3 Core Types of Equity Compensation You May Come Across As A High-Earner

Did someone say equity compensation?

Equity compensation is quickly growing as a popular payment method in various industries like tech, medical, pharma, and business. As you grow in your career, you’ll likely see more equity compensation on the table.

Providing equity is an excellent way for companies to reward and retain top talent. While “stock options” is often used to describe all types of equity compensation, there are several common equity tools with varying pros and cons. No two equity types are quite the same. 

Here are the top types of equity you may come across throughout your career.

Create a Long-Term Plan for Your Equity

Equity compensation serves a different purpose than a traditional payment. While a salary puts money in your pocket today, equity compensation can be a fantastic wealth-building agent—when properly utilized.

If your employer offers stock as part of your compensation package, there are some important considerations regarding concentration risk, tax planning, cash flow, goal setting, and more. These are especially important to keep in mind if you anticipate coming into significant equity—an IPO, job change, or promotion can all trigger a change in your holdings.

Here at Partners in Financial Planning, we help employees like you build a wealth plan that addresses your equity compensation options.

3 Types of Equity Compensation

Let’s look at the most common equity compensation vehicles—what they are, how they work, and the ways that they could impact you.

Type #1: Restricted Stock Units (RSUs)

RSUs grant employees a set number of shares in the company sock. They’re called “restricted” stock units because access is restricted until the stocks have vested. Until then, they have no value to the employee.

RSUs and Vesting

Every company’s vesting schedule is going to look a little different. It could be based on performance goals for the employee or important company milestones like number of sales, product launches, or buyouts. 

For others, the vesting schedule may depend on the length of employment. For example, a company could vest a percentage of the RSUs at different times—25% vested every year for four years. 

Once the stocks have vested, you automatically get the shares with no action required on your part. By comparison, some types of equity compensation require you to purchase the stock at a discounted rate.

RSUs and Taxes

In the eyes of the IRS, vested RSUs are like a cash bonus, and they tax the entire value at your ordinary income rate. This makes it essential to keep a close eye on your vesting schedule and prepare accordingly.

To help ease the tax burden, your employer may withhold some of the stock units to help pay the associated tax. But depending on your tax bracket, they may not withhold enough. Companies are only legally required to hold up to 22%. You could owe an additional amount if you and your spouse are in a higher tax bracket.

As soon as you have access to your RSUs, you can hold or sell however much you want. If you choose to sell, you will be responsible for paying capital gains tax on any short—term or long—term gains, depending on how long you held onto the stock unit. 

If you sell the stock less than 12 months after it vested, you’ll be on the hook for short-term capital gains. If you sell the stock more than 12 months after it vested, you’re liable for paying long-term capital gains. In most cases, long-term capital gains taxes are more favorable for the taxpayer than short-term.

Type #2: Stock Options

Stock options fall into two main categories: Incentive stock options (ISOs) and nonqualified stock options (NSOs). The primary difference is how they’re taxed.

Similar to RSUs, you must wait until your stock options vest before you can access the stocks. From there, things start to differ.

Stock Options and Vesting

Unlike RSUs, you do not automatically own stock the day it vests. Instead, you have the option to buy or wait. Most companies allow you to wait up to 10 years to exercise (buy) stocks from the grant date. The grant date refers to the day your company issues the stock options. At that time, you and the company will sign an agreement regarding the vesting schedule, type of compensation, and other pertinent information. This typically occurs when you get hired or promoted to an upper-management position.

Once your stocks have vested, you will have the option to buy at the strike price, which is a predetermined value. If this price is less than the current market value, you’re getting a bargain on your buy.

ISOs and Taxes

ISOs are considered a qualified stock option. Because of this, they receive favorable tax treatment. You won’t owe income tax on the difference between the strike price and the fair market value if you meet certain holding requirements: hold at least one year from the exercise date and two years from the grant date.

However, you may still have to pay capital gains tax on any gains made through the sale.

While you won’t have to pay income tax on the fair market value difference upfront, you must include that value in your alternative minimum tax (AMT) calculations. AMT can get complicated, so it’s wise to address this with a tax professional and financial advisor.

NSOs and Taxes

When you exercise NSOs, you must pay ordinary income tax on the difference between the strike price (what you paid) and the fair market value. In addition, you’ll be taxed either short- or long-term capital gains tax when you choose to sell the stock.

Because of their less favorable tax treatment, it’s beneficial to work with an advisor to determine the most tax-efficient way to exercise your NSOs. For example, exercising across multiple tax years may be worthwhile to avoid pushing yourself into a higher tax bracket.

Type #3: Employee Stock Purchase Plans (ESPPs)

With ESPPs, your employer allows you to buy company stock at a discounted rate, usually up to 15%. An ESPP works similarly to a 401(k) in that you elect to have your company’s payroll department take automatic deductions from your paycheck and put them into the program.

The period in which you accrue money in the ESPP is known as the offering period. Your company will have purchase periods that run alongside the offering period, and these typically span six or 12 months. The last day of the purchase period is the purchase date and the day the company will buy stocks on your behalf at a discounted rate.

Every company sets up its ESPPs differently, and the tax consequences can vary. In most cases, making a qualifying disposition will provide the most favorable tax treatment. A qualifying disposition refers to selling your stock at least two years from the grant date and one year from the purchase date. If you don’t meet these conditions, the sale is a nonqualifying disposition, and you may owe additional tax.

Equity Compensation Presents Unique Opportunities

Equity compensation adds a whole new dimension to your wealth picture. But between tax obligations and company requirements, understanding your options can get pretty complicated.
Work with a team like Partners in Financial Planning to better ensure you’re making tax-conscious decisions that help you use the equity to reach your goals. Feel feel to reach out to us anytime to get started.