Over the past few decades, stock-based compensation has become an increasingly popular way for both public and private companies to attract and retain highly skilled employees in a competitive job market. The inventiveness of these various compensation schemes has spawned an alphabet soup of confusing acronyms, which can be exceedingly difficult for employees to decipher. Understanding the potential risk and return—along with the tax implications—of these various compensation schemes is crucial to evaluating employment opportunities and developing a well-balanced retirement plan.
Employee Stock Options
A stock option gives the holder the right—but not the obligation—to purchase shares of stock at a specified price (“strike price”) by a specified date (“expiration”). During the late 1990s, a frothy stock market made options a popular compensation tool, particularly among technology companies. They were viewed as a cost-effective way to incentivize and retain employees during a period of low unemployment. Changes to accounting regulations (which required firms to account for stock options more explicitly as an expense) prompted by the collapse of the tech bubble made options modestly less prevalent. However, they are still in use today. Two main types of employee stock options are Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). Both types typically have a vesting period or length of time that an employee must remain with the firm before the options are exercisable.
- Non-Qualified Stock Options (NSO)
- Non-Qualified Stock Options (NSO)
NSOs are the most common employee options and may be granted to employees, directors, executives, and even outside contractors or consultants. They are called “non-qualified” because they are not eligible for special tax treatment (as is the case for ISOs, explained below). The tax treatment of NSOs is straightforward: upon exercise, the difference between the market price of the stock and the strike price of the option is considered ordinary compensation, reported on the employee’s W-2 (and subject to the typical federal, state, and payroll tax deductions). In practice, many employees opt for a “cashless exercise,” whereby they immediately sell enough shares to cover the cost of the exercise and the associated taxes (netting a fraction of the shares from their original grant). The exercise price becomes the new cost basis. Any incremental appreciation is taxed as a capital gain (short-term or long-term, depending on the holding period) when the shares are ultimately sold.
- Incentive Stock Options (ISO)
- Incentive Stock Options (ISO)
ISOs may only be granted to employees (typically senior executives). Unlike NSOs, they are not subject to payroll taxes (Medicare & Social Security) nor any tax withholding at the time of exercise. The entire gain (calculated using the exercise price) qualifies as long-term when shares are held for at least two years after the original grant date and one year after the exercise date. This significant tax break does come with some risks. The employee must be able to front the money required to exercise the ISO to start the clock on the holding period requirement.
Moreover, employees with significant ISO exercises on highly appreciated stock could end up owing taxes under the Alternative Minimum Tax (AMT)—in which case they would have a tax liability even though they had not yet sold their shares. At the turn of the millennium, this precise scenario ensnared many recipients, whose options exercise triggered large AMT bills even as the value of their shares dropped precipitously during the stock market crash. In many cases, employees ended up owing more in taxes than their shares were worth!
Restricted Stock Units (RSUs)
Over time, changes to option accounting rules and a desire for transparency and simplicity led companies to favor a different form of equity compensation: RSUs. These are simply grants contingent on some vesting period (i.e., years of service). Upon vesting, shares are delivered to the employee and taxed as W-2 income based on the fair market value (FMV) on the date of delivery. The FMV at delivery establishes the employee’s cost basis in the shares. If they elect to hold them, any subsequent price appreciation will generate a capital gain or loss upon sale (short-term or long-term). In some cases, RSUs can be structured to defer federal and state taxes (not payroll taxes) upon vesting. Because RSUs typically vest in tranches each year and are forfeited upon leaving the company, they constitute a powerful retention tool.
Stock Appreciation Rights (SARs)
SARs are similar to NSOs and represent a contractual right to participate in the appreciation of company stock over a given period, subject to vesting requirements. Both leverage and tax treatment are equivalent to those of NSOs. SARs can be settled in cash or shares, and the timing of settlement (and the associated taxation) occurs at the employee's discretion once the vesting requirement is met.
Performance Share Units (PSUs)
Many investors and proxy advisors favor PSUs as a form of equity compensation because they create a more vital link between pay and performance. PSUs stock or stock-equivalent awards are granted to employees contingent on some specified operational goal or peer group performance metric. These awards also tend to be staggered over multi-year vesting periods.
Employee Stock Purchase Plan (ESPP)
An ESPP allows employees to set aside up to 15% of their paycheck ($25K annual maximum) on an after-tax basis toward the discounted purchase of company shares. IRS guidelines permit purchase discounts up to 15% below the prevailing market price. Furthermore, some plans also include a "lookback" feature which applies the purchase discount to either the beginning or end-of-offering-period share price (whichever is lower).
Since funds used to purchase shares are deducted from the employee's post-tax payroll, there is no additional tax withholding at the time of purchase. However, when the shares are sold, the proceeds are subject to two types of taxation. Any discount to the original offering price is treated as ordinary income (reported on the employee's W-2), while any difference above or below that offering price qualifies as capital gain or loss.
ESPPs with the maximum discount and lookback features offer employees an attractive "guaranteed" return for a limited holding period, with the caveat that all of such gain represents ordinary income. To truly optimize the tax treatment of their profits, employees need to hold their shares for a minimum of 1 year from purchase and two years from the commencement of the ESPP's "offering period." While this results in a more favorable tax treatment, it also increases the holding period risk, particularly if the company shares represent a high proportion of the employee's savings.
Employee Stock Ownership Plan (ESOP)
An ESOP is a tax-deferred retirement plan (similar to a profit-sharing plan) that grants employees an ownership stake in their employer while simultaneously allowing the controlling owner to sell their interest in the firm over time.
This type of plan is more common among smaller and mid-size private companies. Participating employees receive shares that typically vest over several years. When employees leave the firm or retire, they can sell their shares back to the plan and roll over the proceeds into a tax-deferred IRA. While an ESOP offers attractive tax benefits for both owners and employees, it comes with some trade-offs. Employees may have limited ability to diversify out of the company shares until they near retirement.
Additionally, the market for private company shares can be illiquid or lack transparency on valuation. While ESOPs have certainly helped many employees build wealth, the concentration risk has been disastrous for some. Employees of Enron or Kodak lost both their income and their nest egg when the companies went bankrupt.
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