Calculating Risk and Investing Wisely

What Are The Risks and Tax Consequences of Equity Compensation?

"Equity compensation" describes a form of compensation that gives employees interest in their employers. Typically, it includes stock options, restricted stock units (RSUs), and performance shares.

Equity compensation types 

1. Stock options

A grant of stock options permits an employee to buy the stock of the company at a predetermined price (the "exercise price") at a future date.  The grant terms usually provide dates when the options "vest," permitting the employee to buy the stock only on or after the vesting dates.

The value of stock options is computed by taking the difference, if any, between the exercise price and the fair market value of the stock on the date of purchase.

2. Restricted Stock Units

Restricted stock units are a grant of stock from the employer to the employee.  RSUs typically provide for the grant over a period (the "vesting schedule"), which encourages the employee to remain with the company to receive the shares.

RSUs may also condition receipt of the shares on other conditions, like completing a particular assignment or project.

3. Performance shares

Performance shares are a grant of stock based on the company's performance.  This grant is similar to RSUs, except RSUs are typically conditioned upon designated years of employment with the employer.  Performance shares use the financial metrics of the employer as the trigger for the award.

Risks of equity compensation

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Equity compensation is often described as a benefit conferred on valuable employees, but it's not without risks.

Stock options only have a value if the value of the stock on the date of exercise is greater than your exercise price.

RSUs are included in your gross income when you are entitled to receive them (the vesting date), based on the value of the shares on that date.  If the stock declines in value and doesn't recover on the date of sale, you will incur a loss.

1. Performance shares

You may be incentivized to remain employed at a company, perhaps accepting a salary lower than the market rate, because of the grant of performance shares.

But if the company fails to reach the financial metrics that trigger the grant, your performance shares will be worth nothing.

2. Concentration risk

There's another risk with all forms of equity compensation: Concentration risk.

Your financial future already depends on your employer to pay a salary and benefits.  Equity compensation makes you even more invested in the financial stability of your employer, which can make you vulnerable if the employer falters.

Taxes on equity compensation

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Equity compensation is complex.  To leverage the benefit of your equity compensation, start by educating yourself on all the financial ramifications of your grants.

Understanding the tax consequences of whatever form of equity compensation you receive is especially important.

1. Taxation of stock options

Stock options are taxed differently depending on whether they are incentive stock options or non-qualified stock options.  

While Incentive Stock Options generally have more favorable tax treatment than non-qualified stock options, you should consult with a financial advisor or tax professional to understand the tax consequences of the type of stock option you hold.

You can find a detailed explanation of how both stock options are taxed here

2. Taxation of RSUs

Taxation of RSUs is particularly tricky.  It involves calculating the current stock price on the date your RSUs vest, determining the amount to be withheld for tax purposes, and deciding when to sell your shares to provide sufficient liquidity to meet your tax obligations.

When you sell your RSUs, you will incur tax liability based on the difference, if any, between the cost basis of your shares and the sale price.  You may incur short or long-term capital gains tax.

You can find a comprehensive discussion of the tax ramifications of RSUs here.

3. Taxation of performance shares

Typically, you are not taxed on an award of performance shares until the grant vests.  At that time, you are taxed at ordinary income rates based on the stock's fair market value upon receipt.

You can find a comprehensive discussion of the tax ramifications of performance shares here.

Work with professionals

Find a fiduciary financial advisor and tax professional with experience in equity compensation.  Your "equity compensation team" can help you develop a plan that values your grants periodically and sets dates for when you should exercise and sell your stock, taking into account tax ramifications.

Equity compensation can be a critical part of your overall financial planning when done right.  It's not something you "set and forget."

Equity compensation can be a critical part of your overall financial planning when done right. It's not something you "set and forget."

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