What is Equity Compensation?
Equity compensation. This is a term most people know very little about, but if offered, could mean worlds of differences for your financial life. Investopedia defines equity compensation as a non-cash payment offered to employees and executives of public and some private companies. Equity compensation, as the name implies, is ‘equity’ given in the form of shares (stock) to the employees. Companies use this form of compensation to attract higher quality employees, reduce their turnover rate, and acquire monetary capital for the business.
Forms of Equity Compensation
Companies have a multitude of options to offer equity compensation and each have a different set of opportunities, vesting schedules, costs, and taxes associated.
The most common form of compensation is Stock Options. This type of compensation allows employees the right to purchase shares of the company at a predetermined below market value price. There are two types of stock options: NSOs, non-qualified stock options, and ISOs, incentive stock options.
Owners of NSOs may have to pay taxes under two circumstances: income tax when they purchase a non-qualified stock, and capital gains tax if the stock is held for a year or more. This could create a large tax burden if you plan to hold on to your options and hold on to the shares.
Owners of ISOs are generally only taxed at the sale, not at exercise (purchase) of stock options. However, Alternative Minimum Tax could be triggered at exercise depending on your tax circumstances. This is because the bargain element (the difference between the exercise price and the market price at exercise multiplied by the number of shares exercised) is included in the calculation of the tentative minimum tax.
Many publicly traded companies also offer Restricted Stock Units or RSUs, which are limited by the employer based on your vesting schedule. As your shares vest, the market value of the shares is included as ordinary income. The beauty of Restricted Stock Units is that you do not have to purchase shares to obtain equity. You only have to wait for the shares to vest and for a liquidity event (merger/acquisition, or going public).
Lastly, there are performance-based shares, which are given based upon meeting specific performance goals. These goals may vary and will depend on your company.
The Importance of Understanding Equity Compensation
For people who receive equity compensation, it is important to understand what type you receive but also the many benefits. Because of the discounted price, people are able to use their shares to:
- pay off debt,
- purchase homes,
- diversify their investment portfolios, and raise their net worth.
Equity compensation is complex, but a great wealth-building tool. Understanding the differences between stocks can help you determine the value and tax implications of equity compensation. With that in mind, make it a priority to speak with your financial advisor and/or tax professional about the best way to handle your equity compensation. If you do not have a financial advisor or someone qualified to help you make these decisions, schedule an appointment with one of our advisors at Zenith who would love to speak with you!