Congratulations! If you’re reading this article you’ve likely been offered some form of equity compensation. Perhaps as a new employee, business partner, or the like. While this compensation isn’t as straightforward as a simple number on a check, they can be equally, if not more, lucrative.
Early in our careers our compensation packages are usually straightforward: we receive a salary, maybe a bonus and hopefully nice benefits like health insurance and a 401k plan to save into. Then, as we gain experience, successfully progress through our organizations, or are courted by new companies, we often run into a new form of compensation: Company Stock!
This new form of compensation is exciting! And confusing. Maybe even a little daunting?
We suddenly encounter an alphabet soup of new terminology…ESPP, RSU, NQSO, ISO, AMT, vest, grant etc. As it turns out, receiving company stock as compensation is not always as straightforward as the cash salary and bonus we are used to.
But fear not! This guide will break down the ABC (and D’s) of company stock compensation.
The types of company stock compensation we will review are:
Restricted Stock Units (RSU)
Non-Qualified Stock Options (NQSO)
Incentive Stock Option (ISO)
Employee Stock Purchase Plan (ESPP)
For each type of stock compensation we will cover the ABC and D’s:
(A)dvantage: What is exciting about this form of stock compensation? What can potentially make it more beneficial than a cash bonus or other form of stock compensation?
Tax (B)ill: Unfortunately, with this new compensation also comes new tax consequences. What are the potential tax consequences of each type of compensation?
(C)omplexity: Since company stock compensation is not as simple as cash, we’ll get an idea of how complex one type is compared to another.
(D)ecision: Each type of equity compensation comes with decisions you need to make. Reviewing these decisions will help you feel educated and in control of your company stock compensation.
Let’s dive in!
Restricted Stock Units (RSU)
RSUs are a common form of stock compensation in well-established companies whose stock is publicly traded. With RSUs your employer will grant you a certain number of shares that vest over a specific period, typically 1 – 5 years. Once the shares vest to you, you are free to either sell them and use the proceeds or continue to hold them.
RSUs allow you to participate in the appreciation of company stock price. Of course, a potential downside is you also participate in the decline of the company stock price.
Compared to options like NQSOs and ISOs, RSUs are also easy to understand.
There are two tax consequences to consider with RSUs. You are not taxed when shares are granted to you. Instead, shares are taxed when they vest to you. The market value of the shares is taxed as ordinary income when they vest. It is common for your company to withhold a certain number of vested shares to “pay” these income taxes. Keep in mind that the shares withheld may not cover the entire tax bill you will ultimately owe.
The second tax consequence comes if you decide to hold the shares after they vest and sell them later. In that scenario, any gains you have between the vest date and sale date will be taxed as capital gains. If you do hold shares, you will want to pay attention to how long you hold them for. If you sell less than 1 year from the vest date, any gains would be considered short term capital gains which is taxed at your ordinary income rate. If shares are held for longer than 1 year, gains are considered long term and taxed at the capital gains rate, which is generally lower than your ordinary income rate.
RSUs are generally the simplest form of company stock compensation. Shares are granted, shares vest and then they are yours!
Even though they are simple, RSUs involve several decisions.
Once shares vest to you, it is up to you to decide whether you will sell the shares or hold onto them.
You should consider how much company stock you are willing to hold relative to your other assets. This is known as concentration. It is especially important when considered in the context of stock from the same company that writes your paychecks and will provide you more shares in the future. A significant concentration, which can form if you continue to hold your shares, can present a lot of risk.
A good rule of thumb is for your company stock to comprise no more than 10% of your liquid net worth.
To help avoid a concentration, as well as have a systematic discipline of when you sell shares, a common approach is to sell shares as soon as they vest to you.
One more decision is whether to remain with your company until all shares are vested, or to leave shares on the table by switching jobs before they vest. Ideally, if you are considering a change, unvested shares can be used as leverage when negotiating compensation with a new employer.
Non-Qualified Stock Options (NQSO)
Now we turn the discussion to Stock Options. As the name implies, this type of compensation presents you with a choice, also known as an option. You have the “option” to purchase shares granted to you. There are 2 main types of stock options to review: Non-Qualified and Incentive.
The main advantage of a NQSO is the opportunity to purchase company shares at a pre-determined price. The reason you would choose to purchase the shares is because the pre-determined price you can purchase shares for is less than the current market value. For example, you may have the “option” to purchase your company’s shares at $50 per share while everyone else has to buy them via the stock market at a price of $75 per share. Effectively, your company is offering you a discount on its shares.
Like other types of stock compensation, NQSOs allow you to participate in the appreciation of the company stock price. However, the “option” to purchase the stock or not actually reduces the risk you have. If the company stock price declines below your pre-determined purchase price, you would simply not purchase the shares. Of course, there is still the risk that you purchase the shares, hold onto them and experience a price decline.
Your NQSO will not be taxed at the time of grant or at the time of vest. Instead, they are taxed when you exercise your option (aka make a decision) to purchase vested shares. At the time of purchase (also known as exercise), the difference between what you purchased shares for and the market value of the shares will be taxed as ordinary income.
For example, if you exercise the option to purchase 10 shares at $25 per share your total purchase price is $250. If those 10 shares are worth $100 each at the time, your total market value is $1,000. You will owe ordinary income taxes on the $750 difference between market value and purchase price.
Similar to RSUs, if you continue to hold the shares beyond when you exercise, you would also have capital gains taxes on any additional gains once the shares are eventually sold.
NQSO’s are more complex then RSUs, but not as complex as ISO’s (more on those shortly). The added complexity comes from the decision of whether to exercise, as well as what funds you will use to purchase the shares.
Your main decision with a NQSO is whether to exercise your option and when. One approach is to exercise shares when they vest, assuming they are “in the money” meaning you can purchase the shares for less than the current market value. This approach gives you a systematic, disciplined exercise and sell process. It also helps to avoid having a significant concentration.
When exercising the option you’ll need to decide what funds you will use to purchase the shares. Some companies will allow you to exercise the shares without having to put up your own money, which is known as a “cashless exercise”. In that scenario you would receive the exercised shares, minus the cost to exercise. Assuming that is not an option, you’ll need to plan for how much it will cost you to purchase the shares (even if you plan to turn around and immediately sell them.)
One last thing to watch for with stock options is an expiration date. It is common for options to expire ten years after they are granted. If you want to exercise the options, you will need to do so prior to their expiration date. If you reach the expiration date and the current market value of the stock is less than the price you can purchase it for, letting the options expire makes the most sense.
Incentive Stock Option (ISO)
Much like NQSOs, ISOs offer the opportunity to purchase shares below the current market value. It is common for start-up companies to offer ISOs, so sometimes there is the opportunity to purchase shares at super low costs. The flip side is these companies are typically still private, meaning there is no liquidity available to turn around and sell the shares immediately. So while you may have options worth some amount of money on paper, there may be no way to sell them and actually generate cash.
ISOs do offer another advantage over NQSOs, which is the potential for a more favorable tax treatment. Read on to learn more about that.
ISOs have the potential to be taxed in a couple ways. The first is known as Non-Qualified Disposition. All this means is they are taxed exactly like NQSOs – the difference between purchase price and market value are taxed as ordinary income. The other is known as Qualified Disposition. This is where the tax advantage of ISOs comes into play. When sold with a Qualified Disposition, ISOs are taxed at capital gains rates instead of ordinary income. How is an ISO Non-Qualified or Qualified Disposition? It depends on how long you held the shares for.
More specifically, if you held your ISOs 2 years from the date of grant AND 1 year from the date of purchase, then they are considered Qualified Disposition. If you exercise and sell ISOs either within 2 years of grant, or within 1 year of purchase (or both), then they are considered Non-Qualified Disposition. An example will help illustrate this.
Your company grants you ISOs on January 1, 2021 that will vest to you in one year. You need to consider two dates if you are trying to achieve Qualified Disposition. Two years from grant date would be January 1, 2023. If we assume that you purchase shares as soon as they vest to you on January 1, 2022, then you would need to hold them until at least January 1, 2023 to meet the two year from grant and one year from purchase requirement.
If instead you waited to purchase shares until June 1, 2022, then you would have to wait until at least June 1, 2023 to sell in order to receive Qualifying Disposition. But wait, there’s more.
With the potential for more favorable tax treatment comes the potential for a different tax. If you exercise your shares, but do not sell them in the year of exercise (presumably holding out for the Qualified Disposition), then you will potentially by subject to Alternative Minimum Tax (AMT). Think about the example of purchasing shares in January or June of 2022, but not selling the shares until January or June of 2023. Another situation where this could occur is if your company is private and has no liquid market to sell shares. You might purchase shares years before you are able to sell them.
Discussion on AMT is beyond the scope of this guide. The important takeaway here is that AMT is complex enough to require working with a tax professional. Before exercising any ISOs it is wise to consult a tax professional to get a full understanding of how ISOs might impact your tax situation and if AMT might be an issue for you.
Because of their varying tax treatment and typically illiquid nature, ISOs are the most complex type of equity compensation.
The decisions you make around ISOs can be challenging. Like NQSOs, you decide when to exercise, when to sell and where you will access funds for exercising shares. These decisions are often more challenging with ISOs because you consider whether there is liquidity available for the shares you exercise, as well as if AMT will play a factor if you exercise and hold.
There are a couple common approaches you might consider. First, some people like to exercise their shares early and often. This is especially common with startup companies that have a very low exercise price. The reason this approach can make sense is exercising shares as they become available starts the clock on the 2 year from grant, 1 year from purchase holding period. This strategy also spreads the cost of exercising the shares over time, as opposed to requiring a lump sum cost.
Three challenges that come with this approach are liquidity, concentration, and the potential for AMT. If you work for an early-stage startup company and exercise your shares it is likely that you don’t know when a liquidity event, such as an IPO or acquisition, will occur. It may be years before you are able to sell your shares. There is also the chance that the value of your company shares declines overtime. When there is no liquid market for the shares, there may be a higher chance of becoming super concentrated in your company stock. Finally, exercising and holding shares brings the potential for AMT tax.
Another approach is to start exercising shares once a liquidity event becomes more evident. For example, if your company files to go public in the next 6 months to a year you might consider exercising shares. This again starts the clock on the holding period requirements but may allow for a clearer exit strategy. Of course, you may not always be aware of a forthcoming liquidity event. In the event of your company being acquired by another company, vested shares are commonly purchased by the new company at a negotiated price. In that situation you typically do not have the opportunity to plan ahead and exercise shares.
At the end of the day, it is important to consult with a financial advisor and tax professional on what approach makes the most sense for your personal situation.
Employee Stock Purchase Plan (ESPP)
The final form of company stock compensation we will review is an Employee Stock Purchase Plan or ESPP. This plan differs from RSUs and stock options because shares are not granted to employees. Instead, they offered the opportunity to participate in buying company shares.
The main advantage with ESPP plans is they offer employees the opportunity to purchase company stock at a discounted price. The discount varies by plan but is commonly in the 10 – 15% range. This allows for the potential to participate in the appreciation of the company stock price while purchasing the shares below the current market price.
When you purchase shares through an ESPP plan, the discount you were given will always be taxed as ordinary income once you sell your shares. For example, if your company offers a 10% discount to current market value, when you sell the shares the benefit of the 10% discount will be taxed as ordinary income.
If there has been any further appreciation in the stock price since you purchased the shares, then you also have capital gains tax to consider. Similar to ISOs, there is a specific holding period to be aware of. If you hold your shares 2 years from the offering date AND 1 year from the purchase date, then the shares are considered qualified. The gains from a qualified share are taxed as long-term capital gains. Remember that the original discount is still taxed as ordinary income, however.
ESPP plans are fairly complex due to their tax treatment, but not quite as difficult to manage as ISOs.
The decisions with ESPPs are similar to the other types of company stock compensation reviewed. You have to decide when to sell the shares, as well as how much of a concentration you are comfortable with. One approach to deciding when to sell is to sell as soon as the shares are purchased. Even though the discount is then taxed as ordinary income, you still have a positive net return by way of the original discount. This assumes the stock price has not dropped below the discount level at time of sale. This approach also helps avoid a concentration forming by systematically diversifying the ESPP shares.
In addition, you decide how much you are willing to contribute to purchasing company shares. Once you decide how much you want to contribute, that amount is taken from your paycheck during the offering period and applied toward purchasing the discounted company stock. There is a limit on how much you are allowed to contribute to purchasing discounted company stock in one year. For 2021, the limit is $25,000.
Equity compensation can be one of the most powerful wealth building benefits that employees receive from their company. To get the most from your company stock compensation, it is important to understand the ABC (and D’s). Working with a financial advisor and tax professional can help you better understand and plan for how to handle your company stock.
We hope this guide helped give a better understanding of the various forms of company stock compensation. Now that you have the basics down, it is time to implement a process for handling your shares (insert link to process guide, not yet created)
If you have questions, or would like to review your personal situation in more detail, please feel free to reach out.
Hello! I am Danny Kellogg, an LPL Financial Advisor with Prosperion Financial Advisors. The best part about my job is using my experience and education to help clients discover how their financial resources can serve them. To deepen my knowledge and demonstrate my dedication to serving clients at the highest level, I became a CERTIFIED FINANCIAL PLANNER® and Retirement Income Certified Professional®. My wife Elizabeth and I are both proud Colorado natives. We live in Centennial, CO with our daughter Libby and golden retriever Aggie. I am an avid Colorado sports fan who enjoys cheering on the Rockies, Broncos, Avalanche, Nuggets and Colorado State University Rams. When I am not helping clients, I enjoy spending time with my family and playing golf.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
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