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If you are looking into a job that offers equity compensation on some level, you want to make sure that you are getting the best arrangement possible.
It's also important to understand how this form of income is taxed compared to standard salaries.
Read on to learn more about this process and how it will affect your taxes.
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What is Equity Compensation, and Why Does It Matter?
Equity compensation is a way for your company to compensate you for your work in a non-cash form. Normally, you receive a salary or wages as part of your contract for employment. But with this method, you may also receive equity compensation that represents ownership in the firm. This equity is usually associated with the company's value in the stock market.
This type of compensation system may seem confusing if you've never used it before. But once you break it down, you'll begin to grasp the general idea. It is important to understand this system because it can impact your career path and the types of jobs you take.
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What Type of Companies Use Equity Compensation?
You may be thinking, do all companies do this? The answer is no, but a large number of companies do. And it isn't limited to large companies either. Smaller businesses are also known to do this.
Equity compensation is a popular method of compensation, and most employees appreciate it. When it comes to trends, though, it is most common among start-up companies, especially tech start-ups.
Start-up companies are fans of it for several reasons, including:
To attract high-quality employees
To reward and retain employees
Attracting High-Quality Employees
When a company is first starting, they want to create a strong foundation for their business by hiring top-level employees. An equity compensation program may be the extra push that incentivizes employees to choose the start-up over a more established company.
Rewarding and Retaining Employees
Start-ups, and all companies that use the equity compensation model, use it to reward and retain their employees. If a company wants someone to stay with it for the long-term, this form of compensation is one way to motivate them to do so.
Many start-ups lack the established cash-flow to pay their employees competitive wages. But equity compensation can take the place of that in certain situations.
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Terms for Understanding the Equity Compensation Timeline
The stock market is a market that is constantly changing. It may be difficult at times to view it as strictly linear. But when it comes to equities, it is important to view your options in that manner, as it helps you make sense of how your company is compensating you. It allows you to see the big picture and put a plan in motion for how you want to act upon your investments.
In this section, we will discuss some of the important terms you'll come across if you receive this type of pay at your job.
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Grant Date: The grant date is the date that you were first given an option/type of equity as a part of your employment. Keep in mind that this is not the date when you can take action.
Grant Price: The grant price is the price at which your company dictates you can purchase a specific stock, as stated in the agreement.
Exercise Date: This the date on which you exercise, or take action on, your options. You can exercise at any time once your vesting date has arrived.
Exercise Price: This is the price at which you exercise your options. This is usually the same as the grant price, which is a predetermined amount.
Vesting Date: Depending on the company that you work for, you may have to reach something known as the vesting date before you can exercise your options. Once you reach this date, you can exercise. This is a common strategy for companies who want to encourage retainment.
Expiration Date: It is not uncommon for your options to have an expiration date. This is usually many years after the day your company hired you, perhaps ten years or more. It is the date you have to exercise your options by, or else they will go unused.
Market Price: Simply stated, this is the current price of the stock as it is on the market. It is important to keep track of this price as it changes, so you know when the best time to buy is.
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What Forms Does Equity Compensation Take?
Equity compensation can come in several different forms, known as stock options. It is known as an option because an employer gives employees options for investment, but an employee is never required to act on those options.
It is important to understand these different forms and what they look like. Depending on your situation and the company you work for, one type may be more beneficial than others. Which type works for you may also vary over time.
The most common categories include:
Incentive Stock Options (ISO)
Non-Qualified Stock Options (NQSO)
Restricted Stock Units (RSU)
Incentive Stock Options (ISO)
With this type of option, you have the right to purchase company stock at the exercise price, but you are not required to do so.
One important thing to remember about this type of option is that it is exclusive to employees of a company. It doesn't apply to contractors, consultants, or directors (non-employee status).
With this option, you typically have to wait until a predetermined vesting date to take advantage.
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Non-Qualified Stock Options
Unlike the Incentive Stock Options, your employer can give Non-Qualified Stock Options to outside people hired by the company, including contractors, consultants, and directors (non-employee status).
When you exercise this type of stock, the income you receive from it follows standard income tax rules.
Restricted Stock Units (RSU)
Restricted Stock Units differ some from ISOs and NQSOs because they are real stock units, as opposed to the option to buy stock units. They usually require an employee to complete a specific vesting period before he or she gains access to them.
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Performance shares are a less common type of equity for employees that are given to employees once certain measures are met. Some metrics that relate to performance shares include:
Return on equity (ROE)
Earnings per share target (EPS)
The total return on the stock concerning an index
Performance shares usually occur over multi-year periods.
How Do Taxes Work When It Comes to Equity Compensation?
Now that we've covered some of the basic principles of equity compensation, it's time to talk about how it will affect your taxes. Just like your regular salary at a company, your equity compensation is subject to taxation. Which type of stock option you have will determine the tax laws you'll need to know.
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Incentive Stock Options
When it comes to your taxes for ISOs, this type of stock option has some flexibility. Because you have access to it as an employee of the company (as opposed to a consultant or contractor), there is some preferential tax treatment at play.
Usually, you will defer taxes until you sell the stock.
Tax rates are calculated with the following formula:
10 Shares x ($100 Stock Price at Vest - $10 Exercise Price).
It may lead to an Alternative Minimum Tax in certain situations.
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Non-Qualified Stock Options
Unlike ISOs, NQSOs do not qualify for preferential tax treatment. The money you make while exercising this stock is the difference between the market price and strike price. The income you make from this is then recorded on your W-2 or another tax form.
If you are an employee, your employer should withhold Medicare and Social Security for you. When you sell this type of stock, you can expect to pay a capital gains tax.
Tax rates for this option are calculated using the following formula: 10 Shares x ($100 Stock Price at Vest - $10 Exercise Price).
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Restricted Stock Units
The main thing to remember about RSUs is that they become taxable once you complete the vesting period. Before that is completed, you won't have to do much in the way of RSUs.
The taxes are calculated using the following formula: 10 Shares x $100 Stock Price at Vest.
About Alternative Minimum Tax (AMT)
The Alternative Minimum Tax exists because of the tax breaks that ISOs offer. If your regular tax falls below the threshold for the AMT, you will have to pay the AMT. If your regular tax is higher than the Alternative Minimum Tax, then you will just pay the regular tax. It all depends on your specific situation.
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Need Help Handling Your Equity Compensation?
If you work for a company that offers some type of equity as a means of compensating you, it can be a great way to expand your financial portfolio.
Before you exercise any of your options, make sure you do adequate research first. You want to make sure you are entering the market at a good time so that you can make a profit on your options.
At MYRA, we're a team of financial advisors that specialize in helping clients understand complicated financial processes. We can assist you when managing your options.
Contact us today for help with managing your equities and understanding taxation.