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Equity Compensation Taxation Strategies: The Different Types Of Plans And How To Manage Taxes

Updated: Sep 24, 2023

Equity compensation has become an increasingly popular form of employee benefits and incentives in recent years. Offering employees a stake in the company’s success can boost motivation, improve retention, and align workers’ interests with the company’s goals.


But equity compensation can also seem complicated, especially for employees who are new to it. Different types of equity awards have different tax implications, vesting schedules, and value propositions. It’s important to understand the pros and cons of various equity awards before signing on the dotted line. Having an understanding of the nuances will empower you to make strategic choices when utilizing equity compensation taxation strategies.


In this post, we’ll provide an in-depth look at the most common types of equity compensation and how they work:



We’ll also share tips to minimize your tax burden, companies that offer great equity packages, frequently asked questions, and more. Whether you already receive equity compensation or are considering a job offer that includes it, read on to learn how to make the most of this valuable employee benefit.


What is Equity Compensation?


Equity compensation gives employees an ownership interest in the company, represented by shares of stock or stock options. It has a few major benefits:


  • Motivates employees to increase company value. Employees with a stake in the company's success have an incentive to work hard and contribute to growth.

  • Aligns employee and employer interests. Equity compensation gets employees invested in company performance just like shareholders.

  • Provides a sense of ownership. Equity gives employees a tangible connection to the company's purpose and identity.

  • Offers tax advantages. Certain types of equity get preferential tax treatment compared to cash compensation.

  • Retains talent. Equity compensation usually vests over a period of time, incentivizing employees to stay.


Companies offer equity as part of compensation packages to attract top talent, especially for competitive roles like executives, engineers, and product managers. Equity is also commonly used in startup environments as a way of compensating employees in fast-growing companies that aren't yet profitable.


While equity is a great perk, it is risky compared to cash compensation. The value depends on the company's share price, which can go up or down. Employees shouldn't count on stock as guaranteed income. However, equity offers the potential for wealth if the company succeeds. It links employee pay with company growth and performance.





The Three Common Types of Equity Compensation


Now let’s take a look at the different forms of equity compensation companies offer employees:


Incentive Stock Options (ISOs)


Incentive stock options (ISOs) allow you to buy company stock at a discounted price in the future. The company sets a strike price equal to the current market value when the options are granted. You can then exercise your ISOs to buy shares at the locked-in strike price anytime the market value rises above that price within the 1-10-year expiration period. The key benefit is you profit from the gain between the strike price and market price without laying out cash upfront.


ISOs receive preferential tax treatment if you hold the stock for 1+ years after exercise and 2+ years after grant. At that point, any gains are taxed at the long-term capital gains rate when you sell, as opposed to ordinary income tax rates. The tradeoff is ISOs come with eligibility requirements - you must be an employee, receive under $100K in ISOs per year, and hold the options for no more than 10 years. ISOs reward long-term employees with the ability to profit from stock gains in a tax-efficient manner. Consult a tax advisor to maximize the tax benefits.


Restricted Stock Units (RSUs)


Restricted stock units represent shares of company stock that vest over time. The company grants you RSUs, and you actually receive the shares once the units vest according to a vesting schedule, often over 3-5 years.


RSUs provide guaranteed value because you earn shares no matter what happens to the stock price. The downside is you owe taxes on RSUs as they vest, even if you don't sell the shares. Still, RSUs offer lower risk than stock options, making them more appealing to some employees.


RSUs are often subject to the same vesting conditions as stock options, with a "cliff vest" after the first year followed by monthly or quarterly vesting. Some companies allow employees to defer receipt of RSU shares beyond the vesting date to give them more flexibility in managing taxes.


Employee Stock Purchase Plans (ESPPs)


Employee stock purchase plans let you regularly buy company stock at a discount, often 5-15% below market value. Here’s how they work:


  • Your company will establish 2-24 month offering periods for the ESPP.

  • At the start of each period, you decide what percentage of your paycheck you want to contribute, up to a maximum amount set by the IRS ($25,000 worth of stock annually).

  • On the purchase date at the end of the offering period, your accumulated contributions are used to buy shares at the discounted price.

  • You can immediately sell those shares at the market price and pocket the discount. Or you can hold the shares in your account.


ESPPs have enrollment periods before each offering period. The frequent enrollment and purchase periods make ESPPs low risk because you’re buying at regular intervals, avoiding timing risks. The mandatory holding period also makes ESPP shares a long-term capital gain when sold after disposition.



Aspect

ISOs

RSUs

ESPPs

Grant Taxation

No immediate tax at grant

No immediate tax at grant

No immediate tax at grant

Vesting Taxation

No immediate tax at vesting

Taxed at vesting based on fair market value of stock received

No immediate tax when eligible to purchase

Sale Taxation

Potential for favorable long-term capital gains tax rates if holding period requirements are met

Taxed as ordinary income at vesting (unless a Section 83(b) election is made)

May have capital gains tax if holding period is met

Holding Period Requirement

Must hold for at least 1 year from the date of exercise and 2 years from the grant date to qualify for long-term capital gains rates

No specific holding period requirement for tax purposes

May have holding period requirements for favorable tax treatment

Alternative Minimum Tax (AMT)

May trigger AMT depending on the spread at exercise

Not applicable

Not applicable

Dividend Rights

No dividend rights until you exercise

May have voting rights as an RSU holder

Typically no voting rights

Withholding

No withholding at exercise

Withholding at vesting, similar to regular paycheck withholding

Withholding at purchase, similar to regular paycheck withholding



Two More Types Of Equity Comp Plans Usually Reserved For Executives


Stock appreciation rights (SARs) and Phantom stock are not as commonly offered as other types of equity compensation plans like ISOs, RSUs, and ESPPs. Here are some key points on their prevalence:


Stock Appreciation Rights (SARs)


Stock appreciation rights give you the right to receive cash or stock equal to the appreciation of company shares from the grant date to the exercise date. SARs are like stock options without having to put up cash to exercise. This type of benefit is sometimes included as part of an executive compensation package as an additional perk, but they are rarely the primary equity vehicle.


For example, say you are granted 500 SARs with a $20 grant price, and the share price rises to $35. You could exercise your SARs and receive 500 shares worth $35 each, or $17,500 in cash. You profit from the $15 increase in stock price without laying out any money.


SARs don’t require an upfront tax payment like options so you can defer taxation until exercise. Some employers settle SARs in cash instead of shares to give employees more flexibility in managing taxes.


Phantom Stock


Phantom stock ties incentive amounts to company share value without granting actual equity. Your employer sets a number of hypothetical "phantom shares" and assigns a cash value per share which tracks the actual stock price.


As share value rises, the cash value of your phantom stock increases. You receive payouts based on that appreciated value, either during employment or after reaching time and performance milestones. Some phantom stock programs make payouts annually based on the share price exceeding set targets.


Phantom stock doesn't confer ownership rights - it's merely a cash bonus pegged to company equity. But it provides equity-like incentives without diluting company ownership. Employees don't have to pay taxes until cashing out phantom stock.


Strategies To Minimize Taxion On Equity Compensation


Equity compensation often receives preferential tax treatment compared to salary. However, smart planning is required to maximize tax savings. Here are some tips for minimizing your tax bill:


  • Exercise incentive stock options (ISOs) strategically. ISOs receive highly favorable tax treatment if held for 1+ years from exercise and 2+ years from grant. Carefully plan exercise timing to meet holding periods.

  • Delay RSU conversion. You can defer receipt of RSU shares up to 5 years after vesting to control your income flow. Deferring helps avoid bumping you into a higher tax bracket.

  • Hold ESPP shares for 1+ years. ESPP shares held for 1+ years qualify for long-term capital gains tax rates instead of ordinary income rates.

  • File 83(b) elections for restricted stock. Filing this election treats restricted stock as ordinary income when granted, rather than when it vests. This prevents larger tax bills as company value grows.

  • Diversify your portfolio. Don't hold too much of your net worth in your own employer's stock. Diversify by selling shares periodically.

  • Hire a tax expert. CPAs and financial advisors can help you maximize tax efficiency through careful planning around equity compensation. Their fees may be deductible.

  • Understand state taxes. Some states like California and New York impose extra taxes on equity compensation. Factor this into your financial planning.

  • Implementing a covered call strategy involves selling call options on highly appreciated stock, the income generated can be used to pay taxes on capital gains taxes when the stock is sold.

  • Tax loss harvesting involves strategically selling investments that have incurred losses to offset capital gains from highly appreciated stock, thereby reducing the overall capital gains tax liability by leveraging the losses to offset gains in a given tax year.


Equity Compensation Vesting Schedules


Most equity compensation follows vesting schedules that dictate when you take full ownership of shares. Typical vesting occurs over 4 years with a 1-year cliff before initial vesting begins.


For example, you may receive a grant of 4,000 stock options that vests as follows:


  • 0 options vest in year 1

  • 1,000 options vest at the start of year 2 (1-year cliff)

  • 25% of the remaining 3,000 options vest each quarter over years 2-4


This means you would be fully vested in all 4,000 options after 4 years of employment, receiving 1,000 new vested options each subsequent quarter. If you leave before the cliff, you forfeit the entire grant.


Some companies allow early exercise of options before vesting. But you have to pay the strike price up front for unvested shares, and you'll have to repurchase them at the grant price if you quit before vesting. Early exercise involves financial risks you should carefully consider.


Important Equity Compensation Concepts


Here are some key things to know about equity compensation:


  • Vesting - The process by which you take full ownership of equity compensation over time. Vesting keeps you at the company.

  • Cliffs - Vesting delays during the first year (typically) of an award to incentivize you to stay past the initial period.

  • Grants vs. exercised shares - Granted shares represent the full amount you could earn. Exercised shares are the vested portion you choose to take ownership of.

  • Striking price - The at-grant market price of stock options, used as the purchase price to buy shares upon exercise.

  • Underwater - When stock value drops below the strike price, options are "underwater" and worthless if exercised.

  • Expiration - Equity compensation expires after a set period from the grant, typically 7-10 years. You lose any unexercised shares after expiration.

  • Dilution - Granting equity compensation dilutes share value by increasing the number of outstanding shares. Companies limit dilution with repurchase programs.


These concepts govern when you can exercise equity compensation and how much it will be worth. Understanding these terms helps ensure you use equity compensation optimally.





Evaluating Equity Compensation Packages


Equity can make up a significant portion of total compensation for private and public company employees. When negotiating job offers, pay close attention to the equity component. Here are some things to analyze:


  • Percentage of overall compensation - Industry standards range from 10-50% or more for senior roles. Evaluate if equity aligns with market norms.

  • Vesting schedule - Faster vesting gives you more upside sooner. Look for short cliffs and vesting durations.

  • Number of shares - Compare grant amounts to your role level and company stage. More growth potential equals more equity upside.

  • Strike price vs. current value - Options with strike prices below the current stock value provide instant profitability.

  • Company growth trajectory - Evaluate historical and projected revenue/profit growth to gauge future stock appreciation.


Discussing equity compensation details upfront ensures you understand the real value of job offers and how equity incentives align with your wealth-building goals. Don't leave money on the table due to lack of knowledge!


Top Companies Offering Equity Compensation


These leading technology companies are known for rewarding employees with sizable equity compensation packages:


  • Facebook - Strong performance has sent its stock surging, massively boosting the value of employee equity awards. Software engineering is the key role to target for big equity grants.

  • Google - Generous sign-on equity grants for engineering and product management roles can reach $300K or higher. Google is a long-term winner for growing equity value.

  • Microsoft - Knocking it out of the park with cloud services, Microsoft offers fantastic equity upside, especially for roles in Azure, Office 365, and AI.

  • Amazon - With tremendous market dominance across e-commerce and cloud computing, Amazon doles out mouthwatering equity packages. Look for senior technical roles.

  • Spotify - The streaming music leader hands out large equity awards to recruit top tech and product talent. Fast growth equals major equity gains.


Beyond big tech, seek startup and pre-IPO companies with hypergrowth potential. While riskier, earlier-stage equity will multiply in value the most as the company scales. The key is targeting innovative companies with great prospects for an eventual liquidity event through IPO or acquisition.


Equity Compensation FAQs


Here are answers to some frequently asked questions about equity compensation:


How much equity should I receive?


Amounts vary significantly by company, role, and industry. 1-3% equity for C-suite execs is typical at early-stage startups. At public companies, equity often falls between 10-50% of cash compensation depending on your seniority.


When can I access equity compensation?


Vesting schedules dictate when you take full ownership of equity awards. RSUs convert to tradeable shares on vesting dates. Options must be exercised after vesting to obtain shares.


What happens to equity if I leave the company?


Unvested equity is usually forfeited if you leave before the cliff vest date. After that, you keep the vested portion but lose out on further vesting. Companies have discretion with terminating employees.


Do I have to pay upfront for equity?


RSUs involve no upfront payment - you receive shares when they vest. Options require paying the strike price to exercise. ESPPs involve regular contributions from your paycheck to purchase discounted shares.


What about taxes?


RSUs and exercised options are taxed as ordinary wage income. ESPPs and incentive stock options receive capital gains treatment if held for 1+ years. Always consult a tax professional.


How liquid is private company equity?


Private company equity generally must be held until an exit like IPO or acquisition. Some companies facilitate buybacks, but you can't freely cash out your shares. Go public or sell the company!


What happens to equity in an acquisition?


Outstanding equity awards often convert into the right to receive cash payments. Your vested awards will be converted based on the acquisition price and deal terms.


Does early-stage equity run a risk of becoming worthless?


Yes, if the company fails, your equity can decline to zero. Later-stage public companies carry less risk. Weigh your risk appetite against the growth potential.


Should I hold onto my vested shares after leaving?


That depends on your outlook for the company and your desire to retain shared upside. Many decide to liquidate shares immediately after vesting.


Making the Most of Equity Compensation


Equity compensation can transform your net worth if you make strategic decisions:


  • Target high-growth companies to maximize equity upside

  • Understand tax implications and optimize your liquidation strategy

  • Diversify your portfolio and your income streams

  • Take full advantage of employer matching like ESPPs

  • Negotiate aggressively for equity up front and when renewing

  • Structure vesting carefully when negotiating job offers

  • Model out potential future value based on projected growth


Putting The Knowledge To Practice - Equity Compensation Taxation Strategies


With smart planning, equity compensation can significantly impact your financial future. If you receive stock, options, or other equity awards as part of your employee compensation package, be sure to get expert help optimizing your tax situation. The professionals at United Tax specialize in minimizing taxes related to stock-based compensation. Contact us today for a consultation to discuss how we can help you maximize the value of your equity compensation.




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