Equity Compensation: What is a Stock Option, Employee Stock Ownership Plan, Employee Stock Purchase Plan, and a Restricted Stock Unit?

Tuesday, Sep 07, 2021

In today’s day and age, many large, publicly traded companies are offering equity as compensation. This means that the employees have the option to use different stock programs to generate compensation for themselves. This also helps tie employees to the greater cause of growing the stock price of their respective company. These different programs can be confusing. Below is a summary of some of the common examples of equity compensation, including stock options, an employee stock ownership plan, an employee stock purchase plan, and restricted stock units. When involved in these programs, it is important to learn how to best use them as well as what the tax implications of your decisions may be.

Equity Compensation in a Nutshell

Equity compensation is a form of non-cash employee-payment. It may include stock options, ownership plans, performance shares, or restricted stock units representing ownership in the company the employee works for. Equity compensation is offered by many public companies, and even some private companies (especially start-ups).

Equity compensation is attractive to the companies offering it because the employees’ financial reward depends on the success of the company. Therefore, it is in the employees’ best interest to contribute to the best of their ability to the growth of the firm. It is a highly attractive option for start-ups as cash is not involved, so they can offer equity to highly skilled individuals in lieu of a higher salary. Equity compensation can also generate tax deductions and build better employee retention.

On the employee side of things, equity compensation can be a great financial decision if the company is doing well. It also doesn’t hold much risk in some cases and can provide tax benefits (more on that below). However, with this benefit, there is a chance that your stake in the company will never actually pay off. It is beneficial to receive a salary as well which covers your expenses so you have some certainty.

This article will cover a few of the forms of equity compensation including stock options, ESOPS, ESPPs, RSUs, and phantom stock (which isn’t technically a form of equity compensation, but holds similar benefits).

Stock Options

Stock options extend the right to employees to buy a certain amount of shares of the company’s stock at a pre-determined price known as the “strike” or “exercise” price. Typically, there is a waiting period before you may exercise the options. It is important to point out that you do not actually own the stock until you exercise the options! Stock options simply provide the right to purchase the stock- ownership is not granted until the options are exercised.

There are two major categories of stock options- incentive stock options (ISOs) and non-qualified stock options (NSOs). NSOs are the most common form, and receive relatively straightforward taxation. ISOs, on the other hand, are a bit more complicated. Read on for what makes ISOs and NSOs so different.

Incentive Stock Options vs Nonqualified Stock Options

ISOs may have significant tax benefits over NSOs, however it is a challenge to qualify for them and it is possible to not receive them at all. Here are some of the many differences between ISOs and NSOs:

  • While only employees of the firm can receive ISOs, both employees and independent contractors of the firms can receive NSOs.
  • ISOs have more favorable tax status than NSOs. With an ISO, if the stock is held for more than one year past exercise and two years past the grant date, the spread (difference between exercise and strike price) can be taxed as capital gain. Also, the tax is deferred until the sale of the stock. With and NSO, regardless of holding period, the spread is taxed as income at the time of exercise. The “post exercise” gain or loss will be taxed as capital gain or loss in either case.
  • If you exercise a large amount of ISOs in a year you may be subject to AMT and should consult a tax advisor prior to exercise.
  • ISOs must be exercised within 3 months of termination from the company (although this length of time may be extended in the case of death or disability). NSOs do not have a period limit so long as they are exercised prior to the expiration date of the stock options.
  • The maximum term of an ISO is ten years from the date the ISO was granted, or 5 years for ISOs held by shareholders who own more than 10% in the company. NSOs don’t have a maximum term, although they are commonly set at 10 years.
  • ISOs have an annual limitation of $100,000 worth of stock. There is no annual limitation on NSOs.
  • ISOs have special rules for stock holders owning over 10% of the firm while NSOs have none.

Employee Stock Ownership Plans (ESOPs)

Congress passed a law in 1974 which allowed an owner to sell a portion or all of their business to their employees, who, in turn, pay nothing. ESOPs are often used to align the interests of the employees with that of the company’s shareholders, as the benefit that comes out of ESOPs relies on the growth and success of the firm.

The company takes out a loan and then pays the owner the market value for the company. The benefit to doing this for the company is that they do not have to pay taxes on profits for the portion of the business owned by employees. The owner maintains control of the company, but hands some of the stake over to the employees. The employees benefit by gaining a positive financial future in the case the company continues to succeed.

ESOPs come in the form of tax-exempt trust funds. The company contributes new shares of its own stock into the fund, or uses cash to purchase existing shares. ESOPs can also borrow money to purchase new and existing shares. Once the employee retires, the company is required to repurchase the employee’s shares.

Pros and Cons

There are quite a few pros to holding ESOPs as an employee. First off, on the positive side, ESOPs can serve as a long-term benefit and can build you significant wealth if the shares appreciate over time. They are also known to boost employee morale as everyone in the company shares the same common goal of helping the company to grow and succeed. Because ESOPs come in the form of tax-exempt trusts, profits earned by the company stay with you- the employee! They also take less time to implement than a regular third-party sale, and allow for both instant and gradual ownership on the company.

That being said, ESOPs also face some downsides. ESOPs only pay fair market value for the shares held, while owners outside of the company may receive top dollar for their shares. ESOP companies require strong management in order to succeed. The fall of the company means the fall of share value. Also, because the company must repurchase the shares when an employee leaves or is terminated- they may face significant expenses if a handful of employees were to leave at once, which may create financial strain within the company.

Tax Implications

ESOPs receive a myriad of tax benefits- mostly benefitting the company. There are two employee benefits: One, you pay no tax on contributions. Two, it is also possible to roll the ESOP funds into an IRA and pay only capital gains tax on the gain portion if done correctly under Net Unrealized Appreciation rules. Be sure to consult a CPA to determine your eligibility.

Employee Stock Purchase Plans (ESPPs)

ESPPs are stock plans within a company which offer shares to employees at a discount to fair market value. This discount can reach up to 15% in some cases! A percentage of the employee’s paycheck (an amount which they elect themselves, typically 1-20%) is automatically deposited into their plan each pay period. Sometimes, the employer matches their contribution. At the end of the period, the company uses the money in their plan to purchase the stock at the determined discounted price.

The value of the stock can increase or decrease normally, so it is possible to see both gains and losses. Like you should with any kind of investment, it is important to keep your overall portfolio diverse.

Pros and Cons

ESPPs offer quite a few benefits. First off, if your company is successful during the ESPP period, you can realize large gains. For example, say at the start of the period- the company determines that you can buy the stock at 10% off market value- which is currently $50. You will buy the future stock for $45. But during the time you and your employer are contributing money to your plan, the stock price rises to $100. If you have $180 in your plan- you can buy 4 shares for less than the cost of 2! Sell them immediately, and you could see $220 in gains.

ESPPs also align your interests with that of your company. Focusing on the long-term rather than only being concerned about this week’s paycheck is said to boost employee morale, as everyone is working together for the benefit of the business.

ESPPs also have their risks. There is no guarantee that you will come out ahead by owning stock in your company. Let’s use the same example as before. At the start of the period, the company determines you can buy stock at 10% off the current market value, which is $50. You will buy the future shares for $45. But if the stock prices falls during the period to $40, it would actually be $5 cheaper per share to buy through the general market. So you are no longer purchasing the stocks at a discount.

ESPPs may also require a holding period in some cases, meaning you cannot sell the stock right away. If you believe the share value of your company is going to fall during this time, you could see losses.

Tax Implications

If you sell your ESPP stock immediately after it is purchased with your plan, you will be taxed as a short-term capital gain (income tax). If you hold the shares for longer than one year, the gains in the shares can be taxed more favorably as long-term capital gain.

Restricted Stock Units (RSUs)

RSUs are given to employees only after the RSU remains with the company for a certain length of time or hits a required performance goal. They may not be exercised (hence the term “restricted”) for periods that sometimes last several years, and may not be sold during this timeframe. The value of RSUs is considered income once the right to exercise becomes available.

Pros, Cons, Taxation

RSUs have one major upside for employees. There is no exercise price to purchase an RSU, only a vesting period. You “purchase” the shares with your time. RSUs are nearly always worth something to the employee, even when the company’s stock price drops. When the vesting period is complete, the company gives you the shares and you are taxed on the value as ordinary income. This could push you into a higher tax bracket, even if you hold the shares. Any gain after vesting will be subject to capital gains rules. You are able to sell the shares as you wish after vesting.

Phantom Stock

Although they are not technically a form of equity compensation, phantom stock options can achieve similar goals. A phantom stock plan is a contractual agreement between the company and employee. The company treats the employee as though they are a stockholder, but does not actually sell any stock (or give the option to purchase stock) to the employee. The employee receives phantom units whose value is tied to that of the overall company. Later, depending on how the agreement is written, this value is paid to the employee. Typically, the phantom stock would be paid over a 5 year period at retirement, death or disability. Think of phantom stock like an “I Owe You” from the company which is also going to be taxed as income upon receipt.

Pros and Cons

The pro for employees is that they get to participate in the growth of the business if the business is growing well. The downside is they do not get actual ownership in the business, but instead a cash payout based on the value of the business in the future.

Tax Implications

The cash paid to the employee is taxed as income. They are also subject to FICA and Medicare taxes.

With all of these acronyms, pros, cons, tax implications and more- your head may be swimming. If your company offers one or multiple of these equity compensation options, it is a good idea to review your options with your advisor before arriving at a decision of how to handle them.

 

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