Private companies often find it difficult to attract and retain key employees. This is partly because large, multinational corporations offer more attractive packages. Usually, these feature various forms of equity compensation, including stock options.
Even though equity in a private company can’t be traded on a public exchange, there are other ways to provide equity compensation to employees.
Also read: What Makes Private Equity Fund Accounting Different?
The Goals of Equity Compensation
Attract and retain high performers
When it comes to talent acquisition, offering equity compensation is one way to stand out from your competitors.
If your company can demonstrate an upward financial trajectory, potential employees could be incentivized to join your team. After all, their equity could be worth significantly more in the future. Even modest growth could mean a decent future payday for employees.
Get everyone working toward the same goal
The theory goes that providing equity compensation gives an employee an incentive to help grow the value of a business. You see, if the company’s valuation increases, so does the value of equity compensation. It also encourages employees to think long-term instead of short-term.
Free up cash
Equity compensation allows you to pay less cash compensation now, in return for paying (potentially) higher compensation in the future. So instead of using cash to pay employees, you can use it for operating expenses or expansion opportunities.
Now, let’s look at the different methods of equity compensation.
Restricted Stock Compensation
As its name implies, restricted stock involves awarding or granting the right to own actual shares of a company’s stock.
There are two methods for compensating an employee using restricted stock: Restricted Stock Units and Restricted Stock Awards.
Restricted Stock Units (RSUs)
RSUs are a promise made to an employee by an employer to grant a given number of shares of stock to the employee. RSUs are generally granted based on a vesting schedule.
Let’s consider Jill, who becomes an employee of XYZ Company in June 2020 and is awarded 1,000 RSUs, which are put on a 5-year vesting schedule. Jill isn’t required to pay any money to acquire the RSUs.
On her one-year work anniversary, 200 of Jill’s RSUs vest. She exchanges the 200 RSUs for 200 actual shares of stock. On her two-year work anniversary, another 200 RSUs vest, which Jill exchanges for 200 actual shares of stock. Another 200 RSUs will vest in years 3, 4, and 5 and be exchanged for stock until all 1,000 RSUs are converted to 1,000 shares of stock.
How RSUs are taxed
Let’s assume XYZ Company’s stock is valued at $30 per share when Jill’s first 200 RSUs vest in June 2020. The total value of her 200 shares of stock is therefore $6,000 ($30 per share x 200 shares). This $6,000 is added to Jill’s Form W-2 as wages, which are subject to income, Social Security, and Medicare taxes.
Let’s see what Jill’s tax calculation looks during the 5-year vesting period, assuming that the price per share increases $5 each year:
- 2020: 200 shares @ $30 = $6,000 included in Jill’s Form W-2
- 2021: 200 shares @ $35 = $7,000 included in Jill’s Form W-2
- 2022: 200 shares @ $40 = $8,000 included in Jill’s Form W-2
- 2023: 200 shares @ $45 = $9,000 included in Jill’s Form W-2
- 2024: 200 shares @ $50 = $10,000 included in Jill’s Form W-2
Total vested shares: 1,000
The total income included in Jill’s Form W-2 over 5 years: $40,000
Sale of RSU Stock
Continuing our example, once the RSUs are converted to stock, Jill can either sell the stock right away or hold the stock and sell it at a later date. Here are her choices:
- Jill immediately sells her stock immediately after vesting – i.e. she receives stock for $30 a share and sells it for $30 a share. No gain or loss is recognized.
- Jill sells her stock within one year after vesting. She will report any gains as ordinary income and any loss as a short-term capital loss.
- She sells her stock more than one year after vesting. Jill will report any gains as a long-term capital gain and any loss as a long-term capital loss.
Restricted Stock Awards (RSAs)
A Restricted Stock Award (RSA) is a type of stock compensation plan where a company awards shares of their stock to an employee. This usually happens at the start of employment.
The employee owns the stock – and is thus a shareholder – from the moment the company grants the stock to the employee. However, they must wait until the shares have been vested before selling the shares.
Let’s go back to Jill, assuming now that she becomes an employee of XYZ Company in June 2020 and is given a restricted stock award instead of restricted stock units:
- Jill is awarded 1,000 shares of stock for $0 per share in June 2020. At the time, the stock’s value is $25 per share.
- The 1,000 shares are subject to a 5-year vesting period, and the price increases by $5 annually.
- In 2025, after all 1,000 shares vest, the stock is valued at $50 per share.
- Jill continues to hold the shares until 2027. She then sells all 1,000 shares when the stock price is $60 per share.
How RSAs are taxed
The tax liability on RSAs is calculated using one of two methods:
At Vesting: This is exactly like RSUs. You wait for the shares to vest, then pay ordinary income tax on vested shares. To do this, you including the income on Form W-2. Using the information from our example:
- 2020: 200 shares @ $30 = $6,000 included on Jill’s Form W-2
- 2021: 200 shares @ $35 = $7,000 that she includes
- 2022: 200 shares @ $40 = $8,000 included
- 2023: 200 shares @ $45 = $9,000 is included on Jill’s W-2
- 2024: 200 shares @ $50 = $10,000 included in her W-2
Total vested shares: 1,000.
The total income included in Jill’s W-2 over 5 years is therefore $40,000.
83(b) Election
The second method is to calculate tax liability with an 83(b) election. This way, Jill pays ordinary income tax on all 1,000 shares immediately after receiving the stock award. The amount she pays is based on the share’s value at that time. So 1,000 shares @ $25 = $25,000 included in her W-2.
Note that Jill earns $15,000 less ($40,000 – $25,000) with this method. If Jill’s tax rate was 20%, she would save $3,000 in taxes.
So is an 83(b) election always a good idea? If you make the election, you’re betting that your company’s value is going to continue rising. You’re essentially pre-paying your tax liability on a low valuation.
But what if the opposite happens? Say, for instance, that you pre-pay your taxes at $25 a share. And 5 years later, the share price is $15. One option is to claim a capital loss based on the value of the shares. However, the IRS won’t let you claim the overpaid taxes on your next tax return.
Sale of RSA Stock
If the stock is held for one year or longer past the exercise date, long-term capital gains tax rates apply. Otherwise, any gain is considered ordinary income.
Stock Option Compensation
A stock option gives employees the right to purchase company stock during a specified period of time, at a predetermined price.
Technical note: Stock options ARE NOT the same as stock.
The popular term “stock options” is technically not accurate. An employee only receives one “option” to purchase a pre-determined number of shares. As such, it’s incorrect to say that an employee “has 500 stock options.” Rather, the employee has one option to purchase 500 shares at a certain price point in the future.
Here are the basic terms when discussing stock options:
- Grant Price – The price at which an employee can purchase a company’s stock (a.k.a. Exercise Price or Strike Price).
- Issue Date – The date at which the option is given to the employee.
- Vesting Date – The date an employee can purchase the company’s stock for the grant price.
- Exercise Date – The date an employee actually purchases the stock.
- Expiration Date – The date by which an employee must exercise the options, otherwise the options will expire. Options typically expire 10 years after the grant date, unless the employee leaves the company.
Non-Qualifying Stock Options (NSOs)
Non-qualifying stock options let your employee buy a specific number of shares at a specific price, for a specified period.
NOTE: “Non-qualifying” simply means that this does not qualify for special treatment. Consider “non-qualifying” stock options as “regular” stock options.
Continuing with our example, Jill joins XYZ Company in June 2020 and is given a non-qualifying stock option for 1,000 shares at a grant/exercise/strike price of $5. Shares will vest at 25% per year. This means that from 2021 onwards, she vests 250 shares annually.
In June 2024, all 1,000 shares of XYZ Company’s stock have vested. Then, Jill buys all 1,000 shares at her grant price of $5 per share. However, she does this when the value of the stock is $50 per share.
Jill writes her company a check for $5,000 (1,000 shares x $5 per share), and she receives 1,000 shares of stock. She’s now officially a stockholder.
How NSOs are taxed
Jill paid $5 per share for a stock that is valued at $50 per share. This $45 difference is considered a type of income. As such, Jill must include it on her W-2.
1,000 shares x $45 difference between grant price ($5) and fair market value ($50) = $45,000.
Incentive Stock Options (ISOs)
Incentive stock options are structured like non-qualified stock options. However, they receive preferential tax treatment if certain conditions are met when an employee sells the stock.
For example, Jill joins XYZ Company in June 2020 and is given an incentive stock option for 1,000 shares at a grant/exercise/strike price of $5. Her shares vest at 25% per year, meaning that 250 shares are vested annually until 2024.
At this time, Jill buys all 1,000 shares at her grant price of $5 per share. Once again, say she does this when the share value is $50. So she writes the company a check for $5,000 (1,000 shares x $5 per share), and is officially a stockholder.
In this example, Jill would pay taxes on the “bargain element” of the stock options she exercised ($45,000). With an ISO, she wouldn’t pay taxes on this amount IF she held on to the stock for at least a year after exercising her options. In that instance, she only pays long-term capital gain on the stock.
Whenever Jill exercises her option to buy company stock, her employer will complete Form 3921, and submit it to the IRS.
Why ISOs are beneficial to employees
There are two main reasons:
- Regular federal income tax is not triggered upon exercise of ISOs (although AMT might be).
- Qualifying dispositions of ISOs (selling your stock) enjoy long-term capital gains treatment.
Note that ISOs can only be granted to employees (not to advisors, consultants, or other service providers).
Other considerations
Understanding the tax consequences of equity compensation packages is vital. In fact, offering such compensation presents several challenges:
- An added layer of complexity. If you want to offer equity compensation, you’ll need a payroll processing system that can accurately track and calculate the options and RSUs associated with each employee. And don’t forget about explaining equity compensation to the employees themselves.
- State nexus issues. What happens when your employee moves states after receiving an equity award? You must consider which taxing jurisdiction is entitled to the taxes.
- Alternative minimum tax. If you have compensation tied to stock options or RSUs or have employees in the same situation, you must consult with your tax advisor about the tax implications.
How Much Tax Will You Owe?
Here’s a look at the different types of income that can result from equity compensation:
- Ordinary Income: This type of income includes wages, salaries, bonuses, and interest income earned on investments. For the 2024 tax year, it can be as high as 37% and must be paid by the tax filing deadlines.
- Capital Gains Income: Capital gains income arises when you sell an asset, such as a stock. If you sell the stock less than one year after purchasing the stock, you’ll pay the ordinary income tax rate of up to 37%. If you sell the stock more than one year after purchasing the stock, you’ll pay a tax rate of 0%, 15%, or 20% depending on taxable income.
Considerations for Your Business
Equity compensation can be a valuable tool for attracting and retaining employees. Call us to discuss if adding equity compensation to your compensation package could be a competitive advantage for your business.
Fusion CPA offers outsourced financial services and accounting software solutions to business fund managers and PE firms. To determine the best scenario for your situation, call our office to schedule a comprehensive tax planning session.
This blog article is not intended to be the rendering of legal, accounting, tax advice, or other professional services. Articles are based on current or proposed tax rules at the time they are written and older posts are not updated for tax rule changes. We expressly disclaim all liability in regard to actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.
