Equity compensation for key employees—stock options, stock grants and the like—has become ubiquitous at major American companies. The reasons for this development may be traced to the early 1990s. Companies could pay their CEO whatever they wanted, but the corporate tax deduction was limited to $1 million during the Clinton administration. However, an exception was provided for performance-based compensation. Bonuses for meeting certain targets, such as increasing sales by a large percentage or boosting the company stock price above specified levels, could still generate tax-deductible compensation. The best way to align the interests of management and shareholders was to provide those performance bonuses in the form of equity compensation.
Notwithstanding that origin story, equity compensation plans have become popular further down the income scale.
Types of equity compensation
- Non-qualified stock options. An opportunity to purchase shares in the future at a stated price. When the option is exercised, the difference between the purchase price and the fair market value is taxed as ordinary income. The fair market value becomes the tax basis, and future growth in value of the shares will be taxed as a capital gain.
- Incentive stock options. With an incentive stock option (ISO), a special category under the tax law, there is no tax when the option is exercised, but there may be Alternative Minimum Tax issues.
- Restricted stock units (RSUs). A promise to deliver shares upon vesting. The value of the shares at vesting will be taxed as ordinary income.
- Restricted stock awards. The shares of stock are granted immediately but are subject to forfeiture until they are fully vested over time. As the shares vest, the fair market value is subject to ordinary income tax. Alternatively, the employee can elect to pay tax when the grant of shares is made, which means that subsequent increases in value will be capital gain. This can be risky if there is a chance the employment will not last until the entire grant has vested, and having the liquidity to meet the tax obligation may be problematic.
Long-term versus short-term
The time horizons for grants of equity compensation depend upon the objective of the grant. A short-term grant, with a quick vesting schedule, may be used to recognize outstanding performance or specific past achievements. This can be a powerful tool for boosting morale and fostering a culture of achievement. A long-term grant, on the other hand, is designed to reduce turnover of top talent while focusing on goals that will take years to achieve. These tend to be larger grants with longer vesting schedules.
Evaluation of an equity compensation plan
What does a first-time recipient of equity compensation need to keep in mind? Salary and bonus compensation can provide immediate liquidity and certainty, while equity compensation is a deferral of reward in hopes of a major future benefit. Key items to consider:
- Vesting terms and schedules. How long is the wait for the reward? How reasonable are any performance triggers?
- The company’s trajectory. What is the company’s position in the market? How likely is it that the shares will grow in value at above-market rates? Is there any chance of company stagnation, which could eliminate or diminish the value of the equity grant?
- Exit strategy. For start-up companies, an exit may come with an initial public offering or the acquisition of the firm by a larger company.
Look at the whole financial picture
Equity compensation tends to create a concentration risk in the employer's stock. That's not a problem in a steadily rising market, but it may be prudent to provide a hedge in the overall portfolio. Consider these steps:
- Diversify investments in a 401(k) plan or IRAs away from employer stock and the business sector.
- Have an asset allocation plan for the after-tax portfolio that takes the equity compensation into account.
- Maintain sufficient liquidity in cash or short-term bonds to meet tax obligations and normal expenses, so as not to be forced to sell stocks at an unfavorable moment.
- Have a strategy for meeting the tax obligations associated with turning equity compensation into real wealth. Professional tax advice will be essential.
An Arvest Client Advisor can work with you on integrating your equity compensation into your overall financial planning.
This content has been prepared by The Merrill Anderson Company and is intended as a general guideline.
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Arvest and its associates do not provide tax or legal advice. The information presented here is not intended as, and should not be considered, tax or legal advice. Consult your tax and legal advisors accordingly.
