Whether you just started your first job or have been working in tech for years, chances are that you have received some sort of equity with your compensation package. This usually happens in three main ways:
- You have the option to purchase shares of your company at a set price
- You receive shares of your company as part of your pay
- You can purchase shares of your company at a discount using your paycheck
Depending on what stage your company is in (pre-IPO, going public, or already public) will determine which type of equity you receive. This article will give a high-level overview of the different types of company equity, including stock options (ISOs and NQSOs), Restricted Stock Units (RSUs), and ESPP (Employer Stock Purchase Plan).
Here is an overview of equity compensation you can receive:
RSUs (Restricted Stock Units)
RSUs are a different way for your company to pay you. Rather than paying you a bonus in the form of cash, they can pay you using company stock. This is a great way to incentivize employees to be more efficient and to stay at the company. After all, you tend to work harder when you are an owner and have “skin in the game”.
- Grant agreement – the legal document that lays out the terms of your RSUs
- Grant date – the date that your shares are granted to you. This is important because this date will start the clock for your vesting schedule
- Vest date – the date that you receive the shares and have the option to sell them
- Vesting schedule – the schedule at which the share will become available to you. The FMV at the time the shares become yours is taxable and will report on your paystub and W-2
- Cliff – the amount of time you need to work at your company before you start receiving shares. The most common vesting schedule is over 4 years, with a one-year cliff. Other companies may start vesting immediately or after one quarter
When your RSUs vest, they will be considered taxable income to you. Here is how to calculate this amount:
Number of shares vested X FMV on vest date = taxable income
Your employer will usually withhold taxes on the vesting date. Because of this, you can expect about 40% of your shares to be sold (if you live in California) to pay for Federal, State, and payroll taxes. Based on your income and tax bracket, this is usually not enough withholding, and you may be required to make estimated tax payments.
Stock options are a great benefit that is commonly provided to employees at young, private companies. They give the employee the right to buy company shares at a discounted price. ISOs (Incentive Stock Options) have preferential tax treatment, while NQSOs (Non-Qualified Stock Options) are taxed as ordinary income.
- Stock option agreement – the legal document that lays out the terms of your stock options
- Grant date – the date which your employer granted you the options
- Vesting date – the date that you receive the shares and have the option to sell them
- Vesting schedule – the schedule at which your stock options will become eligible for you to exercise
- Exercise or strike price – the price that you will have to pay per share in order to exercise the option
- Expiration date – the date on which your exercise period ends, and you will no longer be able to exercise the shares
When stock options are granted or vest, there are no tax implications. The tax implications start when you actually exercise and sell your options.
If you have NQSOs, you will recognize ordinary income (NQSO income) when you exercise the shares. To calculate this, multiply the number of shares exercised by the bargain element.
The bargain element = FMV – your exercise (strike) price.
If you have ISOs, you may trigger AMT (Alternative Minimum Tax) when you exercise the shares. AMT is a complex tax calculation, and you should work with a financial planner or tax advisor to determine if you will owe this.
When you later sell the shares, any gains recognized beyond the exercise (strike) price will be taxable income.
ESPP (Employer Stock Purchase Plan)
ESPP (Employer Stock Purchase Plan) shares are offered to employees once your company is public. You are able to deduct a portion of your pay each pay period and purchase shares of the company at a discount (up to 15%).
- Enrollment date – the date where you opt into the ESPP program
- Offering period – the period that you can purchase shares at a discount. This is usually 12 months
- Purchase period – the period where you contribute a certain amount from your paycheck to purchase shares. This is usually 6 months
- Purchase date – the date where your company shares are actually purchased
- ESPP discount – the amount of discount that you will receive to purchase your company stock. The maximum discount is 15%.
There are no tax implications when you purchase the shares. When the shares are sold, any gains recognized beyond the discount you received are taxable income. If the shares are sold within 2 years from the start of the purchase period and 1 year of your purchase date, this will be a disqualifying disposition and taxed as ordinary income. If the shares are sold beyond 2 years from the start of the purchase period and 1 year of your purchase date, this will be a qualifying disposition and taxed as capital gains.
Understanding the different features and tax implications of your equity compensation is crucial to optimizing your finances. If you would like to work with a financial planner to walk you through your options, I would love to help you!
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Disclaimer: This blog is for informational purposes only, and should not be considered advice or recommendations. All opinions expressed herein are solely those of Amaral Financial Planning, LLC, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made to another parties’ informational accuracy or completeness. You should consult your financial advisor, tax professional or legal counsel prior to implementation.