Types of Equity Compensation and How They Are Taxed

Equity compensation is an attractive way for employers to recruit and maintain employees in the long term. Given the various types of equity compensation, it is important for both employers and employees to understand how these different types of equity awards are taxed.  

Before we get into the specifics of each type of equity award, we must first define a few terms. 

Important Dates

The following are a few key dates and terms that both employers and employees must know. 

• Grant Date: The date an employer grants the award to the employee 
• Vesting Date: The date upon which the award is given to the employee 
• Exercise Price: The predetermined price at which an employee is eligible to purchase shares 
• Exercise Period: The predetermined length of time an employee is able to exercise the award 
• Expiration Date: The last day an employee can exercise the award 

Stock Options 

Stock options are a common type of equity compensation that employers will offer to their employees. Stock options work by the employer granting a set number of options to the employee on what is known as the grant date. Upon granting of the stock options, the employer will communicate the exercise price to the employee. The exercise price acts as the baseline from which the employee can measure the value of the options.  

Once the options are vested, the employee has full ownership of the options and is free to exercise when they see fit. The employee will have up until the expiration date to exercise the options. The purpose of stock options is to watch the share price appreciate over time and allowing the employee to purchase shares at the lower exercise price. 

There are two types of stock options, each with their own distinctions on how they are taxed. 

1. Nonqualified Stock Options (NSO or NQSOs)

Nonqualified stock options can be awarded to anyone internal or external to the company as a form of compensation. NQSOs are taxed as ordinary income, similar to wages, when they are exercised. The taxable income recognized upon exercising is the spread between the fair market value (FMV) over the exercise price. Later, when the shares are sold, the income or loss is treated as capital gain or loss. 

NQSOs can be highly beneficial to the employer in that they are able to compensate employees without having a cash outflow. In addition, the employer gets a full tax deduction equal to the amount of income reported by the employee. NQSOs also can act as an incentive to the employee receiving the options are they have a vested interest in the company. 

Employees can benefit from NQSOs by obtaining shares of the company at below market value. In the long term, these may be far more lucrative than cash compensation assuming the value of the company’s shares continues to grow. 

2. Incentive Stock Options (ISOs) 

The second type of stock options are Incentive stock options. These offer more favorability in regards to their income tax treatment. Unlike NQSOs, ISOs do not trigger any income recognition when exercised. In fact, the full income recognition is deferred until the shares are disposed of, upon which the full amount of income recognized is treated as long term capital gain.  

However, there are two caveats employees should be aware of when it comes to ISOs. First, the difference between the FMV of the stock over the exercise price is an adjustment for AMT. Second, the employee must hold onto the shares for at least one full year after exercising and two full years after the grant date to qualify for full long term capital gain treatment. 

Another unique aspect to ISOs which benefits both the employer and employee, is the avoidance of payroll taxes. Unlike NQSOs and other types of equity compensation, ISOs are not subject to Social Security and Medicare taxes. This saves the company and the employee 7.65% in tax.  

NQSO vs. ISO 

There are a couple key differences between ISOs and NQSOs. Primarily, the taxability of ISOs is more beneficial to the employee by the long term capital gain treatment, rather than ordinary income recognition. There is also the condition on who is eligible to receive these options. NQSOs may be offered to individuals both internal and external to the company. Meaning, companies can choose to compensate both employees and external contractors with NQSOs. However, ISOs may only be offered to employees. 

83(b) Election 

Employees who are granted stock options have the ability to make an 83(b) election. An 83(b) election is an attractive option if it is reasonably certain that the value of the shares is expected to appreciate. We go into more detail and even offer an election template in our 83(b) election article.

Restricted Stock Units (RSUs) 

Restricted stock units are shares of the company’s stock that are awarded to the employee. Unlike employee stock options, RSUs are actual shares of stock that are given to the employee. RSUs are granted to the employee either at the start of their employment or the start of a new compensation cycle.  

Taxation of RSUs follow similar treatment to nonqualified stock options. There is no income recognition to the employee until the shares are vested. At that time, the value of the vested shares are treated similar to wages. If the employee decides to later sell the shares, the resulting gain or loss will create a capital gain or loss. 

Stock Appreciation Rights (SARs) 

Stock appreciation rights are another popular form of equity compensation that is tied to the company’s stock price. When the SARs are granted to the employee, the employer will set the grant price, which is usually the value of the stock on the grant date. The grant price is the baseline that will determine how valuable the SARs are over time as the price of the company’s stock appreciates. The employee will be awarded the rights based upon a predetermined vesting schedule, which also mark the beginning of the exercise period. The employee will have the duration of the exercise period in which to exercise the award. Unlike stock options, an employee does not have to purchase the underlying security, and is either given the value of the award in shares or cash. 

Summary and Comparison 

The table here summarizes the income tax implication for each equity award on the various dates described above.  

Understanding the tax implications of various equity compensation types is crucial for both employers and employees to make an informed decision. 

Evolved is a tax compliance and advisory firm with offices in New York City, Philadelphia and Stamford, serving clients nationally throughout the US.  We provide tax provision, private equity and venture capital services alongside advisory for high net-worth tax and family office tax.