A compensation package can open the door to meaningful opportunity, especially when equity is part of the equation. For many executives and key employees, stock awards and other equity-like incentives can help support long-term financial goals, but they also come with important tax and planning considerations.
Understanding how these forms of compensation work is an important first step. When viewed in the context of your broader wealth plan, they can become a valuable tool in helping you make more informed financial decisions.
Below are descriptions of four of the most prevalent equity or equity-like compensation offers, as well as important considerations for how they may affect your income tax withholding throughout the year.
1) Restricted stock
- This is a pure grant of company stock, but the stock is not owned by the employee until certain vesting restrictions (typically time and/or performance) have been met.
- If the stock pays a dividend, those dividends are typically paid to the employee during the holding period.
- The value of the stock will be taxable to the employee as ordinary income at the time that the stock vests. However, if the employee has made a Section 83(b) election under the Internal Revenue Code, the employee will recognize ordinary income at the time the stock is granted (not when it vests) based on the value of the stock at that time.
- Income from restricted stock is subject to payroll taxes, such as Social Security and Medicare taxes.
2) Non-qualified stock options (NQSOs)
- An NQSO is the right to acquire (“exercise”) a fixed number of shares at a fixed price for a specific period of time.
- NQSOs are typically subject to vesting restrictions based on the recipient’s service to the company.
- They can be granted to employees and nonemployees, such as directors and consultants.
- The recipient will recognize ordinary income on the difference between the exercise price and the fair market value of the shares at the time of exercise.
- The exercise is also subject to payroll taxes.
- If the employee later sells the shares, the sale will be treated as a capital gain or loss, with the basis of the shares being equal to the fair market value of the shares at exercise.
3) Incentive stock options (ISOs)
- An ISO is the right to acquire a specific amount of stock at a predetermined price at least equal to the fair market value of the stock at the time that the ISO is granted.
- They can only be granted to employees.
- ISOs are taxed when the stock is eventually sold. If the stock is held until the later of two years from the grant date or one year from the exercise date, the sale receives long-term capital gains tax treatment; if either of those requirements are not met, then the spread at exercise is taxed as ordinary income, and any excess appreciation is taxed as capital gain.
- Alternative minimum tax issues can arise with exercise and a subsequent disposition.
4) Equity-like compensation
- This type of compensation typically provides a monetary benefit based on the appreciation and/or dividends of the company’s underlying stock, rather than giving a right to the stock itself, although in some cases there may be a future right to receive stock.
- Common forms of equity-like compensation include restricted stock units (RSUs), stock appreciation rights (SARs) and phantom stock.
- When interests vest or cash is received, equity-like compensation is generally subject to ordinary income taxes as well as payroll taxes.
- These equity-like interests do not qualify for an IRC Section 83(b) election as they are not considered “property.”
Important withholding considerations
In addition to understanding the types of compensation and their impact on your income tax liability, it is also important to understand how equity compensation may impact your income tax withholding during the year. With the exception of ISOs, equity compensation is typically subject to withholding for income and payroll taxes. Withholding can take different forms:
- Cash payroll withholding is when the company uses the employee’s cash wages to satisfy withholding requirements.
- Share withholding is when the company reduces the number of shares otherwise deliverable at vesting or exercise to satisfy withholding requirements, sometimes referred to as a net cashless vest or exercise.
- Sell-to-cover withholding is when the company sells vested or exercised shares on the employee’s behalf to generate cash to satisfy withholding requirements.
No matter what type of withholding is used, it is important to remember that it may not fully satisfy the employee’s ultimate tax liability.
Equity and equity-like compensation are often subject to complex rules and restrictions. If such incentives are a part of your compensation, it is important that your financial and tax advisors work together so that you can leverage your total compensation package to maximize your wealth potential. For more information about executive compensation, reach out to your CIBC advisor.
