ESPP stock.
Pro Tip: If your employer gives discounts of 15 even the disposition of disqualified ESPP stock can yield higher after-tax revenue than not being a participant in the program at all. The main risk associated with using this method is that of performance for the stock.
> NONQUALIFIED ESPP
Flexible in design as compared to tax-qualified ESPP plans and nonqualified ESPP plans are available at any price and/or discount levels.
Nonqualified ESPPs are not eligible for advantageous tax treatment.
- Discounts offered by the program is taxed in the same way as regular income and subject to payroll tax at the moment of exercising.
- The eventual sale of the stock will be taxed as a short-term or long-term capital gain, based on the length of time the stock is held.
Additional information about ESPPs within Everything about ESPPs.
EMPLOYEE STOCK OWNERSHIP PLAN (ESOP)
A ESOP is a form of retirement plan that allows employees are given shares of stock in the company, that can be kept without tax implications until they decide to decide to sell the shares.
-as an retirement plan, ESOPs have certain regulations regarding vesting as well as the distribution of benefits.
Gains may be delayed by the owner who originally owned the property under IRC Section 1042.
Go through the article “All About ESOPs” to learn more about these plans for ownership.
So, what exactly does your equity compensation acronym mean?
In case you didn’t notice them at the end of each section This is our reference guide for exploring each of the types of equity-based compensation we’ve previously discussed:
All About RSUs — and RSAs, Too
All About NSOs — and ISOs, Too
If the company’s IPO is on the horizon or has happened recently, take a look at My Company Just Had Its IPO. Now What?
