THE DUFF TORNEY TEAM

Wesley Sebacher, CFP®

For many professionals, compensation becomes increasingly more sophisticated. And without the proper planning, it’s easy for anyone to misunderstand the tax implications and what actions to take with their equity compensation. It is becoming commonplace for professionals to be incentivized with equity compensation, such as stock, grants, options, or the right to purchase stock of the employer. 

This can be a great value add for an employee and allows companies more flexibility in the way employees are compensated. As employees continue to work for these companies, equity compensation incentives allow an employee to participate in the potential upside and growth of the business. 

It is essential that you understand how these forms of compensation function and what their tax implications are. These elements should be considered when developing a sound financial plan as you work towards your financial independence.  

Here are some of the common forms of equity compensation, their characteristics, and taxability:  

Restricted Stock Awards (RSA)

Stock awarded by your company, often in the form of a bonus or additional compensation. Restricted stock is typically subject to a vesting schedule, which can take place over several years. Any unvested stock is subject to forfeiture if you leave the company before the shares vest.  

Taxability: Restricted stock shares are treated as income in the tax year they vest (unless a Section 83(b) election was filed), and you will pay ordinary income tax on their market value on that day minus the amount paid for the shares, if any. When you sell your shares, you will pay capital gains tax on the appreciation since vesting at either the short- or long-term capital gains rate, depending on how long you’ve held the shares. If a Section 83(b) election was filed, the market value of the shares at the time of the grant, minus the amount paid for the shares (if any), is included in ordinary income at the time of the grant. When the shares vest, no tax is due until the shares are sold, even if the shares have changed in value. Any appreciation since grant will usually be taxed at long-term capital gains rates since the holding period begins at the grant date. There are pros and cons to a Section 83(b) election that should be considered at the time of the grant. 

Restricted Stock Unit Grants (RSU)

RSUs are grants valued in terms of company stock, but no actual stock is issued at the time of the grant.  After you meet certain vesting requirements, the company distributes shares (or the cash equivalent of the number of shares used to value the unit) to you. RSUs are not eligible for a Section 83(b) election at grant. 

Taxability: RSUs are treated as taxable income in the tax year that they vest, and the shares are delivered. You will pay ordinary income tax on the market value of the shares at vesting. When you sell the shares, any gains above that market value at vesting and delivery will be treated as capital gains and taxed at either short- or long-term capital gains rate depending on how long you held the stock. Some plans do not have vesting and delivery occur at the same time. In this case, you owe Social Security and Medicare taxes at vesting but do not owe income taxes until delivery. 

Performance Share Units (PSU)

Stock (or equivalent value) awarded by your company only if company-wide performance metrics are met, which ties the interest of the unit holder with the interest of shareholders. Upon meeting the performance criteria, company shares will be vested to you in accordance with the terms of the PSU grant. 

Taxability: PSUs are not taxable upon the initial grant of the unit. The units will be taxable when the shares vest, upon meeting the performance criteria provided with the granting of the PSU. Upon receipt of the shares, ordinary income tax will be due on the fair market value (FMV) at the time of vest. Upon the sale of any shares, either short- or long-term capital gains tax will be due on the difference between the FMV at vesting and the sale price. 

Incentive Stock Options (ISO)

Incentive stock options are a grant or award given by an employer with the option to buy company stock at an “exercise price”. Options can be exercised when you meet your company’s vesting schedule or holding requirements. If you do not have the funds to exercise (purchase) your shares, employers will often allow a “same day” or “cashless” exercise. This transaction allows you to buy and sell the stock immediately, allowing the proceeds to cover the cost of the shares. ISOs are a special type of stock options that qualify for favorable tax treatment if certain criteria are met. 

Taxability: If shares are exercised and sold immediately, they do not qualify for the special treatment and the difference between the grant price and sales price will be treated as ordinary income. ISOs can be advantageous for tax purposes if certain criteria are met. One requirement relates to the waiting period before you can sell the shares received from the options. You cannot dispose of the stock within two years after the ISO is granted or within one year after the shares are transferred to you. If you meet all the requirements, the entire gain (the difference between the exercise price and the current fair market value) will be taxed as a long-term capital gain rather than ordinary income. This can allow for significant savings, as long-term capital gains rates are lower than ordinary income tax rates. However, although there is no income for regular tax purposes at exercise, if the shares are not sold in the year of exercise, there is an adjustment for the alternative minimum tax (AMT) at exercise. This could result in an AMT liability, which may or may not be recovered in a future year with an AMT credit. This is another area where planning can be considered. 

Non-Qualified Stock Options (NSO)

Similar to ISOs, they allow you to buy company stock at a predetermined exercise price. You can exercise your options when you meet your company’s vesting schedule. NSOs, however, do not provide the favorable tax treatment of ISOs.  

Taxability: You will pay ordinary income taxes on the difference between the exercise price and the market price when you exercise the options. This amount is reported as W-2 compensation even if you don’t sell your shares. When you eventually sell the shares, any appreciation above the market price at exercise will be subject to either short- or long-term capital gains tax, depending on how long you held the stock.  

Employee Stock Purchase Plan (ESPP)

A voluntary plan that allows employees to purchase company stock at a discounted price (no less than 85% of the fair market value – up to a 15% discount). Payroll deductions are typically accumulated over a purchase period to acquire stock from the company. Most employers offer a window of time where employees can elect to participate in the plan. There is an IRS cap of $25,000 per year for investment in ESPPs. 

Taxability: Stock purchased through a qualifying plan typically comes with favorable tax treatment. There is no income tax owed until the stock is sold at a gain. If you hold the position at least two years after the option grant and over one year from purchase, the sale is considered a qualified disposition and the ordinary income portion of the gain is limited to the discount received below the grant date price and the remaining portion of your gains will be subject to long-term capital gains tax rates. However, if you do not meet this holding period, the difference between the fair market value at purchase and the purchase price would be subject to ordinary income taxes rates and only the gain above the fair market value at purchase would be eligible for capital gains treatment, which would be less favorable.  

Questions?

You may find yourself overwhelmed with the different types of equity compensation and how it ties into your financial plan. A qualified financial professional can help better understand your situation and devise a plan to best manage your equity compensation. 

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