Corporations often use stock-based compensation to reward and incentivize employees. Understanding how these programs work and how they’re taxed can be essential for making informed decisions. Below is an overview of the most common types of equity compensation:
1. Employee Stock Purchase Plan (ESPP)
An ESPP allows employees to buy company stock at a discount, typically around 15% below fair market value. For example, if the stock trades at $100 per share, you might purchase it for $85.
- Contributions: Made with after-tax dollars via payroll deductions.
- Taxation:
- No tax on the discount at purchase.
- When selling:
- Within 1 year of purchase: Short-term capital gains (taxed as ordinary income).
- After 1 year from purchase and 2 years from grant date: Long-term capital gains apply.
2. Incentive Stock Options (ISOs)
ISOs give you the right to buy company stock at a predetermined exercise price, subject to a vesting schedule. You typically exercise when the stock price exceeds the exercise price.
- Taxation:
- Grant date: No tax.
- Exercise: No regular tax, but the bargain element may trigger Alternative Minimum Tax (AMT).
- Sale:
- Qualifying sale: Held more than 1 year after exercise and more than 2 years from grant date: taxed at long-term capital gains rates.
- Disqualifying sale: Does not meet holding requirements: taxed as ordinary income on the lesser of the gain or exercise spread.
3. Non-Qualified Stock Options (NSOs)
NSOs are similar to ISOs but differ in taxation.
- Taxation:
- Grant date & vesting: No tax.
- Exercise: Ordinary income tax on the spread between exercise price and market value.
- After exercise: Short-term or long-term capital gains apply on any appreciation beyond the exercise price.
4. Restricted Stock Units (RSUs)
RSUs are shares granted instead of cash, subject to a vesting schedule tied to tenure or performance milestones.
- Taxation:
- At vesting: Market value is taxed as ordinary income.
- After vesting: Short-term or long-term capital gains apply based on the vest date.
5. Performance Shares
Performance shares are typically awarded to executives based on company-wide goals.
- Taxation:
- At grant: No tax.
- At vesting: Ordinary income tax on fair market value minus any amount paid for the shares.
- After vesting: Capital gains apply on future appreciation.
Key Takeaways
Equity compensation can be a powerful wealth-building tool, but each type has unique rules and tax implications. Always review your company’s specific plan details and consult a financial or tax professional before making decisions.
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