The Equity Series Part 3 – Employee Equity Compensation

Here in the third and final part of the Equity series, we will discuss issues relating to employee equity, in particular the primary employee equity compensations schemes, stock options and restricted stock units.

One of the primary issues surrounding employee equity that employers should be cognizant of is the fact that generally, by default, equity compensation is taxable just like a regular paycheck — not only does the employee have to declare the value of the equity as income, but the employer may also have to pay the appropriate payroll and FICA taxes as well. Of course, there are ways to structure a employee equity compensation plan to avoid income and payroll taxes, so if your company is considering such a plan it is wise to consult with a tax attorney or CPA to ensure that the company’s and employee’s tax burdens are properly limited.

Stock options are a historically popular mechanism for employee equity compensation. With stock options, employees are granted a right, which usually vests at a certain future date, to purchase stock in the company at a certain price. The idea is that while shares of the company are only with a dollar when the options are granted, when they vest five years down the road the shares will be worth $10 — when a liquidity event comes around, the employee can exercise the option to buy at $1 and sell at $10 for a $9 profit.

There are two types of stock option grants: non-qualified stock options (NQSOs) and incentive stock options (ISOs). Each has tax benefits, but the primary difference between the two is who receives the benefits. With a NQSO, the company is able to take a deduction from the corporate income tax when the employee exercises the option; however, the employee must pay regular income tax. With an ISO, while the company cannot take a tax deduction from the exercise, if the employee meets certain holding requirements, and if the plan itself meets other requirements in order to be classified as an ISO plan, the employee’s gain is taxed not as income, but instead is taxed at the long-term capital gains rate, which is generally lower than income tax rates.

Recently, restricted stock units (RSUs) are becoming increasingly popular with companies, due to changes in accounting rules regarding stock options in the past decade. The difference between stock options and RSOs is that while options are just that — an option to purchase the stock — whereas under a RSU plan the employee receives the actual stock. The ‘restricted’ part of the stock refers to the fact that transfer or sale of the stock is restricted until after a certain period of time or the occurrence of an event, at which point full rights in the stock vest and the holder may sell the stock.

When full rights in the stock vest, the employee must report the current value of the shares as income and pay income tax even if the shares are not sold, which can exceed the value of the stock when it was initially granted! However, within 30 days of receiving the RSUs, the employee may make a Section 83b election and pay income tax on the value of the shares when received. No further tax is paid until the employee sells the shares, when the gain is taxed instead at the long-term capital gains rate.

As a final note, it is worth reminding that even employee equity compensation is subject to securities laws and regulation. However, registration burdens are minimized through the use of a Rule 701 offering, a topic I have covered in the past and will likely cover again in greater detail in the future.