Equity compensation: it’s a phrase that rings with promise and potential for employees, a shiny carrot held out by companies big and small to attract and retain top talent. But beyond the allure of holding onto talent without an immediate outlay of cash, there are tax implications.

Let’s cover what business owners need to know about using equity compensation as a recruitment and retention tool and the tax consequences that come with it.

What Is Equity Compensation?

Equity compensation is a non-cash payment provided to employees, offering them a share in the company’s ownership in exchange for their services. We often see equity compensation used in public companies and startups to improve retention or entice employees to work for below-market pay. It can be a win-win because employees have the potential for increased earnings as the company grows.

Equity compensation can take several forms:

• Stock Options. Employees can buy a certain number of shares at a set price, typically lower than market value. The hope is that the value of the company’s stock will increase over time, providing a profit when the employee decides to sell their shares.
• Restricted Stock Units (RSUs) and Restricted Stock Awards (RSAs). These are company shares promised to an employee through a vesting plan and distribution schedule after achieving certain milestones or remaining with the company for a certain length of time.
• Performance Shares. These are tied to company performance and are only granted when the employee or the company meets specific predefined metrics in areas like financial performance, operational efficiency, customer satisfaction, etc.
• Profits interest. A profits interest is a type of equity compensation available only to multi-member LLC’s or partnerships. It entitles the individual to a share of future profits of the company.

Tax Implications of Equity Compensation

When structured appropriately, equity compensation can be a tax-efficient compensation strategy. However, if misunderstood or mismanaged, it can lead to unexpectedly high tax bills for the employee and employer. In this section, we’ll touch on the tax advantages and drawbacks of the different forms of equity compensation.

Stock Options

Stock options can be non-qualified stock options (NSOs) or incentive stock options (ISOs). Individuals pay taxes on NSOs at the time of the grant if the option has a readily-ascertainable fair market value (FMV) or when they exercise it. The employer claims a tax deduction when the individual receives vested shares upon exercising the option. NSOs are generally granted to non-employees, such as contractors and advisors.

For incentive stock options (ISOs), employees generally don’t pay taxes immediately upon exercising, but alternative minimum tax (AMT) may apply. Later, when they sell the stock, any increase in price from the time of exercising to the sale is taxed as a capital gain, which may be short-term or long-term, depending on how long they hold it. Employers can claim a tax deduction for ISOs only upon a disqualifying disposition, meaning a sale within two years or less from the grant or one year or less from exercise.

RSUs and RSAs

Essentially, RSUs and RSAs are taxed when they vest. The employee or service provider recognizes ordinary income on the excess of the FMV on the vesting date over the amount they paid (if any). Any subsequent gains or losses when the employee sells the shares are capital gains or losses.

For the employer, the tax deduction typically corresponds with the employee’s income recognition. Employers should report the amount of compensation the employee recognizes on the employee’s W-2.

Performance Shares

These are taxed similarly to RSUs and RSAs. The total value of the shares at the time they’re granted (i.e., when the employee meets performance targets) is treated as ordinary income. Any future gains or losses from selling these shares are capital gains or losses.

The employer claims a tax deduction when the employee recognizes income and reports that amount on the employee’s W-2.

Profits Interest

When structured appropriately, granting a profits interest to an individual in exchange for services isn’t taxable. However, once the individual receives the profits interest, they’re subject to pass-through taxation of the company’s income.

Choosing the type of equity compensation to offer your employees isn’t a one-size-fits-all issue. Different forms of equity compensation come with advantages and drawbacks; what works for one company might not necessarily work for another.  It’s essential to work with knowledgeable legal counsel to ensure your equity compensation plan is designed and administered in compliance with regulatory requirements.

If you need help deciding if equity compensation is the right strategy for holding onto talent, contact NewWay Accounting. We can help you understand the full impact of equity compensation on your tax situation!