A Guide to Understanding Complexities of Equity Compensation

Equity compensation is an alternative compensation strategy designed to provide employees

with investment opportunities through company-based stock options. Over the years, this

strategy has become increasingly popular. In fact, according to Harvard Law School, roughly 58

percent of CEO compensation is a mix of equity and cash as of 2019. 1

An equity compensation strategy is typically utilized in businesses seeking growth without

drawing on a larger budget. This creates long-term ownership incentives at the cost of some

income stability. Let’s dive into how equity compensation works and examine some of the

different options available to employees.

Types of Equity Compensation

Each compensation option has a different set of opportunities, costs and taxes associated with

it. Also, be aware of the term “exercise,” as this is used often in equity compensation and refers

to the conversion of an option into stock. We recommend considering the differences in equity

compensation strategies when deciding whether equity compensation is right for you.

Equity compensation typically comes with a vesting schedule, a period of time in which stocks

fully become yours. This schedule will depend on the company and equity type. We have

worked with clients who have had no vesting schedule out to 6 years.

Standard Stock Options

With standard stock options, you can purchase a limited number of shares of the company you

work for, generally at a reduced price. After your vesting period, options can be exercised and

converted into shares. Be aware, stock options are typically exercisable for a limited amount of

time and follow different tax rules between pre-vested and vested shares. It’s important to

note that an employee with options is generally not considered a shareholder.

Non-Qualified Stock Options (NSOs)

A non-qualified stock option (NSO) is a type of employee stock option wherein you pay ordinary

income tax on the difference between the grant price and the price at which you exercise the

option.

Incentive Stock Options (ISO’s)

An incentive stock option (ISO) is an option that gives an employee the right to buy shares of

company stock at a discounted price with the added benefit of possible tax breaks on the profit.

The profit on qualified ISOs is usually taxed at the capital gains rate, not the higher rate for

ordinary income.

Restricted Shares

Unlike stock options, which you may receive before your vesting schedule provides full control,

restricted shares are limited by the employer based on your vesting schedule. Instead, you will

receive these stocks when they vest. The rate at which restricted shares are received will

depend on the company, just as the vesting schedule does.

Performance Shares

As the name implies, employees receive performance-based stock grants according to a set of

goals. These goals may vary and will depend on your company.

ESOP

An employee stock ownership plan (ESOP) is an employee benefit plan that gives workers

ownership interest in the company; this interest takes the form of shares of stock. ESOPs give

the sponsoring company—the selling shareholder—and participants various tax benefits,

making them qualified plans. Employers often use ESOPs as a corporate-finance strategy to

align the interests of their employees with those of their shareholders.

Net Unrealized Appreciation (NUA) Strategy

A beneficial strategy for employees with appreciated equity compensation in a retirement plan

is the NUA. Using NUA, employees with low basis company stock can significantly reduce taxes.

The IRS allows for a one-time opportunity to execute NUA distribution of company stock from

ESOP / 401(k) or qualified plan.

When using the NUA strategy, you’re essentially distributing shares of company stock from your

retirement plan with the cost being taxed at income tax rates and the gain at capital gains rate.

Contrast this with distributions from a retirement plan at income tax rates. Once the NUA is

executed, assets are outside your retirement plan, and no longer subject to Required Minimum

Distributions (RMDs) 2 .

To dive deeper, here is an example: Your employer offers an ESOP for it’s employees. You own

company shares in your 401(k) valued at $10 million. At retirement you will have a significant

amount of money in your 401(k) which is subject to RMDs (nearly $700,000 per year). These

RMDs, as well as other distributions from the plan, are taxed at regular income tax rate (37.5%

top Fed rate) plus state and local taxes. Using NUA, you distribute shares out of your 401(k) and

deposit them into a regular investment account. Your cost basis in the distributed shares is

subject to ordinary income tax in year of distribution. Now that the shares are outside the

retirement plan, you pay capital gains taxes (20% top Fed rate) on any gains, as shares are sold

now or in the future. Based on current tax law, the reduction from ordinary income tax rates to

capital gains rates could amount to material tax savings.

Additionally, when implementing the NUA, we often pair a gift of company shares to a

charitable entity, Family Foundation, Donor Advised Fund 3 , or similar to recognize a tax-

reducing charitable contribution in the same year as the tax-causing distribution. The funding

of a charitable entity establishes a pool of assets you can use to support charitable endeavors

for the rest of your life. Make the world a better place and create a significant tax deduction to

offset tax implications: An additional win-win.

Understanding the differences between equity incentive plans and strategy minimize taxes can

provide you the tools to determine benefits and implications of traditional vs equity

compensation. Remember to keep this summary in mind when offered equity by an employer.

If you’re unsure of what the best move may be for your current and future financial needs, we

stand ready to assist. Contact us today to learn more.

1. https://corpgov.law.harvard.edu/2019/04/16/2019-u-s-executive-compensation-trends/

2. https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions

3. https://www.irs.gov/charities-non-profits/charitable-organizations/donor-advised-funds