Understanding Stock Options and Equity Compensation

Different than cash compensation (i.e, salary, bonus, and commission), some forms of equity compensation are not taxed as earned income. Equity compensation makes up almost one third of employees’ net worth, 32% on average[i].

Understanding how your company’s equity compensation plan works is critical to interpreting the advantages and disadvantages of exercising your right to purchase, accumulate and sell your equity shares. Equity compensation comes in various forms including Stock Options, Stock Appreciation Rights, and Restricted Stock Options.

Stock Options

Simply put, stock options offer you the ability to purchase company shares at a pre-set price. In addition to having an ownership stake in your company, the primary incentive of stock options is being able to purchase company shares at a discounted rate. The key word here is “option”. If you choose not to exercise your right to buy shares within a pre-determined window of time, they will expire. Be aware your stock options may be subject to a vesting period before you have full nonforfeitable ownership of the shares. Companies can grant two types of stock options: nonqualified stock options (NQSOs) and incentive stock options (ISOs), each with different taxation.

Nonqualified stock options (NQSO) do not qualify for special favorable tax treatment under the Internal Revenue Code and are the most common form of stock options. They can be granted to employees, officers, directors, contractors, and consultants. You pay taxes in the year you exercise (purchase) NQSOs. For tax purposes, the exercise spread (difference between what you pay and what the value of the stock price is at the time of purchase) is reported on your IRS Form W-2 as income. Expect your company to withhold required payroll taxes – income tax, Social Security, and Medicare. When you sell those shares, the proceeds are taxed under rules pertaining to capital gains and losses.

Incentive stock options (ISOs) do qualify for special tax treatment when they meet certain criteria.[i] Unlike NQSOs, incentive stock options are not considered ordinary income when exercised. Instead, ISOs fall under capital gains/losses tax treatment depending on how long you hold your shares after exercising. For long-term capital gains treatment, you must hold the shares for more than two years after grant and more than one year after exercise. Because ISOs have a longer holding period, it’s important to understand the potential of triggering the federal alternative minimum tax when you purchase shares of incentive stock. 

Stock Appreciation Rights

Stock Appreciation Rights (SARs) are a form of equity compensation linked directly to the company’s stock price. Unlike stock options, SARs are typically paid out in cash and do not require the employee to purchase shares of company stock. The value of the SAR fluctuates, based on the value of the company stock, and is determined at the time you exercise your SAR. If the issuer is a private company without a readily available fair market value, the valuation process may require a third-party determination as spelled out in the plan document. SARs are transferable and often subject to claw back provisions, specifying conditions that the company may take back all or some of the income previously paid out through the Stock Appreciation Right. SARs are taxed like NQSOs, as ordinary income on the spread, in the year they are exercised. Details to look for in your SARs equity compensation grant agreement include the number of SARs, form of payment (i.e. cash or shares), and vesting schedule. Your actual payout of the SARs will be deferred until a future exercise date or designated payment event.

Restricted Stock Unit

Restricted Stock Units (RSUs) have become a popular retention tool by employers since they are issued with vesting schedules made to incentivize employees to remain with the company for a particular length of time. RSUs are often tied to performance milestones that must be met before the RSUs are transferred to the employee. Different from stock options, RSUs have no exercise price since there’s no opportunity or obligation for you to purchase company shares. For tax purposes, RSUs are only taxable in the year you become fully vested, at which point you have to report the full fair market value as income.

Equity compensation can be nuanced and complex. It’s tempting to set this part of your overall compensation on autopilot to address in future years when you are eligible or plan to exercise your benefit. However, because equity compensation comes with unique rules, tax implications, and eligibility requirements, it’s important to have a strategic approach to this part of your compensation and employee benefits.

Working with your wealth advisor will ensure you are incorporating all equity compensation into your broader financial plans and not leaving money on the table.

[i]https://www.aboutschwab.com/schwab-equity-compensation-survey-2020#:~:text=Currently%2C%20equity%20compensation%20makes%20up,%2C%20down%207%25%20from%202019

[ii] https://www.irs.gov/taxtopics/tc427