Navigating Stock Compensation
Navigating stock options can seem complex because there are multiple types and unknown terminology. In this article we will explain the two types of equity compensation and provide clarity on the terminology often used.
Types of Equity Compensation
There are two types of equity compensation:
Value awards
Options with value
Value awards are stocks that are awarded to you without you having to purchase them. Companies often refer to these as Restricted Stock Units (RSUs).
Options with value are “the right or the option” to purchase a stock at a discounted price. Companies often refer to these as Incentive Stock Options (ISOs), Non-qualified Stock Options (NSOs), or Employee Stock Purchase Plan (ESPPs).
Each type of equity compensation has a different tax treatment, holding period, and eligibility, so it’s very important to know which type you have and understand how it’s different.
Three Major Events of Value Awards (RSUs)
There are three major events that happen with value awards (aka Restricted Stock Units or RSUs):
The grant date
The vest date
The sale date
Grant Date
The day your company issues restricted stock units (RSUs) to you is the grant date. This is a promise of a future award if you satisfy the restrictions (usually a length of time). At this point, your RSUs are subject to a vesting schedule or waiting period, before you gain ownership. Your net worth does not increase, and this is not a taxable event.
Vest Date
The day the value is unlocked with no further action required on your side. Once restrictions have passed, you will automatically earn the granted shares of stock valued at the current market price. Your net worth does increase, and this is a taxable event.
TAX IMPLICATIONS: The market value of the stock is considered compensation when EARNED, which generally means the stock value is subject to ordinary income tax rates.
Sale Date
The day the stock shares are sold in exchange for cash. This can be shortly after the stocks vest or many years in the future. There is no limit to how long you can hold the stock.
TAX IMPLICATIONS: Any additional growth in the stock between the vesting date and the sale date are subject to capital gains tax rates.
Consider the trade-offs between holding and selling RSUs. It’s important to remember that RSUs represent ownership in a single company. Always ensure that your investment portfolio aligns with your risk tolerance and desired level of diversification.
Four Major Events of Options with Value (ISOs and NSOs)
There are four major events that happen with options (aka Incentive Stock Options or ISOs and Nonqualified Stock Options or NSOs):
The grant date
The vest date
The exercise date
The sale date
Grant Date
The day your company issues options (ISOs or NSOs) to you is the grant date. This is a promise that if you satisfy the restrictions, you will have the option to buy stock at a fixed price indicated in your grant agreement. At this point, your ISOs and NSOs are usually subject to a vesting schedule or waiting period before you gain ownership. Your net worth does not increase, and this is not a taxable event.
Vest Date
The day the option to buy is unlocked. Once your ISOs or NSOs vest, you have the right (but not the obligation) to purchase a certain number of company shares at the fixed price indicated in your grant agreement. You can choose whether or not to exercise your options anytime until your expiration date (typically, there is a 10-year time frame before expiry). Your net worth does not increase, and this is not a taxable event.
Exercise / Strike Date
The day you choose to “exercise” the option and purchase the stock (generally, if the exercise price of your ISOs/NSOs are less than the current market price of your company shares, you’d consider exercising your options).
ISO TAX IMPLICATIONS: Not subject to ordinary income tax as long as the shares are held for a certain amount of time (qualifying disposition), but possibly subject to Alternative Minimum Tax.
NSO TAX IMPLICATIONS: The bargain element of the stock (current market value less exercise / strike price) is considered compensation, and the stock value is subject to ordinary income tax rates.
Sale Date
The day the stock shares are sold in exchange for cash. This can be shortly after the exercise date or many years in the future, but timing directly impacts taxation. There is no limit to how long you can hold the stock.
ISO TAX IMPLICATIONS: When exercised shares are held for a certain amount of time they tick the “qualifying disposition” box, and are taxed at capital gains tax rates.
NSO TAX IMPLICATIONS: The growth of the stock (current market value less exercise price) is taxed at capital gains rates.
Taxes
Consider the trade-offs of exercising/holding, exercising/selling, etc., and look at the estimated tax due based on those decisions now (AMT or disqualifying ISO positions causing ordinary income taxes) and how that money can benefit your life for the long term.
Don’t make taxes and afterthought! Enlist the help of a tax professional and/or financial advisor to help you navigate this type of compensation.
