Tax Impacts of Equity Compensation

Written by: David Bryant, CPA

Have you received a job offer with an equity compensation package? Equity compensation can be an incredibly lucrative form of employment income, but it also may come with some unique tax consequences that should be considered in order to maximize your benefits and minimize your potential liabilities.

In this blog post, we’ll explore the key tax implications associated with equity compensation packages, so you will know exactly how this additional source of income will affect your taxes.

What is Equity Compensation?

Equity compensation is an incentive system used by employers to reward employees for their hard work and loyalty. It’s a non-cash payment that represents an ownership interest in the company you work for.

Equity compensation is common in public companies and startups, and employers often use this form of compensation to entice top talent to work for their companies while also improving employee retention. However, this strategy can come with its own risks and rewards.

While everyone hopes the value of their shares will go up, it is not guaranteed. For that reason, we often see employees who earn equity compensation sell their shares immediately upon receiving them. By doing so, they lock in their compensation amount rather than risk a loss. We recommend talking to a financial advisor to weigh the risks versus rewards.

Equity compensation can come in several forms, including, but not limited to, stock options, restricted stock units, and performance-based shares.

Tax Impacts of Various Forms of Equity Compensation

Different types of equity compensation have different tax impacts. Let’s explore the various forms of equity compensation and their tax rules, so you know what to expect when receiving this non-cash income.

Stock Options

With stock options, employees have the right, or option, to purchase company shares at a predetermined price. Stock options generally take two forms; non-qualified stock options (NSOs) and incentive stock options (ISOs).

NSOs are taxed as ordinary income when they vest. If you hold the shares for more than a year after vesting, you’ll qualify for the preferential long-term capital gains rates on any increase in value. Remember, though, employees are taxed upfront on the value when their options vest, which then becomes their cost basis in the stock.

With ISOs, the tax treatment is more favorable. While ISOs can trigger the alternative minimum tax upfront, regular tax is not paid until the shares are sold. The two dates to remember are the “grant” date and the “exercise” date. The “grant” date is when you are given your options, and the “exercise” date is when you purchase your shares. If you hold the shares for more than two years after the date they’re granted, and more than one year after exercising your option to buy, you can qualify for long-term capital gains rates on your gains.

Restricted Shares

Restricted stock units (RSUs) and restricted stock awards (RSAs) are forms of equity compensation that allow employees to accrue shares of the company’s stock over time. Unlike other forms of equity compensation, you don’t have to buy RSUs or RSAs—you simply receive the shares as compensation at predetermined intervals or as you meet specific performance goals.

With restricted shares, unless an 83(b) election is made, their value is taxed as ordinary income when they vest.

Performance-Based Shares

Performance shares are a form of equity compensation that rewards employees for meeting predetermined performance goals. Performance shares can be based on various metrics, including financial performance, operational efficiency, customer satisfaction, and other key indicators.

Typically, performance shares aren’t taxable income at the time of the grant. Instead, you’re taxed when they vest unless the plan allows you to defer receipt of the shares. Your taxable amount is the difference between the value of the grant on the vesting date less the amount you paid. Typically, your employer will withhold taxes, but the amount withheld may or may not be sufficient to cover your  total tax liability.

Equity compensation is complex and can come with many tax implications. If you want to know what questions to ask when offered an equity compensation package, or learn strategies for tax optimization, reach out to our team of knowledgeable tax professionals. We would be happy to help you figure out the best way to take advantage of equity compensation without getting hit with an unexpected tax bill down the road.