Equity compensation is a unique form of employee benefits, but what does it mean for your finances?
Today we’re looking at the five steps you should take if you’re offered equity compensation from your employer.
What Is Equity Compensation?
Equity compensation is paid in a non-cash form and is available to certain employees. Standard options typically include restricted stock options that are a form of company ownership.
Public or private companies can offer it, but most commonly, it will be found in start-ups. The company may not have the cash upfront to offer employees, so they offer equity compensation to benefit the employee as the company grows.
That being said, equity compensation is also offered to employees with a below-market average salary.
Of course, as with all investments, there isn’t a guarantee that equity compensation options will provide large profits. This is what makes this form of compensation so complicated!
Step 1: Understand Key Terms
Let’s run through some key terms you’ll need to know if you’re offered equity compensation.
- Vesting: The time you must hold an asset before it can be utilized.
- Grant Date: The date the form of compensation is offered to you.
- Expiration Date: The date the form of equity compensation must be reported to the IRS.
- Strike Price: The discounted share price offered to employees.
- Premium: The asset’s actual price (not the discounted strike price).
- Stock Option: Gives the owner the right to purchase a particular asset at a pre-determined and agreed-upon price and date. They are granted under an employee stock purchase plan.
- Non-Qualified Stock Options (NSOs): Requires regular income tax payment on the difference between the grant price and the price when the option was exercised. These are also known as non-statutory stock options, aka they are granted without a type of plan.
- Incentive Stock Options: Only available to employees. It gives the employee the right to buy company stock shares at a discounted price and potential tax breaks on profits. These are also known as statutory stock options.
- Restricted Stock: Requires vesting period completion.
- Performance Shares: Awarded if specific measures are met (earnings per share, return on equity, etc.)
Step 2: Communicate With Your Employer
If you’re offered equity compensation from your employer, you should ask the following questions:
- Do I have to hold a certain amount of company stock?
- Why? All investments carry risk, you don’t want to carry too much of your investments in employee equity compensation, so you want to know exactly how much you’re required to take.
- What is the vesting timeline?
- Why? Knowing when the assets will be available is essential for your long-term financial plan.
- What type of compensation is offered?
- Why? They each have unique tax treatment, so be sure what compensation you receive.
- How many shares of stock are there?
- Why? It directly impacts the value of your equity.
Step 3: Research Tax Implications
Even though this compensation isn’t cash, you still have to pay taxes. The IRS treats different forms of equity compensation differently, so it’s essential to be aware of the tax implications of each type.
Non-Statutory Options
For example, suppose your employee equity compensation is non-statutory (non-qualified stock option). In that case, there are different tax implications for three dates: when the option is granted, when the option is exercised, and when the stock is sold.
The grant date only has tax implications if the stock’s fair market value can be determined. This isn’t always the case, so be aware of your stock’s details.
When you exercise the option, you must include the fair market value of the stock at the time you acquired it subtracted from the amount you paid for the stock. This number will be reported as ordinary income on your W2.
When the stock option is sold, you must report a capital gain or loss for the difference between what you paid for the option and received on the sale.
Statutory Stock Options
The grant date of a statutory stock option (offered with a plan) does not produce any immediate income tax. In addition, neither does the exercise date! The only tax will be paid when you sell the stock you’ve acquired at a later date.
But, you must also be aware of the alternative minimum tax (AMT). This is put in place by the IRS to ensure that taxpayers that reduce their ordinary income tax through deductions and tax breaks pay at least some sort of tax. If you’re unsure if you must pay the AMT, you can use IRS form 6251 after you exercise the option.
Step 4: Decide How It Fits Into Your Financial Plan
A solid investment plan and portfolio are essential to any solid financial plan. So, you need to determine if and where employee equity compensation fits into your financial plan.
Perhaps the biggest concern is having too much of your investment portfolio tied into equity compensation. This could be detrimental if the stocks don’t do well because they’ll make up most of your portfolio.
This pleads the case for the importance of having a diversified portfolio. By having stocks in different areas and industries, you’re setting yourself up for a better chance of success.
Of course, every type of investment has risk, but avoid putting all your eggs in one basket.
Step 5: Work With An Advisor
Equity compensation is downright complicated. The unknowns that accompany it can be stressful, so don’t be afraid to reach out for help!
Working with a financial advisor that is an expert in this area can help you ensure you dot all of your i’s and cross your t’s. In addition, they’ll be able to help you determine where and if equity compensation fits into your financial plan and long-term goals.
At Woven Capital we help our clients with everything from developing an investment strategy to closely aligning their money (and their investments) with their values. We’re here to help you balance your portfolio and make adjustments when needed.
If you have questions about employee compensation or stock options, please reach out to us today. We look forward to helping you navigate their place in your financial place.