How is Equity Compensation Taxed: What You Need to Know

Many companies offer equity compensation as part of the compensation package of their employees. Startup companies set aside 13% to 20% of equity as part of employee compensation. With that, consider this: equity compensation is taxable income.

In the industry, knowing tax obligations is an integral part in achieving holistic company success. While this can be a complex topic, it is better to be equipped with the basic know-hows when it comes to equity compensation tax treatment to make smart decisions moving forward.

This article will tell you what you need to know about equity compensation, its types, and to answer the question: how is equity compensation taxed?

What is equity compensation?

Equity compensation, also known as stock-based or share-based compensation, is a non-monetary pay offered to employees to participate in the ownership of the company.

Just like any other compensation benefits, equity compensation aids in attracting and retaining talents, cultivating a sense of ownership, and building loyalty and productivity in the workplace.

To ensure the proper administration of equity compensation in your company, you can use Compensation Planning Software. This will help you manage equity by letting go of manual tasks and utilizing versatile spreadsheets with fast-track online tools.

Types of equity compensation

Equity compensation has a variety of plans and forms. These types have different offerings and conditions for the employees. Let’s dissect each of them:

• Incentive stock option grants (ISOs)

  ISOs allow employees to buy company stocks at an exercise price, or the price at which a share can be bought. Once the employee meets the vesting period, or when a worker can take full ownership of the stocks, he can exercise his options.

  When exercising ISOs, an employee does not have to pay equity taxes. If the requirements are met, the employee may be able to pay a lower rate of tax.

• Non-qualified stock option grants (NSOs)

  NSOs are similar to ISOs. They also allow employees to purchase company stocks at a predetermined price and once the employee meets the company vesting schedule.

  However, with NSOs, an employee pays taxes when he exercises and sells his options. This means that employees will pay more taxes with NSOs than with ISOs.

• Restricted stock awards (RSAs)

  RSAs are granted to employees as part on a bonus or additional compensation. They are typically subject to a vesting schedule, so employees receive shares in increments over several years.

  Employees are also granted shareholder voting rights and dividends before vesting, and employers set aside actual shares upon grant. If employees leave the company before vesting, unvested stocks will be forfeited.

• Restricted stock units (RSUs)

  Unlike RSAs, RSUs are not actual stocks but more on a promise that employees will be given shares in the future once they vest. Unless the company allows, RSUs do not give employees shareholder voting rights and dividends.

  Employees don’t have to pay anything to get stocks in RSU, but they are usually responsible for applicable equity taxes once the shares are received. Larger corporations typically use RSUs as stock awards for employees.

• Employee stock purchase plans (ESPPs)

  ESPPs are voluntary and allow employees to buy stocks at a discounted price or without a commission. Payments are done through payroll deductions over a period and employees get to select the amount they want to set aside for the stocks.

Crafting an equity compensation plan for your company is easier when you use Compensation Planning Software. Its workflow automation, customizable workbooks, and comprehensive features can maximize the implementation and management of your employees’ equity.

How is equity compensation taxed?

Equity compensation tax treatment varies depending on the type of equity compensation and the timetable requirements for holding the stocks.

So, how is equity compensation taxed? Here are the details on the tax implications of equity compensation:

1. Incentive stock option grants

   ISOs are taxed as ordinary income if employees exercise their shares and sell them immediately. If employees wait for 2 years before exercising the stocks and hold them for another year, the entire gain will be taxed as long-term capital gain.

   The equity tax rates for long-term capital gains are significantly lower than the equity tax rates for ordinary income. However, the spread between the fair market value at exercise and the exercise price is subject to the alternative minimum tax.

2. Non-qualified stock option grants

   NSOs are taxed as ordinary income based on the difference between exercise price and market price once the employee exercises his options, even if the employee does not sell the shares or realize the gain.

   The company will withhold taxes for a full-time employee. Once the employee leaves the company, taxes will not be withheld. Once the shares are being sold, appreciation above the exercise price will be taxed either as short-term or long-term gain.

3. Restricted stock awards and restricted stock unit grants

   With RSAs and RSUs, employees owe ordinary income tax in the tax year they vest. They also have to pay the income tax of the stock’s market value on its vest day. When employees sell shares, taxes for capital gains must be paid. The rates depend on how long the shares were held.


4. Employee stock purchase plans

   ESPPs are taxed similarly to ISOs. Employees will wait for 2 years before exercising the stocks and hold them for another year to be qualified.

   The discount at the grant date is considered an ordinary income tax. Meanwhile additional gains, such as sale price being above the purchase price plus discount, are considered long-term capital gains tax.

It can be a tedious job to keep track on equity compensation and its tax environment. Good thing Compensation Planning Software has a tracking system for detailed holding reports and vesting schedules, employee portal for financial statements, and award planning for streamlined decision-making.

FAQs

Here are some common questions about taxes on equity compensation:

What are equity compensation's pros and cons?

Equity compensation helps attract and retain employees. It can give them motivation to work, engage them in the organization, and encourage their loyalty. It can also manage cash flows, making companies eligible for tax credits.

However, equity compensation can also cause the reduction of the value of individual shares if it’s offered to all employees. Managing equity plans can also be complicated, such as accounting and company’s financial statements.

Why are my RSUs taxed at 40%?

Before the deposit of an employee’s vested shares into a broker account, a certain fraction of the RSU compensation is withheld for tax purposes. Usually, 40% will be withheld for federal, state, local, medical care, and social security taxes.

Do you have to pay taxes for equity money?

Yes, the equity taxes are ordinary income tax and capital gains tax. Usually, ordinary income tax on equity comes in the tax years at which an employee acquires the stocks. Capital gains tax comes when an employee sells the shares.

Does equity compensation count as income?

Yes, equity compensation can count as an income since it is part of an employee’s total compensation package. When the employee exercises the stocks, it is considered an income for tax purposes.