Equity compensation continues to be a popular way to incentivize and reward employees. When a firm pays an employee with equity, the employee’s compensation becomes tied to the success of the company. The taxation of equity compensation can be extremely complex. We wanted to provide a brief and general taxation overview of common types of compensation and planning ideas to consider.
There are several types of stock options with different tax implications. The most common are Incentive Stock Options (ISO), Restricted Stock Units (RSU), Nonqualified Stock Options (NSO), and Employee Stock Purchase Plans (ESPP). We have compiled a brief summary of these options and their tax implications below.
Key Terms
For any type of option, there are a few important components to know about each holding:
- Grant Date: This is the date the option is granted or given to employee.
- Vest Date or Vest Schedule: These are the dates when the employee can purchase stock using the option and restrictions removed.
- Exercise date: This is the date the employee elects to purchase stock using the option.
- Exercise Price: The cost to exercise the stock option and purchase the stock.
- Expiration Date: The date by which the option expires.
Nonqualified Stock Options (NSO) – NSOs can be issued to both employees and nonemployees. The exercise of NSOs results in ordinary income. Income is generally calculated to be the difference between the fair market value of the stock at exercise date and the exercise price of the stock. Any appreciation beyond the fair market value of the stock upon exercise may be eligible for capital gains treatment.
Incentive Stock Option (ISO) – There are differing tax treatments for regular and alternative minimum tax (AMT) purposes upon exercise of ISOs depending on a variety of factors. The exercise of an ISO is a non-taxable event for regular tax, but it triggers income for AMT, which is calculated to be the difference between the fair market value of the stock at exercise date and the exercise price of the stock. While sale of stock generally results in capital gain treatment similar to NSOs, there are additional restrictions in terms of the timing of the sale. For example, if stock is not held for at least 2 years from grant and one year from exercise, gains will be taxed as ordinary income.
Restricted Stock Unit (RSU) – RSUs are generally issued to employees, advisors, and board members. Tax typically occurs upon two events: 1) vesting of the units, and 2) the ability to liquidate the shares. The income is generally reported as additional compensation income. Any appreciation beyond the fair market value of the stock at the time of income recognition is eligible for capital gain treatment with the holding period starting with the date of income recognition.
Employee Stock Purchase Plan (ESPP) – This plan allows an employee to purchase stock from their employer for an agreed upon price. There are various types of ESPPs that result in different tax consequences. For most plans, a mix of ordinary and capital gain income is recognized at sale. In addition, there are also holding period restrictions on ESPP shares, which may result in a greater mix of ordinary versus capital gain income.
Below is a general chart summarizing the tax effects of the various types of compensation:
In addition to the complexities related to the tax treatment of the various equity compensation categories, there are numerous tax planning opportunities to consider when buying and selling stock. You may want to consider the following tax planning strategies:
- Filing an 83(b) election, which can minimize ordinary income taxation and maximize capital gains treatment.
- Reviewing and modeling the mix and timing of various types of stock options to minimize the tax impact upon exercise.
- Assessing Qualified Small Business Stock (QSBS) treatment. If the company stock is eligible for qualified small business treatment, we may consider additional planning strategies to maximize the benefits.
Planning related to equity compensation can be extraordinarily complex. We encourage you to contact us to discuss the best ways to report your equity compensation.