OTHER FORMS OF EQUITY COMPENSATION
You might be wondering, what about my RSUs, ESPP, SARs, or other flavors of equity compensation that I have through my employer? A trend that we see within the world of equity compensation is an uptick in Restricted Stock Unit (RSU) awards. An RSU isn’t a direct share of the underlying stock. Rather, the delivery of shares of stock occurs after the RSUs vest. An RSU is granted to an employee and is usually subject to a three or four-year vesting schedule. Taxation occurs, at ordinary income rates, when the RSUs vest and the stock is delivered. Once you own the vested stock, taxation is treated just like any other stock: It depends on 1) the holding period (if it is greater than one year or not) and 2) if the stock is sold at a gain or loss. Employee stock options still exist, of course, but RSUs have become more popular since they usually have some value – unless the company stock goes to $0. In the case of ISOs and NSOs, if the options are out of the money, there is no value (technically there might be some “time value,” which is the concept that an option has more value the further away it is from its expiration date). I’ll leave it to Bill Gates to describe it in a way that I couldn’t do better myself:
“When you win [with options], you win the lottery. And when you don’t win, you still want it. The fact is that the variation in the value of an option is just too great. I can imagine an employee going home at night and considering two wildly different possibilities with his compensation program. Either he can buy six summer homes or no summer homes. Either he can send his kids to college 50 times, or no times. The variation is huge; much greater than most employees have an appetite for. And so as soon as they saw that options could go both ways, we proposed an economic equivalent. So what we do now is give shares, not options.”
I’ve had many conversations with people and they find themselves using the terms “Restricted Stock” and RSUs synonymously. Restricted Stock (RS) is different from an RSU! Restricted stock is company stock that is granted to you but you have voting rights and the right to dividends during the vesting period. That is not the case with RSUs. From a taxation perspective, the big difference between RS and RSUs is that the RS has the option to make an 83(b) election. If an employee has RS, the 83(b) election allows the employee to be taxed on the grant date, instead of the default of being taxed at vesting. The 83(b) election might make sense when the employee strongly believes that the price of the stock will increase over time. The thought process is that they would rather get taxed on the grant date when the value of the stock is, say $1000, opposed to when the stock vests when its value is $2000, for example. An 83(b) election is risky. There is a chance that one makes the 83(b) election and is taxed on an amount that is higher than the value when the stock vests or is sold at a later date. In that case, the employee overpaid taxes, and cannot get refunded for the overpayment. Therefore, if the employee thinks that the stock price might go down, they might not want to utilize the 83(b) election. Ultimately they should engage with their tax advisor to take into consideration all other tax-related factors in their decision.
Employee Stock Purchase Plans (ESPP) are also quite common. These plans allow employees to purchase company stock with funds deducted directly from their paycheck, usually at a discount (up to 15%). In the case of an ESPP that has a 15% discount, if the fair market value of the stock is $100 (as defined by the plan document), the employee has the opportunity to buy the stock at $85. Taxation upon sale of stock acquired from an ESPP can be a combination of ordinary compensation income and capital gains. The amount of time that you hold the stock from the offering period (when money is deducted from your paycheck) and the purchase period (when the actual stock is purchased) will determine the type and extent of taxation. ESPP taxation is similar to the tax treatment of ISOs, from the perspective of a qualified disposition (generally favorable tax treatment) vs. a disqualifying disposition (generally not as favorable).
Stock Appreciation Rights (SARs) are another form of equity compensation. We still see SARs, but in our experience much less than RSUs or traditional employee stock options (ISOs & NSOs). With SARs, an employee can profit when the stock appreciates, just like the name implies. Depending on how the plan is set up, the employee can be paid in cash or company stock (taxed as ordinary income upon exercise, regardless if you receive cash or stock). Note that the SAR must be exercised! The payout doesn’t occur automatically when the price of the underlying stock appreciates. Similar to employee stock options like ISOs and NSOs, SARs may have no value, in the case where the stock never appreciates after the SARs were granted. The “gain” (fair market price of the stock minus exercise price) is taxed as ordinary income upon exercise.
As you can see, a taxable event may occur at different stages of the game, depending on what type of equity compensation we are talking about. Many wonder, will I have to pay taxes out-of-pocket? In most cases, you will be able to withhold an amount to account for the tax due from a taxable event. Depending on the type of plan you have, there could be multiple options when it comes to withholding. This is another area where a good review of the plan document will tell you your options.
In some cases where the employee receives cash (e.g. exercise of a SAR where they get their payout in cash instead of shares of stock), the company may simply withhold taxes in the form of cash, similar to withholding from your paycheck. They will withhold for federal & state income tax, Social Security, and Medicare. In a case where the employee is receiving stock (e.g. RSU vests, shares of company stock are delivered to the employee’s brokerage account), the company may withhold the appropriate amount in the form of shares. In that case, the employee receives an amount of shares net of withholding (I’ve also seen it described as “surrendering” shares). By withholding shares, it allows the employee to avoid paying the withholding with cash. Note that just because taxes are withheld doesn’t mean that a taxpayer won’t have to pay anything out of pocket! In other words, there are cases where the tax withheld was too little, and the taxpayer still owes a portion of their tax liability by the time they file their taxes.
Investing comes with risk, although not all risks are equal. Obvious statement ahead, but people participating in the many types of employee stock plans mentioned above want the price of their company stock to go up! However, we know that stocks don’t increase exponentially (or linearly, for that matter) into perpetuity. They can be volatile and in some cases can lose significant value. As discussed earlier, in the case of employee stock options like ISOs and NSOs, forms of equity compensation can lose all of their value. Think back to the Bill Gates quote above. All in all, equity compensation plans can provide a unique opportunity for you to save, invest, and grow your net worth. It doesn’t always work out exactly as planned, but if managed appropriately, equity compensation plans can provide an excellent supplement to help you meet your financial goals in a tax-advantaged way.
– Mitch DeWitt, CFP®, MBA