Understanding the Most Common Types of Employee Equity Compensation Plans
What You Need to Know About These Valuable, Complex Benefits
Equity compensation can be an incredibly valuable employee benefit, but it can also be a complex subject matter to get your arms around. Not only are there multiple types of equity compensation, but each has unique characteristics you should keep in mind in order to maximize its value.
Below, we’ll discuss the most common types of equity compensation and dig into the potential challenges and unique benefits of each one so that you can make smart decisions for your financial situation – and avoid costly mistakes, too.
When most people think of equity compensation, it’s stock options that come to mind. They are an incredibly popular type of employee equity compensation, and they give employees the right to purchase a stated number of company stock shares at a fixed price. Companies can offer two different types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs). It’s important to know which type you’ve been granted, as their tax treatment differs in important ways.
Most often, an employee must work at the company for a certain number of years before they can exercise their stock options. This is referred to as the vesting period, and employees will forfeit their stock options if they leave company employment prior to vesting.
It’s important to note that stock options can expire, too. Employees typically have ten years from the grant date to exercise their stock options, and it’s important to be strategic about when you choose to exercise them. That’s because the purchase price is usually the stock’s price on the grant date, and the options only become valuable if the stock price increases after that date, thereby creating a discount between the market price and the employee’s lower purchase price.
Ultimately, any value in stock options is theoretical until an employee exercises them. This is why the phrase “you’re only rich on paper” has become a common refrain.
Employee Stock Purchase Programs (ESPPs)
Employee Stock Purchase Programs are lesser-known than stock options, but they offer a valuable benefit to employees, too. In essence, ESPPs allow an employee to purchase company stock easily – and on favorable terms, too. They allow employees to purchase company stock at a discount from the market price – up to 15%, according to IRS regulations.
Here’s how they work:
There will be an offering period, during which the employee has the right to purchase company stock though deductions from each paycheck. There is also an offering date – the first day of this period – which is important for tax purposes The offering date acts as the date of grant and it’s used to determine how long you held the company stock before selling, assuming you choose to do so in the future. There will also be one or more purchase periods within the offering period, and your accumulated payroll deductions will buy shares of the company stock at the discounted price at the end of a purchase period.
ESPPs also offers a helpful “lookback feature” for pricing flexibility. For example, let’s say you have $500 deducted from your pay to invest at the end of the current purchase period. At the beginning of the purchase period, the share price was $10. However, it increased to $15 by the end of the purchase period. The lookback feature means that your price will be the company discount from the market price at either the beginning or the end of the purchase period, whichever is less.
Restricted Stock and Restricted Stock Units (RSUs)
These types of equity compensation offer less market risk because, unlike stock options, they can never lose all practical value. Restricted stock and RSUs are always worth something. They are termed “restricted” because they tend to be subject to a vesting schedule based on length of employment or, in some instances, performance goals.
Restricted stock is stock that has been granted and is subject to forfeiture under certain company conditions, such as termination. RSUs are not granted; they are simply a promise by the employer to grant a set number of shares once conditions are met.
With both of these types of equity compensation, employees are taxed at vesting. The fair market value of the shares counts as taxable income, but employers typically withhold at least a portion of your tax liability for you when vesting occurs. With restricted stock, the other option is a Section 83(b) Election, in which the IRS permits you to pay taxes at grant, rather than at vesting. If you have good reason to believe the stock value will increase before vesting, it’s a good bet to elect this option so you can benefit from paying taxes on the lower grant price. Note that this option is not available with RSUs.
Final Thoughts on Common Equity Compensation Plans
Equity compensation is becoming more common, meaning more employees must determine what they have and how to maximize the value of their benefits. If your employer offers an equity compensation plan and you’re unsure how to get the most out of it, reach out to us today. At Paces Ferry, we offer comprehensive financial planning services to fit your needs. We can help you create a strategy that is designed specifically to meet your goals.
Paces Ferry Wealth Advisors, LLC is a registered investment advisor with the U.S. Securities and Exchange Commission (“SEC”). This material is intended for informational purposes only. It should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney or tax advisor.