Demystifying “Equity Compensation”

Jul 10, 2017

Does your employee incentive package include something called “equity compensation?” If so, congratulations! If all goes well, equity compensation can increase your personal net worth. What is it and how does it benefit you?

While equity compensation can be a valuable asset that impacts your personal bottom line, it is also one of the most misunderstood forms of earnings. Developing a savvy strategy for managing it is key to enjoying the full benefit of this perk. Here’s some info that can help.

Public and private companies, especially startups, often offer employees non-cash payment in the form of shares in the company. Giving ownership in the company is an incentive for employees to work harder so the business grows.

So what’s in it for you, the employee? As the company grows and prospers so does your net worth. But you shouldn’t just sit back and enjoy the ride. To maximize the advantage of this asset, you need to understand the basics about equity compensation and develop a strategy that works best for your needs.

Know What Flavor You’ve Got

All equity compensation is not the same. Each type has its own rules and tax consequences. It’s important to know the type of equity compensation that you’re being offered.

Stock Options. With stock options, you can buy shares of the company’s stock at a discounted or “set” price. The purchase price or exercise price is usually the price of the company’s stock on the day the options are granted. Typically there’s a waiting period before you are allowed to “exercise” the options. There’s also an expiration date. You may receive non-qualified stock options (NQSO) or incentive stock options (ISO). The type of options you own will impact the taxes you pay.

  • NQSOs are taxed when you decide to purchase the stock. You’ll pay ordinary income tax on the difference between the fair market value at the time of exercise and the exercise price. For example, if the current fair market value is $18 and you have the right to purchase the stock at $10 (exercise price), you will be taxed on the $8 at ordinary income tax rates.
  • ISOs are taxed when you sell the stock you received from the exercise. Depending on the length of time you hold the stock, long-term or short-term capital gains taxes will apply to the sale proceeds.

Restricted Stock. With this type of equity compensation, you receive shares of company stock, but you aren’t allowed to sell until predetermined restrictions lapse. If you leave the company prior to that time you may forfeit your shares of stock.

The value of restricted stock is typically taxed as ordinary income on the vesting date – the date the stock is yours to sell. If you sell on your vesting date, you won’t need to pay any additional tax liabilities. However, if you hold the shares, you’ll be taxed on any gains attained between the vesting date and the sale of the stock. Depending on the holding period, short-term or long-term capital gains tax will apply.

Do you anticipate the stock price will increase before your shares vest? If so, you may want to elect to pay taxes when your restricted shares are granted rather than waiting until they vest at a potentially higher value. To do this, submit a Section 83(b) election within 30 days of receiving the stock.

Stock Appreciation Rights (SARs). Similar to stock options, SARs allow you to benefit if the company’s stock price rises over a designated period of time. Assuming the stock price increases within the designated time frame, you’ll receive the value of the increase in either stock or cash without having any skin in the game. Let’s say you are granted 100 SARs and the stock price increases by $8 per share over a set period of time. You’ll receive $800 – the value of the appreciation of 100 SARs at $8 per share. That $800 will be taxed at ordinary income tax rates.

Create a Proactive Plan

If your employer provides equity compensation, talk with your financial advisor about the best strategy for managing it. A large bonus awarded in stock options, restricted stock, or SARs can have a significant impact on your taxes as well as your investment portfolio. Working with your financial advisor, the tax impact can be planned for and your portfolio’s diversification can be maintained.

Summary

Equity compensation isn’t a traditional income stream, but it doesn’t have to be confusing. Understanding how your equity compensation plan works and coordinating it with your overall investment strategy will move you closer to your financial goals.

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