Equity Compensation

Equity compensation is compensation paid in the employer's stock or in a right measured by the value of that stock, rather than in cash. The common forms are restricted stock units, restricted stock awards, non-qualified and incentive stock options, shares bought at a discount through an employee stock purchase plan, stock appreciation rights, and performance shares; phantom stock and other cash-settled awards track the share price without ever delivering shares. The phrase is a general description rather than a defined legal category, though the SEC uses it in its disclosure rules: Regulation S-K requires public companies to report the securities "authorized for issuance under equity compensation plans."

Why the label hides more than it reveals. A restricted stock unit and an incentive stock option are both equity compensation, and they share almost nothing else: one delivers shares you owe tax on when they arrive, the other gives you the right to buy shares at a fixed price and can produce no regular income tax at exercise while still creating an alternative minimum tax adjustment. Three questions sort every award into its place.

1. Do you own shares now? With a restricted stock award the shares are issued to you on day one and can be taken back until they vest, which is what makes an 83(b) election possible. With restricted stock units you own a promise; shares arrive only at vesting. With options and stock appreciation rights you own a right, not stock. With phantom stock you never receive shares at all.

2. Do you pay anything? Units, restricted stock awards and performance shares are generally granted without a purchase price. Options require you to pay the exercise price to buy the shares, which can take real cash. Stock appreciation rights deliver the gain without a purchase. An employee stock purchase plan is the one where you buy with your own pay, through payroll deductions, at a discount.

3. When is it taxed, and as what? Units and restricted stock are compensation income when they vest, unless an 83(b) election moved the restricted stock's income to the grant date. A non-qualified option produces ordinary income on the spread when it is exercised. An incentive stock option produces no ordinary income at exercise if its statutory conditions hold, but the spread counts for the alternative minimum tax, and its favorable treatment depends on holding periods. Qualified employee stock purchase plan shares have their own holding-period rules. The details, and the traps inside each, are on the individual pages; they do not transfer from one instrument to another.

What every form shares. Nearly all awards vest, on a schedule, on performance targets, or on a sale of the company, and unvested awards are generally forfeited when employment ends. Many are subject to company trading windows and blackout periods. And every one that converts to shares leaves the employee holding stock in the company that also pays their salary. That is the planning issue the instrument-by-instrument tax rules tend to crowd out: once shares have vested and been taxed, as restricted stock unit shares are at vesting, keeping them is economically the same decision as receiving the cash and using it to buy the employer's stock.

What it is not. An employee stock ownership plan holds employer stock too, but it is a qualified retirement plan rather than an award to an individual, and its rules come from the retirement-plan side of the tax code.

The cycle is broadly the same across the forms, even though the tax points differ.

1. Grant. The company awards units, options, shares or rights under a written plan, usually with a vesting schedule.
2. Vesting. Time passes, targets are met, or both, and the award becomes yours. Anything not yet vested when you leave is generally forfeited.
3. Settlement or exercise. Units convert to shares. Options and appreciation rights can be exercised. Purchase-plan shares are bought at the end of each offering period.
4. Tax. Depending on the form, compensation income arises at vesting, at exercise, or only at sale. An employer may withhold on equity income at a flat supplemental rate, which can fall short of a high earner's actual rate.
5. Hold or sell. The shares you keep take a cost basis equal to what you paid plus whatever was taxed as compensation, and later price changes are capital gain or loss.

Take an example: Ines has 400 restricted stock units vest when the share price is $50. The vesting creates 400 x $50 = $20,000 of compensation income, the same as a $20,000 cash bonus. Her employer withholds federal income tax by keeping back 88 shares, worth 88 x $50 = $4,400, or 22% of the income, and delivers the other 312 shares. If all of the $20,000 falls in her 32% federal bracket, the federal income tax on it is $6,400, so $6,400 - $4,400 = $2,000 is still owed when she files. Her 312 shares have a basis of $50 each, and if she later sells them at $60 she has a capital gain of 312 x $10 = $3,120.

Pros

• Lets employees share in the company's growth, sometimes on a scale cash pay would not reach.
• Several forms need no cash from the employee; units and restricted stock are simply granted.
• Some forms, such as incentive stock options and qualified purchase plans, can turn part of the gain into long-term capital gain when their rules are met.
• Vesting schedules reward staying, which can be an advantage for an employee who plans to stay anyway.

Cons

• Concentrates pay and savings in one company, so a bad year can hit the job and the portfolio together.
• Tax timing can produce a bill before any shares are sold, and default withholding often falls short.
• Unvested awards are generally lost on leaving, which makes changing jobs expensive.
• Private-company shares may have no market to sell into for years, and their value is an appraisal rather than a price.