43% of millennials wealth has been built through equity compensation. This is no surprise as we all have been taught to seek it out.
Yet only 1 out of every 3 people understand how it works.
Here's your guide to RSUs, ISOs, NSOs, and ESPP Plans:
For those that don't know, equity compensation refers to various forms of non-cash compensation that companies provide to their employees. Typically in the form of stock or stock-based instruments.
Today, we’re going to walk through the common types of equity compensation, how they are taxed, and how to think and plan around them.
RSUs represent a promise by the employer to provide shares of company stock at a future date, upon vesting.
At the time of vesting, the value of the vested RSUs is treated as ordinary income and is subject to income tax withholding.
Once the RSUs are vested and shares are delivered, any subsequent gains or losses from the sale of the shares are treated as capital gains or losses. The holding period for capital gains tax purposes starts from the date of delivery of the shares.
This confuses people.
They often hold the RSUs for a year to get long term capital gains treatment since they do not understand that income taxes were already no matter what the date they vested.
With RSUs, it often makes sense to either sell the date they vest or hold long term if you believe this is the best use of your dollars.
If not, then you may want to invest it elsewhere, pay off debt, save it, etc.
The biggest mistake with RSUs is not planning for taxes well. They often withhold at 22% if under $1mil, or 37% if greater than $1mi. You need to get tax estimates and plan well so you don't have a surprise tax bill.
There are two main types of stock options:
Non-qualified stock options (NSOs)
NSOs are taxed when they are exercised. The difference between the fair market value of the stock at the time of exercise and the exercise price (the "spread") is treated as ordinary income and subject to income tax withholding.
Incentive stock options (ISOs)
ISOs are not taxed upon exercise, but may trigger alternative minimum tax (AMT) implications. This is a tax that is at 26% or 28%.
If the shares acquired through the exercise of ISOs are held for a certain period of time (usually at least one year from the date of exercise and two years from the date of grant), then the gains on the sale may be taxed as long-term capital gains.
With NSOs, most times it makes sense to wait to exercise. Yes, you will pay more income taxes, but if you exercise early, you will be paying income taxes on something that may never amount to anything.
The earlier you exercise, the less tax you could pay if it does well, but the more risk you are taking on.
The longer you wait, the more income taxes you pay, but the more certainty you have around them.
With ISOs you really have to think through them well. Since no tax exists on the exercise (unless you trigger AMT), many exercise early to avoid the chances of triggering AMT and to start the long term capital gains clock.
The earlier you exercise, the less AMT and you start long term capital gains close. The later your exercise, the more likely you are to trigger AMT as the spread gets bigger.
Also... with ISOs, you potentially early exercise and file and 83(b) election which you can read more about here.
ESPPs allow employees to purchase company stock, usually at a discounted price, through payroll deductions over a specific offering period. Typically its between 3-12 months. The most common I see is 6 months.
The discount received on the purchase of company stock through an ESPP is generally treated as ordinary income and subject to income tax withholding
The discount cannot exceed 15% and the maximum contribution employees can make is $25,000 per year
Any gains or losses from the sale of shares purchased through an ESPP can be taxed as either short-term or long-term capital gains, depending on the holding period. However, there is a wrinkle: ESPPs are generally classified into two categories:
The primary difference is that qualified ESPPs follow specific guidelines that defer their taxes so long as they hold onto their shares for the duration of a specific holding period - typically one year or more.
Non-qualified plan participants are typically taxed on contributions as ordinary income at the time of purchase and gains between cost and proceeds during a sale are subject to capital gains tax.
Let’s go over the tax rules for a qualifying disposition:
This happens when you sell your shares at least one year after you purchase them and at least two years after the offering date. A qualifying disposition will usually come with ordinary income tax and long-term capital gains tax.
Here’s a quick example:
Jim enrolled in this ESPP two years ago and bought them on the purchase date. Two years later, he sold them:
Stock price on Offering Date: $100
Stock Price on Purchase Date: $110
Discount rate: 15%
Price actually paid: $85
Current price: $150
With a look back provision, you get to buy at 15% off on the purchase date or offer date, whichever is lower.
So even though the market price was $115, he got it for $85. This is a huge benefit of ESPP plans.
We’re also going to assume Jim is in the 24% marginal tax bracket and the 15% long-term capital gains bracket.
The shares Jim sells are valued at $150 at time of sale.
Jim will owe ($100-$85 = $15 gain).
$15 x 100 x 24% in ordinary income tax = $360.
Jim will owe ($150 - $100 = $50 gain)
$50 x 100 x 15% in long term capital gains = $750
The discount is taxed at his income rate.
This would constitute a total tax of $1,110.
So what happens if you have a disqualifying disposition?
Like I said above, If the holding period requirements are unsatisfied, you will have a disqualifying disposition.
This likely means you’ll be subject to capital gains and ordinary income tax.
However, this time, there’s a bit more complexity. You will pay capital gains on the difference between the purchase date price and the final sales price.
This can mean either short-term or long-term capital gains.
Also, you’ll have ordinary income tax on the difference between the actual purchase price and the fair market value on the date of purchase.
Let’s revisit our example above to clarify.
We’ll first look at what happens if we don’t have a long-term capital gain.
Jim sells his shares less than two years after the offering AND less than one year after purchase.
This means that he would only deal with ordinary income tax rates because we only have a short-term capital gain in this scenario.
Jim will owe ($110 - $85) x 100 x 24% = $600
And Jim will also owe ($150 - $110) x 100 x 24% = $960
For a total of $1,560 in taxes.
Finally, if Jim were to have sold less than two years after the offering, but at least one year after purchase, we would be dealing with long term capital gains rates.
This ends up being the same scenario as the last, except for the gain on the shares sold, we would use the long-term capital gains rate instead of ordinary income rate.
Jim will owe ($110 - $85) x 100 x 24% = $600
Jim will owe ($150 - $110) x 100 x 15% = $600
For a total of $1,200 in tax
ESPP plans are a great tool. When they have a discount and look back, you are getting a great guaranteed return if you sell the date they become yours. A really nice return too.
Even if you don't want to hold the stock and need the funds elsewhere, it often makes sense to leverage, sell, and then reallocate.
These are very basic examples, and your effective rate in terms of taxes will likely vary, but this should help you understand the basics of ESPP.
Thanks for reading!
Hopefully this helps you better understand the various types of equity compensation.
Financial Advisor