Equity-based compensation is a popular way for employers to reward and retain key employees. These awards not only serve as additional compensation for employees who provide critical contributions, but they also function to align the interests of both the employee and the firm. The three most common categories of equity compensation are stock options (NQSOs and ISOs), restricted stock units (RSUs), and employee stock purchase plans (ESPPs). If you have received equity-based compensation, understanding the key attributes of these awards is important since they may play a meaningful role in your financial landscape.
Stock option grants give you the right to purchase a set number of shares at a given price (known as the strike price) over a specified time period. These grants, however, typically can only be exercised after a vesting requirement has been met. Vesting schedules are often time-based—requiring several years of service by the employee—or they can be set to vest upon achieving performance goals set by your employer. Once vested, you can then decide whether to exercise your stock options and either keep the shares or sell them. Keep in mind that your stock option grants will expire worthless if you don’t exercise them before the expiration date which is usually 10 years from the grant date. Lastly, stock options come in two main forms, non-qualified stock options (NQSOs) and incentive stock options (ISOs), each with different tax characteristics surrounding their vesting and sale.
Restricted Stock Units (RSUs)
RSUs are a promise to deliver shares of company stock after a vesting period is satisfied. Unlike stock options, RSUs do not have a strike price, and purchasing the shares is not required. Instead, once RSUs vest, you automatically receive the shares and will typically recognize compensation income based on the fair market value of the stock on the vesting date. Depending on your outlook on the company and your financial situation, you can then hold your shares or sell them at your discretion. Selling RSUs immediately will likely result in no additional taxes being owed whereas selling the shares in the future will cause any gain to be taxed as either a short-term or long-term capital gain.
Employee Stock Purchase Plans (ESPPs)
ESPPs give you the right to purchase a number of shares in your company at a reduced price—often through after-tax payroll deductions. Shares are usually offered at a discount between 5% and 15% but there is an annual pre-discounted purchase cap of $25,000 set by the IRS. ESPP shares are not subject to vesting requirements and can be sold at any time. Additionally, ESPPs are generally subject to qualifying disposition rules in which you receive favorable tax treatment for holding the shares two years after the offering date and one year after the purchase date.
To better illustrate the tax implications of each equity award, the following chart breaks down the taxes due at the grant date, vest date, exercise date, and sell date.
|Equity-based Compensation||Grant Date||Vest Date||Exercise Date||Sell Date|
|Incentive Stock Options (ISOs)||N/A||N/A||Possible AMT Item||Taxed (Qualifying Disposition Rules)|
|Non-Qualified Stock Options (NQSOs)||N/A||N/A||Taxed (Ordinary Income)||Taxed (ST or LT Capital Gains)|
|Restricted Stock Units (RSUs)||N/A||Taxed|
|N/A||Taxed (ST or LT Capital Gains)|
|Employee Stock Purchase Plan (ESPP)||N/A||N/A||N/A||Taxed (Qualifying Disposition Rules)|
To help offset a portion of the additional income tax liability generated by equity awards, there are several opportunities you may want to consider:
- Increase your 401(k) or other pre-tax retirement plan contributions if you are not already deferring the annual maximum.
- Limit the number of equity award shares sold in one year. Working with your tax professional will help you determine the number of shares you can sell before being pushed into a higher tax bracket.
- Defer additional salary through your employer’s non-qualified deferred compensation program, if eligible.
Lastly, no discussion of equity-based compensation is complete without mentioning the risks associated with a concentrated portfolio position. To help maintain adequate asset diversification, it is often recommended that you invest no more than 10% to 20% of your portfolio assets in any one stock. This is of particular importance with equity-based compensation since both your wage income and a portion of your investment portfolio are tied to one entity—your employer.
When dealing with complex issues like equity-based compensation, always work with your tax professional and financial advisor to navigate the nuances of your individual tax and financial situation. This will help ensure that you are positioned to achieve your personal and financial goals. For additional details on each type of equity award, please see our full fact sheet, Equity-Based Compensation.
MEET THE EXPERT
Tom Gilbers, CFP®
Aldrich Wealth LP
Tom joined Aldrich Wealth in 2020. In his capacity as a financial planner, Tom helps clients to create a road map to fulfilling their personal goals. Tom particularly enjoys helping people envision the future they want for themselves and strategizing the many different ways they can get there. Before joining Aldrich Wealth, Tom worked in…
- Financial planning
- Wealth management
- High-net-worth individuals
- CERTIFIED FINANCIAL PLANNER™