Editor’s Note: This article is the first in a two-part series adapted from “Employment Contracts,” Chapter 14 of The High Achiever’s Guide to Wealth. Pick up your own copy here to read more on this topic and many others.
Receiving a job offer or new compensation package is exciting. But if that offer includes equity compensation, it’s important to take time to know what you are getting.
While wages and cash bonuses are easy to understand, parsing that offer can become confusing if you are also offered some form of ownership in the company. Understanding the terms and implications of equity compensation are critical to accurately assessing your job prospect. It will also be important for planning to maximize your benefit if you accept the position.
Equity compensation comes in a variety of forms, and the terms of those offerings can vary from company to company. Popular equity compensation benefits include stock options, restricted stock, restricted stock units or outright shares of a company. These offerings vary in whether or not you need to invest any of your own capital to purchase the stock. If you receive equity and pay less for it than its fair market value, the difference between those figures is considered income. You will also owe tax on that compensation at some point. The timing and type of the taxation will vary with the different types of equity compensation.
Types Of Equity Compensation
At their most basic, stock options are an agreement in which a company grants an employee the right – but not the obligation – to buy shares of stock at a set price, known as the strike price or exercise price. When the company’s shares trade below that set price, stock options are effectively worthless. As the stock price increases beyond the strike price, options become more and more valuable. Of course, stocks do not move in only one direction, so the company’s performance will contribute to what your options are worth over time.
Stock options come in two flavors: nonqualified stock options and incentive stock options. Nonqualified stock options are more common. Incentive stock options are more limited in scope, but offer some tax benefits. They can also potentially trigger the complexities of the alternative minimum tax, often abbreviated AMT. In some cases, an employer may offer you a choice between nonqualified and incentive stock options. In other cases, the company will only offer one or the other. Your employment status could also come into play. Companies can offer incentive stock options only to employees, but they can offer nonqualified stock options to contractors and consultants as well.
Restricted stock refers to shares of a company subject to certain stipulations. Most often, restricted shares vest after you maintain employment with the company for a set period. Until you meet the relevant milestone, you risk receiving no value at all for restricted stock. In general, this means you will not include the value of the stock in your income until it vests, which has the benefit of deferring the income.
As the name suggests, restricted stock units are related to restricted stock, but the mechanism works slightly differently. RSUs are not an actual transfer of stock on the grant date. Instead, they represent the company’s promise to transfer the stock once the recipient meets certain requirements. The company also may have the ability to grant the cash equivalent of the stock’s value on the grant date. Be sure that you understand the company’s particular vesting requirements for any RSUs.
The complications of equity compensation increase if you’re receiving shares in a private company. Be sure you know what percentage of the company your equity represents and how that will change as the company issues more shares. In most cases, though not all, the company issuing more shares will dilute your position. Valuing shares in a private company is less straightforward than equity in a public company, so ask how your interest will be valued. You should also ask whether you will be subject to any restrictions on selling it. What will happen to your equity if you leave the company should be clear, and you should inquire about any other agreements that might affect the outcome. For example, a buy-sell agreement might dictate that you sell your interest back to the company or other shareholders when you leave. The contract or offer letter should also state what will happen to your equity in the event of a sale or a public offering.
Tax Considerations
Almost any type of stock you receive from your company will be taxable as ordinary income, just like wages. When you owe that tax will depend on how the company structures the equity. In general, the value of your stock compensation becomes taxable when you no longer risk forfeiting it unless special rules apply.
If you exercise a nonqualified stock option, you will owe tax on the difference between the exercise price and the stock’s market price at that time. If you have incentive stock options, you will incur long-term capital gains tax on all appreciation over the exercise price, as long as you hold the acquired shares for at least two years after the date the company granted you the option and at least one year after the exercise date. This can represent a significant tax saving when the long-term capital gains tax rate is lower than ordinary income tax rates (as it is at the time of this writing).
As I mentioned before, you do not owe tax on restricted stock before it vests in most cases. However, if you expect to stay with your company and have high expectations for the stock’s performance, you could benefit from making a special election to include the equity compensation in your income when it is granted. If the stock appreciates between the grant date and the vesting date, the election saves you ordinary income taxes. Named for the relevant section of the Internal Revenue Code, an 83(b) election allows you to recognize the fair market value of the stock as ordinary compensation income at the time of the award. If you make an 83(b) election, you will still have to pay capital gains tax on any appreciation that occurs between the point at which you included the restricted stock as ordinary income and the future date when you sell your shares. But while you recognize the same amount of income either way, an 83(b) election allows you to characterize more of that income as capital gains.
This strategy comes with risks. If you lose your right to the property before it vests, you will have paid tax on income you never received. Similarly, if the value of the restricted stock decreases between the date of grant and the date of vesting, making an 83(b) election means you will recognize more ordinary income than you otherwise would have. Because you must notify the Internal Revenue Service that you are making an 83(b) election using specific procedures and within tight deadlines, it is a good idea to consult a tax professional as soon as you receive a restricted stock award to be sure you make the election correctly. For more details about 83(b) elections, see my colleague Melinda Kibler’s article “When And How To Make An 83(b) Election.”
While I have focused on companies that issue stock to their employees, a business structured as a partnership may want to attract new talent or keep high performers by offering to make the employee a partner. The full details involved in considering a partnership arrangement go beyond the scope of this article. But it is important to know that all partners report their share of the profits and losses from the business on their individual income tax returns, regardless of whether they received that income in cash. This can result in owing tax on so-called “phantom” income. If you expect to deal with private company taxation, especially for the first time, you may want to consult a tax professional. An experienced adviser can ensure that you are meeting your current obligations and making the most of planning opportunities.
Diversification
Once you have equity in your company, it is important to consider the risks of continuing to hold that stock. Having too much stock in any given company exposes you to risk; if that company is also the one that pays your wages, a large part of your financial well-being rests on your future with the company and the future of the company as a whole. Company-specific risk exists for even well-established and profitable firms. If you are optimistic about your company, you can certainly hold on to some portion of your equity. But you should make sure it is part of a diversified portfolio.
When looking to reduce your exposure to your company stock, first make sure you understand the rules for the equity you receive. Not only should you pay attention to vesting rules, if any, but also note that some employers offer company shares as part of a 401(k) plan. In these plans, you may face requirements that you hold company stock received through an employer match for a certain period. If you can reallocate your holdings within the 401(k), doing so is straightforward. Since the account is tax-deferred, selling your shares won’t trigger any extra tax.
If you own your shares outright and can do as you like with them, consider consulting a financial adviser to develop a tax-effective plan for diversifying your holdings. This process may spread over more than one year to avoid tax bracket creep.
In the event your company is not yet public, you will need to bear extra restrictions in mind when selling private company stock. Employees typically have to resort to transactions in a limited, nonpublic secondary market. Buyers in these transactions often demand a steep discount. If a public offering, merger or acquisition is on the horizon, it may make more sense to wait until your company goes public to diversify.
Equity in a company you work for, especially a private company, can be complex. You may want to consult a third party, such as your financial adviser or attorney, when evaluating a job offer that includes equity in the compensation package and in deciding how to handle your equity once you receive it. Despite these complications, a stake in a company can give you a greater sense of ownership and a more personal interest in your enterprise’s success. With careful planning, equity compensation can be a rewarding benefit that pays off in the long run.
