3 most common Equity compensation plans

Does your employer offer stock options, restricted stock, stock purchase plans, or any combination? Equity compensation can be extremely lucrative and a huge aid in building long term wealth, but these plans can also be extremely complex to navigate and, if not handled properly, can derail retirement plans very quickly due to risks involved with single stock concentration.

There are several different ways equity plans can be designed, for simplicity, we will cover the three most common plans and discuss how to maximize these plans conceptually from a growth, risk management, and tax planning perspective.

Employee Stock Purchase Plans (or ESPP)

The most common type of equity compensation plans we see are Employee Stock Purchase Plans (or ESPP). If available, your employer will offer an opportunity for you to purchase company stock at a discount to the fair market value and typically can be funded through payroll. The largest discount allowed is 15% so we typically see this as the benchmark for the ESPP plans offered, especially from larger companies. With an ESPP, no tax is due at the purchase of the companies share but, can be taxed at the time the stock is sold. If the stock is sold at least one year past the original purchase date and two years after the grant date (when the shares were offered), the gains on the stock plus the applicable discount will be taxed at long term capital gains rates, typically 15%. However, if these requirements are not met, any gains and the difference between the discount price and fair market value at purchase, will be taxed as ordinary income in the year the shares were sold. For this reason, shares accumulated through the ESPP may not be the best shares to sell until the requirements are met to qualify for long term capital gains treatment.

Non-qualified stock options

Second, we have non-qualified stock options. Here you are given a window of time to exercise your options at a specified price and, can do so at any point during that timeframe. You will be taxed as ordinary income on any difference between the grant price and price in which you exercise the options and, after exercise, any gains moving forward will be treated as any other stock with a requirement to hold for a year or longer to qualify for long term capital gains treatment. You will also pay ordinary income taxes on any difference between the grant price and price in which you exercise the options at the time of exercise (even if the stock is not be sold at that time). Generally speaking, the shares are granted to you at exactly the fair market value at the time of the grant. Because there is no discount, there is no real advantage to exercising your options at the time of the grant as this would be the same as purchasing you company stock outside of any employer benefits. However, if you notice the stock price increase, you may exercise your options and only pay the price that the options were issued at when they were granted to you. If you feel the company has strong prospects for continued growth you may want to continue to hold but if you feel this may be a good time to “take some chips off the table” this would be a great place to take the option as cash and lock in the difference, almost as if you received an additional bonus.

Restricted Stock Units (RSU’s)

Last, we have RSU’s or Restricted Stock Units. RSU’s are typically given as a signing bonus and additional RSU’s are given to executives to encourage them to stay with the company. There is no tax at the time of the award and typically RSU’s are issued with a vesting schedule (restriction) that may require you to continue to work for your company a year or more before they vest. Once the restriction is satisfied, the shares are given to you in the form of company stock and you are taxed at the full value of these shares at the time of the event. One way to look at RSU’s when determining whether to sell these shares or not, is to ask yourself if you would buy shares of your employer stock with your own money in the first place at that time. If the answer is no, you may want to sell right when you receive these shares. This is because the shares are taxed as ordinary income already regardless of whether you sell them or not at the time you receive the shares and the only time additional taxes are due is if there is appreciation from that point moving forward.

As a separate opportunity to purchase employer stock, some companies will also allow you to purchase company stock within your 401(k) plan. If this is available there can be very effective strategies to maximize this stock and minimize taxation for long term planning (assuming there has been significant growth in the stock price). If you find yourself in this position, there can be significant tax savings as well as tax consequences involved with these less common strategies so be sure to fully understand the pros and cons involved.

Employers may offer many variations of the plans mentioned and it is critical to fully understand the specific plan being offered and taxation of these benefits when making these financial decisions. Although these are great rule-of-thumb strategies, in order to truly maximize opportunities for your individual plan, this should be viewed as a guide and not a one-size fits all solution for all circumstances. There can be more nuanced strategies within these categories as well that may allow for even further benefits, so it is strongly recommended to consult with your financial planner and/or tax accountant. Please feel free to reach out if you have any questions or would like some help evaluating how these options may work best for you.

If you have questions about this article, or if we can be of service, be sure to get in touch with us!