Corporations may pay their employees through stock compensation to reward and incentivize them. There are multiple ways that employees can be compensated through stock. As an employee with stock compensation, you need to understand how different stock-based compensation programs work, how they are taxed, and considerations of each. Here’s a summary of the different types of stock compensation and how they work:
1) Employee stock purchase plan (ESPP): ESPP’s allow employees to purchase company stock at a discounted price. The discount differs based on the company but is often a 15% discount from fair market value. For example, if the stock is trading at $100/share, you can purchase it at$85/share instead. Employees typically have ESPP contributions deducted out of their paychecks with after-tax dollars. In most plans, you will not owe tax on the discount on the date of the purchase. Typical short-term and long-term capital gains rates will apply when selling. If you sell the stock within 1 year of purchase, you will pay short-term capital gains which are taxed as ordinary income. If you sell the stock greater than 1 year from purchase and 2 years from the grant date, favorable long-term capital gains rates may apply. Oftentimes, there are mandatory holding periods after purchase.
2) Incentive stock options (ISOs): ISOs provide you the right to purchase your company stock at a specified/pre-determined price called the exercise price. ISOs come with a vesting schedule. The term “vesting” refers to the time period you must stay with the company in order to receive ownership in the stock. You are given the right to “exercise” your ISOs at any time and would typically exercise them if the stock has appreciated above the price it was granted to you at (the exercise price). Here’s how they are taxed:
- At grant date: No tax
- At exercise: No tax but the bargain element is subject to Alternative Minimum Tax (AMT).
- At sale: There will be either a qualifying sale or disqualifying sale. A qualifying sale is when you held the stock for more than 1 year after exercising the option and 2 years from the date the ISO was granted to you. In a qualifying sale, all proceeds above the exercise price will be taxed at the favorable long-term capital gains rates rather than income tax rates. A disqualifying sale is defined as not meeting the requirements for a qualifying sale. In the case of a disqualifying sale, you are taxed at ordinary income rates on the lesser of the gain or exercise date spread.
3) Non-qualified stock options (NSOs): NSOs work very similar to ISOs in the way that they’re given but differ in the way they’re taxed. NSOs provide you the right to purchase company stock at a specified/pre-determined price (like ISOs). At a specified date, you are given the right to exercise these options and would exercise if the stock has appreciated above the price it was granted to you at (the exercise price). NSOs are taxed as follows:
- At grant date: No tax
- At vesting: No tax
- At exercise: Taxed as income on the spread between the grant/exercise price and current price of the stock.
- After you exercise, you now own that stock. Short-term and long-term capital gains apply above the exercise price at that point.
4) Restricted stock units (RSUs): RSUs are compensation given as stock shares instead of cash. They are issued through a vesting plan and are given upon meeting certain milestones such as length of time with employer, sales goals, etc. They are considered income once they are vested or paid out. The market value of the RSUs at their vesting date is taxed as ordinary income in that year. After the RSUs vest, you now own the stock. Short-term and long-term capital gains apply based on the vest date.
Here’s an example:
An employee has RSUs that vest on 1/30/24. On1/30/24, the market value of those shares is $30,000. In the 2024 tax year, they have $30,000 of additional income from the vested RSUs (taxed just like salary). This employee now owns the stock. Short-term and long-term capital gains apply based on the vest date.
5) Performance shares: A performance award is compensation of stock given to company leaders or executives if certain performance criteria are met. Typically, the criteria are based on company performance, not individual performance. Performance shares are used to incentivize leaders to do what they can to meet company goals. When an employee is granted the shares, there is no tax liability. Income tax is paid on the fair market value of the shares at the vesting date less any amount paid for the grant. Short-term and long-term capital gains apply based on the vest date.
That’s a high-level summary of the different types of equity compensation, how they work, and how they are taxed. Each company has different rules when it comes to their specific programs. Make sure you understand the details of the programs available to you before making any decisions.
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