Many of us are familiar with retirement plans like 401(k) or 403(b). Some of us even have a TSP (Thrift Savings Plan). However, when employers share a bigger slice of the pie and reward employees with equity, it can get a little more confusing.
Many companies, especially technology companies, give employees a chance to share in the growth and prosperity of the company. Companies do this by offering employees a variety of equity awards. These awards come in various types and have multiple acronyms. The awards also have very different rules when it comes to taxation and how the award can affect your bottom line. Let’s look at the very basics of just four of the most common awards.
ESPP – The Employee Stock Purchase Plan offers employees a chance to defer salary and then purchase company stock at a discounted price. An ESPP can either be a tax-qualified plan or a nonqualified plan. The employee contributes to the plan via payroll deductions for a defined period. At the end of the period, the accumulated payroll deductions are used to purchase shares of company stock at a discount. Every plan is different, but generally the discount can be up to 15%. One added advantage if the plan is tax-qualified is called a “look back” feature. This means the plan may look back and select the lower share price either on the offering date or the purchase date thus giving the employee an even better benefit. Rules vary for each ESPP and taxation can be tricky whether you ultimately sell your shares in a qualifying disposition, or a disqualifying disposition.
Options – A Stock Option at its core is an agreement between two parties that gives the buyer (optionee) the right, but not the obligation, to buy stock at an agreed upon price within a specific time. Option agreements come in many forms but two common types are ISOs (Incentive Stock Options) and NSOs (Nonqualified Stock Options). One advantage to an ISO is that when exercised you can avoid ordinary income tax and may ultimately pay only capital gains tax. However, ISOs come with a host of requirements to be qualified and are not always the best choice for the optionee as they can generate Alternative Minimum Tax. An advantage to NSOs is that the company granting the option has greater flexibility in who they may select as an optionee, including granting to outside directors and contractors. Options have their own lingo, unique rules and complex timing and taxation issues which go far beyond this basic explanation.
The next two award types are frequently confused by recipients; some even use the acronyms interchangeably. They are NOT the same and careful attention should be paid to the type of award you may have received.
RS – Restricted Stock is a grant of stock to executives that is nontransferable and becomes available to the executive pursuant to a graded vesting schedule. It is generally subject to insider trading regulations under SEC Rule 144. Although it can be risky, recipients of RS awards may be able to make a Section 83b election thus reporting the compensation value of the stock when received versus when it vests. This can result in substantial tax savings if the shares appreciate in value. If the shares do not increase in value, or worse, the grantee forfeits the shares, you’ve accelerated the tax payment without receiving a benefit.
RSU – Restricted Stock Units are conceptually similar to Restricted Stock. However, they are granted to employees and the employees must meet a set of underlying criteria outlined in the plan document to receive their actual shares. That is, the RSUs are granted as an unsecured promise until the employee meets the criteria according to the vesting schedule. Another key difference is that RSU recipients cannot make a Section 83b election (there is no actual stock issued at grant).
There are many types of equity awards that companies make available to employees, consultants and directors. Each plan or award type may have different variations. Each award type has its own set of rules to be either qualified or nonqualified and will have various complex tax regimes. If you have been granted an equity award, hold on to your plan documents and read the details very carefully.
Next, call me to strategize! As an independent Certified Financial Planner™, I can help you with a strategy to address taxation and what to do with the subsequent cash. Contact me and let’s get started! #talktometuesday #savings #equity #espp #sop #rs #rsu #CFPPro