Equity Compensation Guide on RSUs, Stock Options and Taxes

Whether you’re a seasoned executive or a new recruit, understanding how equity compensation works could transform your financial future, offering you a share in the company’s success and aligning your achievements directly with its performance.

In this complete guide, we’ll walk you through the different types of equity compensation, discuss how and when to sell shares, explain the tax implications and share some smart strategies to make the most of your benefits. Most importantly, we want you to know how crucial it is to plan ahead. Being proactive can really help you achieve your financial goals by reducing your tax burden and maximizing the value of your equity compensation.

Equity compensation is a significant part of your overall wealth and a powerful tool for reaching your long-term objectives. Whether you aim to fund your children’s education, save for a comfortable retirement or make a substantial philanthropic impact, the decisions you make about your equity compensation will play a key role in realizing these dreams. This is about more than just income; it’s about making informed choices that could change the trajectory of your life. Let’s get started.

Learn the Lingo We understand that not everyone reading this article is familiar with the terminology used when talking about equity compensation. Whenever you need a bit more understanding of any terms associated with your compensation package, please feel free to refer to the glossary section at the end of our article.

Table of Contents

Understanding Equity Compensation
Types of Equity Compensation
Taxes on Equity Compensation
Maximizing Your Equity Compensation
Glossary

Understanding Equity Compensation

What is equity compensation?

Equity compensation is more than just a paycheck perk—it’s a stake in your company’s future. As an employee, you receive ownership interests, such as stock options or shares, aligning your financial incentives with the company’s performance. This arrangement not only motivates you to contribute to the company’s success but also offers the potential for significant financial rewards. Investopedia notes that startups often opt for equity compensation as they may lack the cash for high salaries or prefer to reinvest their cash flow into growth initiatives. This strategy not only aligns employees’ goals with those of the company but also attracts high-quality talent by offering a share in the potential financial successes. It can be a win-win for you and your company.

Types of equity compensation

• Stock options:
  • Non-Qualified Stock Options (NQSOs)
  • Incentive Stock Options (ISOs)
• Restricted Stock Units (RSUs)
• Employee Stock Purchase Plans (ESPPs)

What being offered equity in compensation really means

Each type of equity compensation has its own set of rules regarding taxation, rights and obligations, which can significantly affect the value from your perspective as the employee. There are resources like Indeed to help you understand negotiating tactics and the importance of researching equity options prior to negotiating with your potential employer. Indeed provides a guide on the pros and cons of these perks and our team weighs in on that topic below.

Pros and cons of equity compensation

When considering equity compensation as part of your job offer, it’s important to carefully evaluate both the advantages and disadvantages. Each point is essential for understanding how your equity-based compensation can affect your financial planning and align with your personal and professional goals.

Pros

Cons

Financial reward: Significant potential gains if the company’s stock price increases. Direct benefit: Aligns your contributions with company success, promoting shared corporate prosperity. Wealth building: Opportunity to participate in company plans that allow you to purchase stock at below market prices. Long-term wealth: Potential for substantial personal wealth from company growth or premium acquisition.

Stock price decline: Risks include significant loss in value if the company’s stock price declines, potentially becoming worthless. Vesting schedule: Equity compensation doesn’t fully belong to you immediately; it’s subject to a vesting schedule to promote long-term commitment. Salary vs. equity: In exchange for the potential of significant financial rewards, companies may offer lower salaries but greater equity compensation. Early exercise and tax elections: Employees can sometimes exercise stock options early or make an 83(b) election, both of which involve upfront costs and financial risks if the company does not succeed.

Types of Equity Compensation

Stock options

A stock option as a form of equity compensation can be a valuable part of your employment package. Stock options are a benefit given to employees, granting them the right to buy shares of their company’s stock at a predetermined price, often referred to as the “exercise” or “strike” price. The main idea behind stock options is to align the interests of the employees with those of shareholders. If the company performs well and the stock price increases, you can benefit financially by purchasing the stock at the lower, predetermined price.

As is noted in our fathom article, Know Your Life Options with Stock Options, it’s crucial to initiate discussions with your financial planner and tax advisor about your expectations, the available opportunities and your priorities when starting to strategize on how to maximize your stock options.

There are two types of stock options granted to employees:

1. Non-Qualified Stock Options (NQSOs)
2. Incentive Stock Options (ISOs)

Non-Qualified Stock Options (NQSOs)

What are NQSOs?

Non-Qualified Stock Options are a form of equity compensation often granted to a wide variety of employees, including executives, mid-level managers and sometimes even all company employees. They offer the right to buy stock at a fixed price and become valuable if the stock’s market price rises above the exercise price. NQSOs can be a valuable component of your compensation package but if the company’s share price stays the same or goes down relative to the exercise price, you can end up receiving no value from them.

Benefits of NQSOs NQSOs are most beneficial in scenarios where the company’s stock price is expected to rise significantly above the exercise price. However, they come with risks and tax liabilities that need to be carefully managed.

How do employees receive NQSOs?

The process typically begins during your job offer and acceptance stage. It’s formalized through an option agreement that outlines the terms of your grant, including the number of options granted, the exercise price, the vesting schedule and other conditions. When receiving a job offer that includes NQSOs, it’s important to understand not only the quantity of options granted but also the potential value they represent.

How do NQSOs work?

Once vested, you can exercise your options – buying the stock at the predetermined exercise price. Do you hold onto the shares or sell them? The ideal timing for this should align with your financial goals and expectations for the stock price in the future.

The timing of the exercise is crucial. It determines the taxes you must pay.

When you exercise your options, you must pay the exercise price along with ordinary income taxes on the difference between the exercise price and the current market value of the shares. Monitoring your company’s stock performance is crucial for maximizing your financial benefits from NQSOs, as their value is closely linked to share price but there are other factors to consider too . Yes, everyone wants a windfall, but there is strategy to maximizing how much you will end up with. This Charles Schwab article shares a great lesson in how it takes thought and planning to make the most of your equity compensation. We couldn’t agree more. Read on to see how taxes play a big part of this strategy.

How are NQSOs taxed?

Non-Qualified Stock Options require you to pay taxes when you exercise them. You don’t owe any taxes just for receiving a grant of NQSOs or holding onto your options as they vest. However, when you exercise them—meaning you buy the stock at the agreed-upon price—any increase in the stock’s value from when you received the option to when you exercise it (this increase is called the “bargain element”) is taxed as ordinary income.

For example, if the strike price when you received the option grant was $10 per share, and you exercise them when the stock is worth $20, that $10 difference per share is what you’d be taxed on at ordinary income tax rates. This can lead to a hefty tax bill, especially if you exercise a lot of shares when the stock price is high above your exercise price. Companies will withhold taxes when you exercise your NQSOs. This can be accomplished by you providing cash to the company to meet withholding requirements or you can do a cashless exercise and ask the company to sell some shares from the exercise and use the proceeds to cover withholdings.

Given the complexities and potential tax implications of exercising NQSOs, many people look to their financial advisor for guidance on how to optimize the timing of their option exercise and the subsequent sale of shares.

NQSO Example The significance of the tax impact Damian is an employee at Acme, Inc., where he received Non-Qualified Stock Options (NQSOs) as part of his compensation. After three years, the value of his shares reached $150,000. However, following tax deductions, Damian was left with $90,000. Let’s see how this unfolded and how the Aspiriant team can help Damian maximize his assets. Grant date: Damian receives 1,000 NQSOs with an exercise price of $50 per share. Vesting: The NQSOs have a three-year vesting schedule, with 33.33% vesting each year. Damian remains with Acme, Inc. for the full vesting period. Exercise: After three years, when all 1,000 NQSOs have vested, Damian decides to exercise his options. Currently, the fair market value of Acme Inc.’s stock has increased to $200 per share. Taxation upon exercise: Upon exercising his NQSOs, Damian incurs ordinary income tax on the bargain element, which is the difference between the fair market value at exercise ($200) and the exercise price ($50) per share. Since Damian exercises all 1,000 NQSOs, the total bargain element is $150 per share x 1,000 shares = $150,000. This $150,000 is taxed as ordinary income at Damian’s applicable income tax rate. Holding period: Damian may choose to hold onto the shares acquired through NQSO exercise for any duration. Sale: Damian decides to sell his shares immediately after exercising his NQSOs when the fair market value of Acme Inc.’s stock is still $200 per share. Taxes: Since Damian paid income taxes on the bargain element at exercise, his cost basis in Acme Inc.’s shares is equal to the fair market value at exercise of $200. Damian sold the shares immediately after exercise at the same $200 per share price, so he did not have any capital gains or losses from the sale. The gain or loss from the sale is calculated as the difference between the sale price and the fair market value at exercise ($200 – $200 = $0 per share). If Damian decided to wait six months and then sold the shares at a price of $250, his gain would be $50 per share ($250 – $200) and he’d pay short-term capital gains taxes on that amount. If Damian waited more than a year and then sold his shares for $250, his gain would be the same at $50 per share but he would pay long-term capital gains taxes on that amount rather than higher short-term capital gains. Overall, Damian incurs ordinary income tax upon exercising his NQSOs based on the bargain element and any subsequent gains or losses from selling the shares are subject to short-term or long-term capital gains tax rates depending on how long he holds the shares.

Incentive Stock Options (ISOs)

What are ISOs?

Incentive Stock Options (ISOs) are stock options that can qualify for favorable tax treatment if certain holding period requirements after grant and exercise are met. Unlike NQSOs, ISOs can potentially reduce tax burdens for employees when they sell their stock.

Benefits of ISOs The primary advantage of ISOs lies in their favorable tax treatment. When you exercise ISOs, you do not have to pay ordinary income tax on the difference between the exercise price and the market value of the stock at the time of exercise. This can result in substantial tax savings, especially if the stock price has increased significantly since the options were granted.

How do employees receive ISOs?

As a prospective employee, you might be offered ISOs as part of a comprehensive compensation package. However, it’s important to understand that ISOs are not typically available to all employees. They are strategically granted to align the interests of key personnel with the success and growth of the company. Because of their favorable tax treatment, the United States government limits the amount of ISOs that can become exercisable in any calendar year. The total market value of the stock for ISOs that can become exercisable for the first time during any calendar year cannot exceed $100,000, based on the fair market value (FMV) on the grant date. Any amount over this limit becomes NQSOs for tax purposes

The company will draft an option agreement that specifies the terms of your option grant including confirmation that all or part of the grant are intended to be ISOs. This agreement will outline the number of options granted, the exercise price, the vesting schedule and the expiration date. Once the agreement is executed, either your human resources department or an external stock plan administrator will track the options for you.

How do ISOs work?

Here is the process of how an ISO works:

1. Exercise Price and Vesting Period: When you receive ISOs, they come with a set exercise price and a schedule that determines when you can start using them, known as the vesting period.
2. Exercising Options: You get to choose when to “exercise” these options, meaning you decide when to buy the stock. This decision also determines when you might owe taxes.
3. Tax Considerations: It’s important to know that when you exercise ISOs, it could affect your taxes, sometimes triggering what’s called the alternative minimum tax (AMT), depending on your overall tax situation.

This setup allows you some control over when you might face tax implications, and it ties your potential financial benefit to the success of the company’s stock. Let’s take a look at how ISOs are taxed next.

How are ISOs taxed?

Understanding your tax liability is crucial in financial planning. We want to ensure you’re able to maximize your equity compensation, too. That’s why when it comes to taxes on ISOs, here’s what you need to know:

1. When taxes apply: You don’t owe any taxes just for receiving ISOs or when they become officially yours (vest). However, taxes come into play when you decide to exercise your options.
2. Tax calculation at exercise: When you exercise your options, the difference between what you pay for the stock (exercise price) and its current market value isn’t taxed like regular income right away. This difference, known as the “bargain element,” does get factored into a special tax calculation called the Alternative Minimum Tax (AMT).
3. Holding period: To get a favorable tax rate, you need to hold the stock for at least one year after you exercise the options and for two years after they were granted to you. If you sell the shares before meeting these time requirements, the profit you make will be taxed as ordinary income, just like your salary.
4. Consequences of selling early: If you don’t meet these holding time requirements, the benefits of ISOs are lost and they’re treated like regular stock options for tax purposes, which could mean a higher tax bill.

Understanding these details can help you plan when to exercise your options and decide the best time to sell your shares. Your financial planner can help you navigate your equity compensation and the taxes that come with it.

ISO Example Timing your ISO sales Imagine you’re an employee at a growing tech startup and as part of your compensation package, you’ve been granted ISOs. Here’s how you could maximize your equity by understanding when to sell: Grant and vesting: Let’s say you were granted 1,000 ISOs with an exercise price of $10 each when the company’s stock was valued at the same amount. These options are set to vest over four years, meaning you gain the right to exercise 250 shares each year. Decision to exercise: Fast forward two years and the company’s stock has risen to $50 per share. You decide to exercise your options for the 500 shares that have vested so far. You buy these shares at the original price of $10 each, costing you $5,000. Tax considerations: Even though the current market value of these shares is $25,000 (500 shares x $50 per share), you don’t owe regular income tax on the $20,000 bargain element ($50 market price minus $10 exercise price, multiplied by 500 shares). However, this $20,000 is included in your Alternative Minimum Tax (AMT) calculation, potentially increasing your tax liability for the year. Selling your shares: You plan to sell the shares but must consider the tax-smart strategy. To receive favorable long-term capital gains tax treatment, you need to hold the shares for at least one year after exercising and at least two years after the initial grant date. If you sell the shares after meeting these requirements, your gains will be taxed at the lower long-term capital gains rate. Early sale risks: If a sudden need for cash arises and you sell the shares before meeting the holding period requirement, the gains from the sale are taxed as ordinary income. This can lead to a higher tax rate on your profits. In this scenario, understanding the timing of your exercise and the sale of your shares can significantly impact your financial outcome. By carefully planning when to exercise and when to sell, you can maximize your benefits from ISOs while managing your tax obligations effectively. An Aspiriant wealth manager can walk you through these scenarios and help you plan ahead.

 

Stock options have leverage built in Stock options allow you to participate in the appreciation of a company’s share price without putting any capital at risk. As an example, if you have options with an exercise price of $10 and the stock is trading at $20, you could capture $10 worth of value (pre-tax) by exercising your options. If you think the share price might continue to appreciate but you don’t want to spend cash on exercising costs and taxes immediately, you could decide to delay exercising your options until the future. If the share price enjoys a 100% increase from $20 to $40, your spread amount will increase at a higher rate. Your bargain element would increase from $10 to $30 or 200%.

Restricted Stock Units (RSUs)

What are RSUs?

Restricted Stock Units (RSUs) are a form of equity compensation that companies might offer you as part of your benefits package. Unlike stock options, RSUs are grants that don’t require you to purchase shares; instead, you receive them once they vest.

How do employees receive RSUs?

As a new or current employee, RSUs may be part of your compensation, signifying the company’s investment in your future contributions. RSUs are typically offered to roles with significant impact on the company’s growth, creating a shared interest in its success. You’ll receive a grant agreement detailing the quantity of RSUs, vesting schedule and conditions, such as staying with the company for a set time. Once you accept, the RSUs are yours but remain restricted until they vest. Your employer will track the RSUs (usually in partnership with a stock plan administrator), helping you navigate vesting events and your subsequent options, like selling or holding the shares.

How do RSUs work?

Typically, RSUs are part of a signing bonus or annual compensation package. RSUs vest over a set period, typically one to four years. To fully earn these shares, you must remain with the company through the vesting period and sometimes additional performance goals must be met. RSUs are taxed as income at your regular tax rate when they vest, regardless of whether you sell the shares or hold onto them. This simplicity means they become yours automatically after vesting and can increase in value if the company’s stock price rises. However, keep in mind that you don’t control the timing of the tax event, which could lead to a tax liability even without selling the shares.

In private companies, RSUs vesting might also be tied to specific events like an IPO or acquisition, ensuring you are rewarded for the company’s growth as well as your tenure. Understanding how RSUs work can help you integrate them into your financial strategy and make informed decisions about your compensation package.

Benefits of RSUs One of the main advantages of RSUs is their simplicity. They automatically become yours after vesting without any initial investment. Their value increases if the company’s stock price goes up.

We suggest thinking of your RSUs that vest as a cash bonus with the value you receive tied to your company’s share price. A question we like to ask is: if you got a cash bonus instead of shares, what would you do with it? If the answer is turn around and buy shares, then it may make sense to hold shares after vesting. If the answer is save or spend the dollars elsewhere, selling makes sense.

Another component of this is concentration risk. You’re dependent on your company for your salary and you probably have additional RSUs that will vest in the future. If you constantly hold shares after vesting, the concentration of your assets in your company stock will continue to grow. This could certainly pay off if your company does well. However, there is risk since it is not a certainty that your company’s stock will appreciate.

Typically, selling shares as soon as they vest makes sense as proceeds can be used to meet cash needs or build a diversified investment portfolio. That said, holding shares also makes sense for some clients. The profile for those clients usually involves folks who are bullish on their company’s stock price, have built up a significant amount of diversified assets and are otherwise financially secure – in other words, they can afford to take on additional single stock concentration risk.

For a deeper dive into effective strategies for managing your RSUs, particularly after they vest, consider exploring What to do with RSUs. This article provides valuable insights and practical advice on how to align your RSU management with your long-term financial goals.

How are RSUs taxed?

When your RSUs vest and you receive the shares, they are taxed as income at your regular tax rate based on their market value at that time. This means you are taxed whether you decide to sell the shares or hold onto them. A crucial aspect to remember is that you don’t control when you’re taxed; it happens automatically at vesting. This could lead to a tax bill even if you haven’t sold the shares and haven’t received any actual cash from them.

As additional background, there is a statutory withholding on RSUs at vesting. For income levels up to $1 million, the withholding rate is 22%. For income above $1 million, the rate increases to 37%. However, this withholding rate often does not cover the full tax liability, potentially leading to a surprise tax bill when you file your taxes. It’s important to plan accordingly and possibly set aside additional funds to cover any shortfall.

Typically, RSUs are taxed as ordinary income when they vest. This means that the full market value of the RSUs at the time they vest is treated as income for that year. To cover the tax liability, most companies will automatically sell a portion of the vested shares and use the proceeds to pay the taxes. However, the amount withheld might not always the cover the total tax due, especially if you have high income. Therefore, you should plan accordingly for any potential tax bill that could arise from the vesting of RSUs.

RSU Example Comparing RSU Outcomes at Two Different Companies Imagine two employees, each joining different companies at the same time, with the share price at both companies initially set at $50. Each employee receives 10,000 RSUs that fully vest after one year. Here’s how their situations play out based on the company’s stock performance:
Company A’s Success Story	Company B’s Challenging Year
Initial Situation: Employee at Company A receives 10,000 RSUs. Stock Performance: Company A excels, and its stock price rises to $75 by the end of the year. Vesting Outcome: The total value of the vested shares is $750,000. Tax Handling: The company automatically sells 22% of the shares to cover required tax withholdings, totaling $165,000. Employee’s Takeaway: The employee retains 7,800 shares worth $585,000, providing a substantial increase in value from the initial stock price.	Initial Situation: Employee at Company B also receives 10,000 RSUs. Stock Performance: Unfortunately, Company B struggles, and its stock price halves to $25. Vesting Outcome: The total value of the vested shares is now $250,000. Tax Handling: Similarly, the company sells 22% of the shares for taxes, which amounts to $55,000. Employee’s Takeaway: The employee is left with 7,800 shares worth $195,000, significantly less due to the poor stock performance.
Key Takeaways: Market Volatility: This example highlights how market conditions can drastically affect the final value of RSUs. Employees benefit greatly from rising stock prices but also bear the risk of declines. Tax Obligations: Both scenarios illustrate the tax implications of RSUs, demonstrating that taxes are withheld based on the value at vesting, which may not necessarily align with the cash on hand if shares are not sold or with the ultimate tax bill associated with the income from the vesting. Decision Points: Employees need to decide whether to sell the remaining shares to realize their financial value or hold onto them in anticipation of future price appreciation. In both cases, the employees’ financial outcomes are tied to the company’s performance, showcasing the inherent risks and rewards of RSUs as part of a compensation package.

Employee Stock Purchase Plans (ESPPs)

What are ESPPs?

Employee Stock Purchase Plans (ESPPs) are programs that allow you to purchase company stock at a potentially discounted price using payroll deductions. Each year, you can invest up to $25,000 in tax-qualified plans. They essentially offer a straightforward way for you to become shareholders, potentially benefiting from increases in their company’s stock value while leveraging substantial discounts and convenient payroll deductions.

How do employees receive ESPPs?

If you qualify for an ESPP, you’ll get the chance to sign up during specific enrollment periods, usually after you’ve been with the company for a certain amount of time. You decide how much of your paycheck you want to set aside for this plan—this amount gets deducted regularly throughout the offering period, which can last from a few months to a year.

These contributions go towards purchasing your company’s stock at a special discounted rate, as much as 15% less than what everyone else pays. If your plan has a lookback option, you might even get to buy the stock at its lowest price either at the start or end of the period, whichever works out better for you.

After the stocks are bought, they’re added to your account, and you officially own a piece of your company. You can keep your shares to see if they increase in value or sell them whenever you think it’s the right time, depending on what your financial goals are. Since ESPPs happen in cycles, you’ll have plenty of opportunities to buy more shares in the future. Along the way, you’ll get updates and statements that show how many shares you’ve bought and their current worth, keeping you in the loop about your investments.

How do ESPPs work?

You can enroll in the ESPP and allow after-tax funds to be deducted from your regular paycheck. The company uses those funds to purchase shares on your behalf at specified purchase dates.

• Enrollment period: You can choose to enroll in the ESPP during an open enrollment period. At this time, you decide how much of your paycheck will be deducted for the purchase of stock, usually expressed as a percentage of your salary.
• Discount and purchase price: One of the biggest attractions of ESPPs is that the stock can often be bought at a discount from the current market price, typically between 5% and 15%. The exact discount will depend on the specific terms set by your employer.
• Offering and purchase periods: ESPPs usually operate through offering periods that last several months to a year, during which payroll deductions accumulate. At the end of each period, your company uses the accumulated funds to purchase shares on behalf of the participating employees at the discounted price.
• Lookback provision: Some plans include a lookback provision, where the purchase price is based on the stock price at either the beginning of the offering period or the end, whichever is lower. This can significantly enhance the discount applied to the purchase allowing you to purchase more shares for the money set aside via your payroll deductions.
• Selling the stock: After purchasing the stock, you can choose to hold onto your shares or sell them. Selling right after the purchase to capitalize on the discount is a common strategy, though you might hold longer if you are optimistic about the share price and want to meet holding period requirements to receive long-term capital gains treatment of gains.

How are ESPP shares taxed?

Understanding how taxes work with Employee Stock Purchase Plans can seem complex, but it’s important to know when and how much you might owe. Here’s how you can navigate the tax rules:

Types of taxable ESPPs:

1. Tax-qualified plans: These plans adhere to specific IRS rules and offer tax advantages if you follow certain guidelines.
2. Nonqualified plans: These do not meet the IRS criteria for tax-qualified plans and might have different tax implications.

Taxing of tax-qualified plans:

• Discounted purchase price: If your ESPP is tax-qualified, part of its appeal is buying company stock at a discount. When you sell these shares, how they are taxed depends on how long you hold them.
• Holding period: To take full advantage of the tax benefits, you need to hold onto the shares for at least one year after the purchase date and for at least two years after the beginning of the offering period (when you started contributing to the ESPP).
• Tax on the discount: The discount you received when purchasing the stock is taxed as ordinary income during the year you sell the shares.
• Tax on additional gains: Any additional profit beyond the discounted price is considered a long-term capital gain if you’ve held the shares long enough. Long-term capital gains are typically taxed at a lower rate than your regular income. If the holding period requirements are not met, these gains are taxed at higher ordinary income rates.

Taxing of nonqualified plans:

For nonqualified plans, the rules can vary. Generally, the discount you receive is taxed as ordinary income in the year you purchase the stock, not when you sell it. Any gains from the sale of the stock are then taxed according to how long you held the shares—short-term for less than a year (at your regular income tax rates) or long-term for more than a year (at reduced capital gains rates).

Knowing these details can help you plan the best time to sell your shares to minimize taxes and maximize returns. Always consider consulting with a tax advisor to navigate your specific situation—it can save you a lot of headaches and help you make the most out of your ESPP.

ESPP Example Understanding the ESPP Lifecycle Joining an Employee Stock Purchase Plan can be a smart financial move and it’s straightforward once you get the hang of the timeline. Here’s what you need to know: Enrollment period: This is your window to sign up for the ESPP. Offering (or grant) date: From this date, a portion of your salary is set aside for the ESPP. This doesn’t mean you’ve bought the stock yet—it’s more like you’re building up your investment fund paycheck by paycheck. Purchase periods with lookback provision: For this example, there are two six-month periods where your accumulated savings go towards buying company stock. Here’s where the real magic happens—if the stock price at the end of this period is lower than when you started, you still get to buy at the lower price, thanks to the lookback provision. This provision allows you to buy the stock at the lowest price between the start and end of your purchase period, making it a win-win. By the end of a 12-month cycle, you’ll have had two opportunities to purchase stock at a discounted price. It’s a great way to invest in your company and potentially grow your wealth alongside it. Remember, ESPPs are a benefit to you as an employee, offering a discounted path to owning a piece of your company. So, if your employer provides it, it’s worth considering how it fits into your financial picture.

Taxes on Equity Compensation

Navigating the tax landscape of equity compensation is critical to leveraging the full potential of your benefits while managing your tax obligations effectively. Early planning cannot be overemphasized—it’s a crucial step towards optimizing your financial outcomes. Below, we provide a high-level overview of how different types of equity compensation are taxed to help you plan accordingly. Given the complexity of equity compensation taxes, consult with a tax advisor who specializes in this area. They can provide tailored advice and strategies based on your unique financial situation.

 

Equity Compensation Type	What Gets Taxed?	When Are Taxes Owed?	Tax Treatment
NQSOs	Bargain element (The difference between market value and exercise price)	At the time of exercise	Taxed as ordinary income
ISOs	Bargain element (The difference between market value and exercise price)	It depends: At exercise (May owe under AMT) and/or At sale	Possible AMT; may qualify for capital gains treatment if holding period is met
RSUs	Fair market value of shares	Upon vesting	Taxed as ordinary income
ESPPs	Discount provided by employer and any subsequent gains	Upon sale of shares	Discount taxed as ordinary income; gains taxed as long-term capital gains if holding period requirements are met

Essential Tax Strategy Tips

Here are some crucial aspects to consider when developing your tax strategy for equity compensation:

• AMT and ISOs: ISOs can be particularly complex. Exercising ISOs may trigger the AMT, requiring careful planning to mitigate potential impacts. Understanding the interplay between your exercise strategy and the AMT is essential. Unlike NQSOs, companies aren’t required to withhold any taxes when ISOs are exercised. Understanding the tax implications of an ISO transaction at exercise will help avoid surprise tax bills at Tax Day.
• Capital gains and holding periods: Long-term versus short-term capital gains rates can significantly affect the taxes owed upon the sale of equity. Shares held longer than a year typically benefit from lower long-term capital gains tax rates.
• State taxes: Don’t forget to consider state taxes, which can come in addition to federal taxes.
• Tax withholding and reporting: Employers often withhold taxes for equity compensation at the time of exercise or vesting. Ensure that this is accurately reflected on your W-2 and in your tax filings.
• Financial planning integration: Integrate your equity compensation into your wider financial plan, including retirement and estate planning, to ensure a cohesive strategy that aligns with your long-term financial goals.

Incorporating these tax minimization strategies can help you navigate the complexities of equity compensation. By understanding when and how your equity is taxed, you can make more informed decisions that align with your financial objectives. We also recommend you discuss your equity comp benefits with your financial advisor and your accountant as they can help you navigate any tax complexities.

Maximizing Your Equity Compensation

Navigating equity compensation can significantly boost your financial well-being, offering unique opportunities for wealth accumulation. Let’s explore some thoughtful strategies to effectively manage and maximize these benefits.

Setting your financial goals

Understanding your financial aspirations is crucial when dealing with equity compensation. Are you dreaming of early retirement, buying your first home, or funding your children’s education? Different equity instruments, like stock options or RSUs, can help you reach these milestones. Identifying your goals early on will guide you in making informed decisions about how and when to sell your shares, aligning each step with your broader financial plan.

Consider your current life and career stage:

• Early career: If you’re just starting out, you might be more inclined to take financial risks, given the long road ahead to retirement. This stage is an opportune time to utilize equity compensation to potentially grow your wealth. For instance, if you’re planning to buy a home soon, strategically selling some of your equity for a down payment can secure the funds you need, while keeping some equity to potentially capitalize on future stock price increases.
• Mid to late career: As you advance in your career, your focus may shift towards preserving the wealth you’ve built. It’s vital to balance your investment portfolio at this stage. Diversifying your investments can protect you from market volatility and reduce the risk of having too much tied up in company stock. It’s also a time to assess your needs for a comfortable retirement and adjust your investment choices accordingly.

Understanding Vesting Schedules

Simply put, vesting is how you earn the right to fully own stock options, RSUs or other equity forms over time. This process ensures that the benefits of equity compensation are earned gradually as you contribute to your company’s success.

Vesting schedules determine how and when you gain full ownership of equity awards such as stock options, RSUs or other forms of equity compensation. Each vesting schedule has its advantages and strategic uses, both for the company in managing its workforce and for you as an employee in maximizing the benefit from your equity compensation. Understanding these schedules can help you plan your career moves and financial decisions more effectively. Here are some common types of vesting schedules that you might encounter:

Types of vesting schedules:

1. Time-based vesting:
   • Cliff vesting: This type of vesting occurs when all your equity vests at once after a set period. For example, you might have a one-year cliff, meaning if you leave the company before completing one year, you receive none of the equity. If you stay beyond that year, 100% of the equity vests at once.
   • Graded vesting: With graded vesting, your equity vests in increments over time. For example, 25% might vest after one year, another 25% after two years, and so on until you are fully vested in four years. This is a common schedule designed to keep employees engaged over a longer period.
2. Performance-based vesting:
   • Milestone achievement: Here, vesting is contingent upon achieving specific company or personal performance goals, such as reaching a sales target or a project milestone. For example, a portion of equity might vest only if the company’s revenue hits a certain benchmark within a set timeframe.
   • Hybrid vesting: Some companies combine time-based and performance-based vesting, where some equity vests over time and additional portions vest as performance targets are met.
3. Accelerated vesting:
   • Change in control: This occurs when a company goes through a merger or acquisition. Often, vesting of all or part of your equity may accelerate, meaning you gain immediate ownership of your shares or options, to protect employees in case of such corporate changes.
   • Termination for good reason or for cause: Some equity compensation packages allow for accelerated vesting if an employee is terminated for good reason (such as a drastic change in role or location) or without cause

Navigating your vesting schedule:

• Plan your financial milestones: It’s crucial for you to understand when your shares or options vest because this timing affects when you might plan significant financial decisions—like buying a home or planning for retirement.
• Check your documents: Your equity grant agreement will detail your vesting schedule. Take the time to understand it fully—know when each portion vests and what conditions might affect this timing.
• Strategic financial planning: Recognize how each vesting milestone fits into your broader financial landscape, especially considering potential tax impacts when equity vests or when you’re thinking about selling shares.

Tax implications of vesting:

Depending on the type of equity you receive, vesting could be a taxable event on its own. With the help of a tax advisor or wealth manager, your taxes can be strategically managed to avoid surprises.

Changing Jobs:

• Potential losses: Leaving your job before equity vests typically means you forfeit what hasn’t vested. Weighing the potential losses against a new opportunity is crucial.
• Look for acceleration clauses: In events like mergers, your vesting might accelerate. Knowing this can influence how you negotiate new job offers or plan for sudden financial gains.

Tax Planning and Strategies

Tax planning is perhaps the most complex yet critical aspect of managing equity compensation. Each type of equity has different tax implications at various stages, from receiving and exercising to selling. You can refresh your tax knowledge from this article’s section, Taxes on Equity Compensation.

We know we’ve mentioned it a few times throughout this article, but we cannot stress enough the importance of having you consult with your tax advisor or financial planner on how best to navigate taxes when it comes to your equity compensation.

Here are a few additional tax topics that could be related to your equity compensation package that we suggest you familiarize yourself with.

83(b) Election: This election is commonly used by employees of startups or rapidly growing companies who anticipate significant appreciation in the value of their shares. election is a critical decision point at the time a grant is received in managing equity compensation, particularly for those receiving restricted stock. It offers an opportunity to optimize your tax implications based on the expected performance of your company’s stock. Here’s a deeper dive into the mechanics and strategic considerations of the 83(b) election:

• Why consider making an 83(b) Election?
  • Tax efficiency: If the stock appreciates between the grant date and vesting date, you avoid paying taxes on the appreciation at ordinary income tax rates. Instead, that appreciation would be taxed as capital gains when the shares are eventually sold, potentially at a lower rate if the gains are long-term.
  • High-growth potential: This election is particularly advantageous if you are in a startup or a fast-growing company where early-stage stock valuations can be significantly lower than future valuations. By electing 83(b), you’re betting on the company’s success and potentially reducing your future tax burden.
• Risks and considerations:
  

• • Irreversible decision: Once made, the 83(b) election cannot be undone. Let that sink in. That means you’ll be liable for taxes on the stock at the current valuation regardless of future changes in stock value or your employment status.
  • Financial risk: If the stock value declines or if you leave the company before the stock vests, you may find that you’ve paid taxes on a benefit that has diminished in value or that you cannot fully realize. This risk requires careful evaluation against your long-term expectations for the stock and your personal financial situation.
• Advanced strategies for experienced employees:

• • Tax planning: Understanding the impact of an 83(b) election on your broader tax picture is an important aspect of personal financial planning. For example, pairing the gains from shares eventually sold with tax loss harvesting on another investment can optimize your overall tax situation. Incorporating tax minimization strategies when making an 83(b) election can further enhance the benefits of this decision.
  • Financial planning context: For those further along in their careers or with significant financial portfolios, the decision to make an 83(b) election should be considered in the context of overall financial and estate planning. How does spending cash on taxes now fit into your long-term financial plan?

Qualified Small Business Stock (QSBS)

Qualified Small Business Stock (QSBS) represents shares issued by a qualifying small business in the United States. For a business to qualify for QSBS status, it must be a domestic C corporation whose gross assets do not exceed $50 million before and immediately after the stock issuance. This asset threshold is designed to ensure that the tax benefits are targeted towards smaller, growing companies. It’s part of an incentive to encourage investment in these types of businesses that could drive innovation and economic growth.

QSBS Tax Tips Not all state tax laws align with the federal QSBS tax rules. For instance, California does not conform, so QSBS gains are 100% taxable for California taxpayers. Additionally, a portion of the excluded gain might be subject to the AMT.

If you hang onto these shares for at least five years, the IRS gives you a high-five in the form of tax benefits. You could potentially wave goodbye to taxes on a significant chunk of profit when you sell your shares, all thanks to QSBS. It’s the IRS’s way of saying, “Thanks for believing in the little guys!” And if you decide to pass on the baton by reinvesting in another up-and-coming company, you might just be able to defer those capital gains taxes. It’s all about keeping that innovative spirit alive.

It’s smart to loop in a tax professional who’s familiar with QSBS rules—they can help ensure that the stock meets all the IRS requirements, so you can plan for those potential tax benefits down the road.

1. Capital gain exclusion: If you hold your QSBS for at least five years, you can exclude some or all of the capital gain from your income when you sell or exchange the stock. The exclusion amount is the greater of $10 million or 10 times your cost basis in the QSBS. The specific exclusion percentage depends on the purchase date of the stock:
   • 100% for stocks purchased after September 27, 2010
   • 75% for stocks purchased between February 18, 2009, and September 27, 2010
   • 50% for stocks purchased between August 10, 1993, and February 17, 2009
2. Deferral of capital gain: If you sell or exchange your QSBS and invest in a different QSBS within 60 days, you can defer the capital gain recognition. This requires that you held the original QSBS for at least six months prior to the sale or exchange.

Option strategies

The timing of when you exercise your options is crucial and should be based on market conditions, your personal financial needs and potential tax impacts.  By proactively managing when and how you exercise your stock options, you’re taking a powerful step toward securing your financial future. This strategic approach ensures that your equity compensation acts as a tool for building and sustaining long-term wealth. Remember, making these decisions isn’t just about capitalizing on immediate gains—it’s about crafting a thoughtful financial strategy that supports your life’s goals and dreams.

Early Exercise for ISOs Pros Cons Potential for long-term capital gains: If you hold the shares for at least one year after exercise and two years from the grant date, any increase in value is taxed at the more favorable long-term capital gains rate. Lock in lower AMT impact: Exercising early when the spread between the exercise price and fair market value is small can reduce the Alternative Minimum Tax (AMT) liability. Cash outlay: You need to pay the exercise price upfront, which requires capital. Risk of forfeiture: If you leave the company before the options vest, you may lose the shares, although you may be able to recover some or all of the exercise price depending on the company’s policies.   Early Exercise for NQSOs Pros Cons Potential to reduce ordinary income tax: Exercising early when the stock price is low can minimize the ordinary income tax hit, as the bargain element is smaller. Flexibility: You can manage your tax liabilities better by spreading out the exercises. Cash outlay: Similar to ISOs, you need to pay the exercise price upfront. Risk of forfeiture: As with ISOs, you risk losing the shares if you leave the company before the options vest, and recovering the exercise price depends on company policies.

 

1. Understanding your exercise windows:
   • What are exercise periods? These are the designated times you’re allowed to exercise your options. If possible, weigh the benefits and risks of exercising your options early. This choice can significantly impact your tax picture, so it’s essential to make an informed decision. Additionally, if you leave a company, you could exercise options for 90 days after your departure – don’t leave any value on the table! Some companies offer employees the right to exercise options early before they vest.
2. Navigating tax implications:
   • Immediate and long-term tax consequences: Be mindful that exercising options often triggers immediate tax liabilities, like ordinary income tax on Non-Qualified Stock Options. Conversely, holding onto shares post-exercise could allow you to benefit from lower long-term capital gains tax rates on any appreciation above the price at exercise.
   • AMT concerns: For ISOs, it’s crucial to understand how exercising could impact your AMT liability. Planning with a tax advisor can help you manage this effectively and avoid surprises.
3. Considering market conditions:
   • Timing your decision: Keep an eye on market trends and your company’s performance. This insight will help guide you in choosing the best time to exercise your options to maximize potential gains. Factor in both the company’s current performance and future prospects to make an informed decision.
4. Aligning with your financial goals:
   • Financial plannings: Align your exercise strategy with your personal financial ambitions, whether that’s preparing for retirement, buying a home, or securing educational funds for your children.
   • Liquidity considerations: Consider your need for liquidity—whether you might need to sell some shares immediately after exercising. This decision is crucial for managing your cash flow and achieving a balanced investment portfolio.
5. Managing risks:
   • Scenario planning: This is a good exercise to have with your financial advisor. It’s where you walk through different scenarios together, exploring how varying exercise timings and market conditions could affect your financial outcomes.
   • Diversification: Diversifying your investments post-exercise is wise. Spreading your investments can help mitigate risks and promote financial stability. We share more about this in the Diversification Strategies section next.

Diversification Strategies

While equity compensation can be lucrative, having a significant portion of your wealth tied to your company’s stock increases risk. Implement diversification strategies by allocating investments across different asset classes, reducing the volatility of your overall portfolio and protecting against company-specific downturns. Tax minimization strategies can also be applied when diversifying your portfolio.

• Diversifying proceeds: Proceeds relate to the cash generated from exercising stock options, selling vested shares or shares acquired from employee stock purchase plans. The funds obtained from the sale constitute the proceeds. These funds can be used however you see fit. If you choose to reinvest in other assets, we recommend diversifying into a variety of investments rather than putting all the proceeds into a single investment type.
• Long-term investment strategies: Take a long-term approach to investing your equity compensation proceeds. Understanding the long-term growth potential of an investment is critical when developing an expectation of the investment’s future cash flow. Buying low and selling high is always sage advice, though we recommend looking at the fundamentals of an investment and keeping a long-term mindset. Following the math and not the emotions, is what makes an investor successful as we mention in 4 sound long-term investing strategies.

Diversifying your equity compensation proceeds can help mitigate risk and optimize returns. Essentially, the goal is to spread risk to reduce the impact of any single investment performance. Aspiriant’s investing philosophy encourages global stocks across sectors and industries and in a mix of asset classes. A portfolio containing investments in developed international countries as well as emerging markets allows investors to take advantage of economic success around the world.

Legal and regulatory considerations

Stay informed about insider trading laws and SEC regulations that affect equity compensation. Adhering to these laws is crucial when exercising and selling your shares. Establishing a 10b5-1 trading plan, for example, can provide an affirmative defense against insider trading allegations when you use one to sell your shares. Let’s learn more about a 10b5-1 plan below.

Avoid insider trading accusations with a 10b5-1 plan

When it comes to maximizing your equity compensation, understanding the tools and strategies available to navigate legal complexities is crucial. One such strategy is the 10b5-1 plan, designed to protect corporate insiders by allowing them to sell their shares at predetermined times to avoid accusations of insider trading. Setting up a 10b5-1 plan allows you to sell stock even if you come into possession of material non-public information later. This approach is key for anyone who has access or can be exposed to material nonpublic information in their role with a company, as it helps align your financial actions within legal boundaries. To better understand how a 10b5-1 plan can safeguard you against insider trading allegations, read more in our detailed article here.

Deferred compensation plans:

In your journey through understanding equity compensation, it’s important to consider how deferred compensation plans can play a pivotal role in your financial strategy. These plans are especially useful if you’re in a higher income bracket now and anticipate being in a lower one upon retirement.

• What are deferred compensation plans: Deferred compensation plans allow you, particularly if you are an executive or a senior employee, to defer a portion of your income to a later date. This isn’t just about delaying income; it’s a strategic move to manage your tax liabilities over time. By deferring compensation, you lower your current taxable income and, consequently, your taxes. Then, when you access these funds in the future—possibly in retirement—your tax situation may be more favorable.
• Why opt for deferred compensation?
  • Tax savings: By deferring your salary or bonuses, you reduce your taxable income for the current year. This can be particularly advantageous if you expect to be in a lower tax bracket in the future, such as during retirement, when you withdraw these funds.
  • Investment growth: Often, these plans allow your deferred income to be invested until they are ultimately distributed to you. This means you’re not just putting off taxes; you’re potentially increasing your dollars as the funds grow tax deferred over time.
  • Planning flexibility: Deferred compensation gives you flexibility in managing your income streams. For example, if you have major expenses planned for future years, like your children’s college tuition or a dream retirement vacation, you can plan to receive distributions around those times.
• Considerations before you choose:
  • Irrevocable decision: Often, choosing to defer compensation is an irrevocable decision for the year. Once you decide to defer a portion of your income, you can’t usually reverse that decision within the same fiscal year.
  • Risk factors: It’s crucial to understand that deferred compensation is typically not protected in the same way as retirement accounts like 401(k)s. In the event of the company’s financial downturn or bankruptcy, your deferred compensation could be at risk.
  • Regulatory compliance: Ensure that any deferred compensation plan complies with the laws and regulations, such as those outlined in Section 409A of the U.S. Internal Revenue Code, to avoid severe tax penalties.
    

Empower your financial future with equity compensation

We hope this guide has clarified the path to understanding the full potential of your equity compensation. Whether you’re just starting out or looking to optimize an extensive portfolio, the strategies and insights shared here are designed to empower you and align your compensation with your long-term financial goals.

Don’t navigate this alone

Understanding and managing equity compensation can be complex, with significant implications for your financial future. But you don’t have to go it alone. Our team of dedicated financial professionals at Aspiriant is here to guide you through every step—from decoding your compensation package to crafting a personalized investment strategy that considers market conditions, tax implications and your personal financial goals.

Start a conversation today

Ready to take control of your financial destiny? Schedule a consultation and let us help you transform your equity compensation into a powerful tool for building lasting wealth. Remember, the right guidance is key to maximizing your employee benefits and achieving your financial aspirations.

 

Glossary 10b5-1 Plan: This is a plan that allows you to sell your company shares at predetermined times. It provides you with an affirmative defense against insider trading allegations, allowing you to sell shares, even if you learn material non-public information later. 83(b) Election: If you make this election, you agree to pay taxes on equity (like restricted stock) at the time they’re granted, rather than when they vest. This can be a smart move if you think the stock’s value will go up because you might save on taxes later. Alternative Minimum Tax (AMT): This is a different way of calculating taxes that ensures you pay at least a minimum amount. It’s designed to prevent you from paying too little tax if you have a lot of deductions or tax-exclusive benefits. Bargain Element: This is the difference between your stock options’ exercise price (what you pay) and their market value (what they’re worth) when you choose to buy them. If your options are worth more than what you pay, that difference is your bargain element. Capital Gain: This is the profit you make from selling something, like stocks, for more than you paid. It’s what you earn from a good investment when you sell at a higher price. Concentration Risk: The risk of significant financial loss that arises from heavily investing in a single asset or a small number of assets, such as a single stock or sector. Deferred Compensation plan: This is a way to put off getting part of your income until later, allowing you to reduce current taxes and/or plan for future lower tax years like retirement. ESPP (Employee Stock Purchase Plan): This is a program that lets you buy shares of your company’s stock, often at a discount, through money taken out of your paycheck. Exercise: This term means you’re using your right to buy stocks at a special price set when you received the stock options. Exercise Price (Strike Price): This is the fixed price at which you can buy shares according to your stock option grant, no matter how much the stock’s market price increases. Fair Market Value (FMV): This is the current price that your company’s stock is being sold for in the stock market. The value of private companies is set through a valuation process and approved by the company’s board. ISO (Incentive Stock Options): These are a type of stock options that qualify for preferential tax treatment if certain holding period conditions are met. Lookback Option: In ESPPs, this lets you buy stock at the lower price from either the start or end of the buying period. NQSO (Non-Qualified Stock Option): These are stock options that don’t qualify for special tax breaks and their bargain element is always taxed as regular income upon exercise. Performance-Based Vesting: This is when your stock or options vest (become yours) based on achieving specific goals, like sales targets or project milestones. Qualified Small Business Stock (QSBS): This is stock in a small, growing business that offers tax advantages, like tax-free gains under certain conditions, to encourage investment. RSU (Restricted Stock Unit): This is a type of stock grant that becomes completely yours as it vests over time. You’re taxed when the stock vests, not when you first receive it. Stock Appreciation Rights (SARs): These give you a bonus equal to the increase in your company’s stock price over a set period, which you can receive as cash or more stock. Stock Options: These are opportunities to buy your company’s stock at a set price in the future, potentially below its market value at that time. Vesting: This process determines when and how you gain full ownership of stock options or RSUs given to you. It’s based on a schedule and can be based on time served or other milestones.