An employee equity or stock compensation plan offers noncash benefits through restricted stock units (RSUs), stock options, and employee stock purchase plans (ESPPs). These plans allow employees to gain partial ownership in their company, providing a motivating factor for increased productivity and contributing to company growth. They are popular among companies that cannot offer higher cash salaries, and have been gaining in popularity. In this Navigator, we discuss the types of compensation plans and how they can benefit you.
What are Equity Compensation Plans?
An employee equity or stock compensation plan is a noncash benefit given to employees via the use of restricted stock units (RSUs), stock options, and/or employee stock purchase plans (ESPPs). These plans allow employees to gain partial ownership in their company through equity compensation. Morgan Stanley’s State of the Workplace Financial Benefits study found that 76% of HR leaders reported that their company offers some form of equity compensation benefits, this is up four percent year-over-year and twelve percent since 20211. It can also be seen as a motivator for employee production. Increased employee productivity typically correlates with better company performance. In turn, this leads to stock and company value gains. In this way, equity compensation can be a win-win for both employees and employers.
Equity Compensation Plan Types
Stock options
Stock options permit employees to purchase shares of their company’s stock at a prearranged price, commonly known as a strike price, after a predetermined vesting period. If you have been granted stock options and your company is performing well, it is likely that the strike price of your stock options will be less than the market price at the time your vesting period ends. If that is the case, you can buy the stock at the strike price and sell at the market price, creating profits that effectively act as incremental income. However, if the company performs poorly over the vesting period and your strike price is greater than the market price, your options may expire worthless. In this case, there would be no financial gain from this employee benefit. This type of employee benefit is generally low-risk for employees because they may not be required to provide any of their own capital to execute a profitable transaction.
There are two ways stock options can be exercised: cash and cashless.
Cash Exercise
In a cash exercise, the option holder pays the exercise price of the stock options in cash to acquire the underlying shares. To do so, the employee must have the necessary funds available to cover the cost of exercising the options. Once the payment is made, the shares are issued to the option holder.
Cashless Exercise
A cashless exercise allows the option holder to exercise their stock options without using their own cash, hence the name. Instead, they use a portion of the value of the options themselves to cover the exercise price. Commonly, the option holder sells enough of the acquired shares to cover the exercise price and any applicable taxes or fees. The remaining shares are then transferred to the option holder.
What Exercise Method Should You Choose?
A cash exercise may be the preferable method when the option holder has sufficient funds to cover the exercise price and wants to acquire the shares outright. On the other hand, a cashless exercise might be chosen if the option holder wants to avoid using their own capital or does not have the necessary funds. It’s important to note that a cashless exercise may trigger a taxable event.
Non-qualified stock options (NSOs)
NSOs permit the employee to buy a certain allotment of shares at a predetermined strike. When the options are exercised, the employee will pay ordinary income tax on the difference between the strike price and the market price at the time the option is exercised. Thus, there is no taxation until the options are exercised. This allows employees to exercise options when it is most favorable for their tax situation. NSOs commonly expire 10 years after being granted or within 90 days of separation from the employer.
If the employee employs a cash exercise on an NSO and sells the shares at a later date, there might be a tax obligation. The difference between the exercise price and the fair market value of the stock on the exercise date, if capital gains occurred, is generally subject to capital gains tax.
NSO Example:
If an employee is expecting to earn a lower income in a particular year and has stock options with gains (the market price is greater than the strike price), it would most likely be beneficial to exercise the NSOs in that year and realize the gains. Exercising the options in a higher income year would unnecessarily create a larger tax bill for the employee.
Incentive stock options (ISOs)
ISOs are akin to NSOs but provide greater potential tax relief. There are two primary benefits of ISOs in relation to NSOs. First, there is no income tax at exercise (though it may trigger the alternative minimum tax; you should consult with your tax professional about your personal situation). Second, if the shares purchased at exercise are sold two years after the date of the grant and one year from exercise, the profit is considered a long-term capital gain, which is taxed at a significantly lower rate than short-term gains and ordinary income. ISOs also have a typical expiration timeline of 10 years after granted or 90 days after separation.
ISO Example:
An employee was granted ISOs in April of 2020 and exercised the ISOs in April of 2021. In order to meet the special holding period requirement and benefit from the lower capital gains tax, the employee would need to withhold from selling the purchased shares until at least April of 2022.
Restricted stock units
Restricted stock units, or RSUs, have become a These stock units are commonly offered after a private company is taken public or reaches a stable valuation. Similar to stock options, RSUs also have vesting periods; however, employees are not required to actually purchase RSUs. Immediately upon vesting, RSUs are no longer labeled “restricted” and become ordinary shares that can be bought and sold in the open market. This makes RSUs less risky than stock options because they will always carry some value, assuming the company does not fail. Another potential benefit of RSUs is that they may enjoy partial value recognition during the vesting period. It is not uncommon for RSU grants to vest in tranches throughout the vesting period. For example, 25 percent of an RSU grant may vest after one year with another 2-3 percent vesting every month thereafter until the grant is fully vested.
RSUs are a form of compensation, and employees are taxed at ordinary income rates on the market value of the shares when they vest. Companies may withhold a certain number of shares at vesting in order to cover the employee’s tax burden. Employees who hold onto vested shares in order to sell at a later date may also owe capital gains tax if the eventual sales price is greater than the market price on the vesting date.
RSUs versus Stock options – Example:
Assume an employee is granted 5,000 RSUs that have a 3-year vesting period and that the company stock stays at $20 for the entirety of the vesting period. In this scenario, the value of the RSUs would be $100,000. However, if the employee had been granted stock options with a strike of $20, these options would expire worthless, and the employee would have no financial gain.
Employee stock purchase plan (ESPP)
An ESPP grants an employee the right to purchase his or her company’s stock at a discount to the market price, typically between 5 and 15 percent. Contributions to an ESPP are made through payroll deductions on fixed dates. Using the accumulated funds, the company will purchase the stock on behalf of the employee at the discounted price. It is important to note that the contributions are withheld on an after-tax basis. In a qualified ESPP, an employee does not owe taxes on the discount at the time of purchase. A non-qualified ESPP is effectively the same, but it does not have the preferred tax treatment so employees must pay tax on the value of the discount.
Like other stock comp plans, ESPPs have their own terminology. The offering period is the period of time during which payroll deductions are accumulating. The period of time within an offering period during which shares can actually be purchased is called the purchase period. Offering periods will often include multiple purchasing periods. When the shares are purchased, it is known as the purchase date and the discounted price at which they were purchased is known as the purchase price.
If a plan allows for withdrawals, contributions can be refunded to the employee, and the employee can re-enroll during another enrollment period. Withdrawals are typically done during the offering and purchasing periods. Rules vary, so it is important to know the details of your specific plan.
If an employee decides to leave his or her company, the shares that they have purchased belong solely to the employee, and any excess funds contributed to the account will, in most cases, be returned to the employee.
ESPPs are an optional benefit and typically create less value for employees than other stock incentive plans because of share price fluctuations and a lack of optionality. Also, IRS rules limit employee purchases to a maximum of $25,000 of fair market value of the stock per year.
ESPP Example:
An employee earns $5,000 on a bi-monthly, post-tax basis and chooses to contribute 5 percent of that ($250 bi-monthly) to the company’s ESPP. The employee receives a 10% discount at the purchase date. On the purchase date, the current market price is $30/sh. The employer will purchase the shares on the employee’s behalf at a price of $27/sh, and the employee will receive as many shares as the account can fund.
Tax Optimization
Plan rules vary, as do individual tax situations, so it is important to consult with your financial advisor and tax professional to determine the optimal strategy for your situation.
For a more in-depth look at the rules and regulations visit the IRS website here.
Stock options can be a valuable component of an employee’s compensation package, providing an opportunity to benefit from potential stock appreciation. However, it is crucial to thoroughly understand the terms of the stock option agreement, evaluate the financial implications, and seek professional advice from a trusted advisor to make well-informed decisions.
This article is prepared by Pekin Hardy Strauss, Inc. (“Pekin Hardy”, dba Pekin Hardy Strauss Wealth Management) for informational purposes only and is not intended as an offer or solicitation for business. The information and data in this article does not constitute legal, tax, accounting, investment or other professional advice. The views expressed are those of the author(s) as of the date of publication of this report and are subject to change at any time due to changes in market or economic conditions. Pekin Hardy cannot assure that the strategies discussed herein will outperform any other investment strategy in the future, there are no assurances that any predicted results will actually occur.
