Fernway DiarySM

Dec 09, 2021

Figuring out what type of equity compensation to issue can be a challenge for startups and established business, and the best strategy for your company and employees may change as you grow.

Thinking about how your organization will structure your equity, how much to give founders and employees, and how to structure incentive compensation so it gives everyone the best tax treatment possible should start right from the beginning.

Types of Equity Compensation

Understanding different forms of equity compensation and how they are treated for tax purposes – from both the employer and employee perspective — is important. Otherwise, these equity incentive plans can have unintended tax consequences.

Nonqualified Stock Options

Nonqualified stock options (NSOs) can be given to employees as well as independent contractors, partners, vendors, and other individuals not on the company payroll.

The tax treatment of an NSO depends on whether the stock option has a readily ascertainable value at the time of the grant. Typically, the stock must be actively traded on an established securities market for its fair market value to be readily ascertainable. This is not the case for most privately held companies.

If the value is readily available, then the NSO is taxable compensation for the employee at the time the options are granted. If the value is not available, the spread — or the difference between the stock’s value and option price —is taxable compensation for the employee when exercised. Thus employers must withhold federal income and employment taxes at the time of exercise and include that income as wages on the employee’s Form W-2.

The employee faces another taxable event when they sell the shares. At that point, they may have a long-term or short-term capital gain or loss, depending on whether they held the shares for more than or less than one year from the date they exercised the options. The employee’s basis is the amount they paid for the shares, plus any amount included in income when they exercised the option.

Incentive Stock Options

Incentive stock options (ISOs) also allow employees to buy stock in the company at a discounted price. They are more favorable for employees from a tax perspective because they are generally not taxable for the employee when they receive the option grant or exercise the option. Instead, the employee pays capital gains only when they sell the stock.

ISOs are less common than NSOs because they have to follow certain strict guidelines. They can be granted only to employees — not consultants or contractors. There is also a $100,000 limit on the aggregate grant value of ISOs that may first become exercisable in any calendar year.

After exercising the options, the employee must hold the shares for at least two years from the grant date and one year from the exercise date to pay taxes on the transaction at favorable long-term capital gains rates rather than ordinary income tax rates.

Restricted Stock Units

Restricted Stock Units (RSUs) are another way employers can grant shares of company stock to employees. Unlike stock options, which give the holder a right to buy the company’s stock at a future date, RSUs give the holder a commitment to receive the value of a certain number of shares in the future without requiring upfront payment.

These grants are “restricted” because they are subject to a vesting schedule, which may be based on length of employment or performance goals.

RSUs are generally taxable as they vest. Some companies withhold a portion of the RSUs to help employees pay the corresponding taxes that will be owed when they are vested. However, a company may also give employees the option of paying taxes out of pocket so they retain all vested RSUs.

Restricted Stock Awards

Restricted Stock Awards (RSAs) are a form of equity compensation like RSUs, but with some key differences.

RSAs are actual shares of stock that the recipient receives, but the rights to sell or transfer the shares are restricted until a vesting period passes. Like RSUs, RSAs may have vesting periods dependent on the length of employment or performance goals.

Another major difference is that RSAs entitle the owner to dividends and voting rights. The dividends from restricted stock can be paid out in cash or accrued and paid after the award vests completely.

Employees who receive restricted stock can exclude the value of the stock from taxable income during the vesting period. This exclusion is possible because the employee is at risk of losing the RSA if they do not meet the vesting requirements. Once the vesting period ends, the employee recognizes the fair value of the stock received as taxable income.

The employee may also make a special tax election known as the IRC Section 83(b) election within 30 days of the grant. This election allows the employee to include the RSA’s fair market value in their taxable income on the grant date. Making this election may be advisable if the employee believes the stock’s value will appreciate from the grant date to the vesting date. This election also changes the character of stock appreciation from ordinary income to capital gains, which are taxed at a lower rate.

The timing of the employer’s deduction depends on when the employee recognizes income. If the employee does not make the Section 83(b) election, the company takes the deduction when the shares vest. If the employee does make the election, the company takes the deduction on the RSA grant date.

As companies grow, they usually move from granting restricted stock to stock options and then to restricted stock units. However, equity incentive plans and their tax consequences are highly complex. The rules are subject to change, so companies considering adopting or amending an equity incentive plan or making grants under an existing plan should consult with their tax advisor before taking definitive action.

For more information, please contact your US tax advisory team at youradvisor@fernwaysolutions.com or visit us at www.fernwaysolutions.com.

Disclaimer:

The above content is intended to support the marketing of professional services and should not be construed as written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular tax situation. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with, or attached to this content is not intended to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Fernway Solutions assumes no obligation to inform the reader of any such changes.