October 6, 2015

Taxation of Equity Compensation

Equity compensation continues to be a popular way to incentivize and reward employees, unifying their compensation with the success of the company. The taxation of equity compensation can be extremely complex. We wanted to provide a brief and general overview of the taxation of some common types of compensation and some planning ideas to consider.

There are several different types of stock options.  The most common are Incentive Stock Options (ISO), Restricted Stock Units (RSU), Nonqualified Stock Options (NSO), and Employee Stock Purchase Plan (ESPP).  We have compiled a brief summary of the different types of options and tax implications below.

With all types of option there are a few terms to know:

  • Grant Date – date option is granted or given to employee
  • Vest Date or Vest Schedule – date(s) when the employee can purchase stock using the option
  • Exercise date – date employee elects to purchase the stock using the option.
  • Exercise Price – Cost to exercise stock option and purchase the stock
  • Expiration Date – date when the option expires

Nonqualified Stock Options (NSO) – NSO’s can be issued to both employees and nonemployees. The exercise of NSO’s results in ordinary income. Income is generally calculated to be the difference between the fair market value of the stock at exercise date and the exercise price of the stock.  Any appreciation beyond the fair market value of the stock upon exercise may be eligible for capital gains treatment.

Incentive Stock Option (ISO) – There are differing tax treatments for regular and alternative minimum tax (AMT) tax purposes upon exercise of stock options depending on a variety of factors. Regular or AMT income is generally calculated to be the difference between the fair market value of the stock at exercise date and the exercise price of the stock. While sale of stock generally results in capital gain treatment similar to NSO’s, there are additional restrictions in terms of the timing of the sale. For example, if stock is not held for at least 2 years from grant and one year from exercise, ordinary income will result.

Restricted Stock Unit (RSU) – RSU’s are generally issued to employees, advisors and board members. Tax occurs upon vesting of the units and is generally reported as additional compensation income. Any appreciation beyond the fair market value of the stock upon vesting may be eligible for capital gain treatment.

Employee Stock Purchase Plan (ESPP) – This plan allows an employee to purchase stock through their employer for an agreed upon price. There are various types of ESPP plans that result in different tax results. For most plans, a mix of ordinary and capital gain income is recognized at sale. In addition, there are also holding period restrictions on ESPP shares which may result in a greater mix of ordinary versus capital gain income.

Below is a general chart summarizing the tax effects of the various types of compensation:

  NSO ISO RSU ESPP
Grant Date No taxable income No taxable income No taxable income No taxable income
Exercise (Regular tax) Ordinary income N/A N/A Generally, no taxable income
Exercise (AMT tax) N/A Ordinary income N/A N/A
Vesting Date N/A N/A Ordinary income N/A
Holding Period Begins At exercise At exercise At receipt At purchase
Cost basis upon sale of stock FMV at exercise Varies dependent on treatment at exercise FMV at vesting Purchase price

 

In addition to the complexities related to the tax treatment of the various types of equity compensation, there are also numerous tax planning opportunities to consider. For example, some tax planning strategies that we may consider are:

  1. Filing an 83(b) election which can minimize ordinary income taxation and maximize capital gains treatment.
  2. Reviewing and modeling the mix and timing of various types of stock options to minimize the tax impact upon exercise.
  3. If the company stock is eligible for qualified small business treatment, we may consider additional planning strategies to maximize the benefits. (QSBS Requirements)

Planning related to equity compensation can be extremely complex. We encourage you to contact us to discuss your equity compensation.