As of 2023, a study showed that over 70% of companies are offering some form of equity compensation. The main forms of equity compensation include Restricted Stock Units (RSUs), Performance Stock Units (PSUs), restricted stock, Incentive Stock Options (ISOs), and Non-Qualified Stock Options (NQSOs).
Below, I will give an overview of each flavor listed above. However, before doing so, I wanted to dive a little more into one issue that usually arises around equity compensation.
Concentration risk. In my experience, equity compensation is one of the most frequent culprits of concentration risk being built into someone’s overall financial life.
Usually, this is due to a lack of planning around vesting company stock and slowly letting it accumulate over time. For some individuals, this can lead to a massive outsized position relative to their other assets!
Concentration risk in employer stock can arguably be even more risky than that of another company. Why? Because not only is the company responsible for your employment, but the employer’s stock now makes up a significant portion of a portfolio!
When individuals have some form of equity compensation, it is generally important to draw the line somewhere. This will be subjective and can vary between people. Maybe one person feels that 10% of their investable net worth is a comfortable position. Maybe another finds 20% to be a better fit.
In any event, when individuals are compensated with some form of equity, I always pose this question: “If you were paid that money as cash, would you have put it ALL into your employer’s stock?”
Many times, the answer is no! Then a conversation about how to diversify the proceeds of company stock comes about.
Anyway, here is an overview of RSUs, PSUs, Restricted Stock, Incentive Stock Options and Non-qualified Stock Options:
Restricted Stock Units (RSUs):
These are some of the most common forms of equity compensation. Restricted Stock Units are not to be confused with restricted stock. These are two different things!
When RSUs are granted, there is not necessarily any taxable event or income realized. Generally, RSUs will follow a time-based vesting schedule. This will dictate the cadence of taxable events for an individual.
As shares vest, the individual will be taxed as if they had been paid the FMV (fair market value) of the shares vesting.
Performance Stock Units (PSUs):
These work very similarly to RSUs. However, they are typically reserved for managers and executives.
PSUs will vest according to performance metrics set by the company, unlike RSUs, which vest on a time-based schedule.
Restricted Stock:
This differs from RSUs in the sense that they are awarded to an individual but maintain a substantial risk of forfeiture. RSUs are seen as more of a “promise” of the company to deliver shares upon vesting.
Restricted stock cannot be sold until certain requirements are met.
This form of equity compensation can follow a time-based vesting schedule or a performance-based schedule. It can be awarded at no cost to the employee, or it may come with a “purchase price,” in which the employee may have to pay FMV for the shares or a discount to FMV.
As shares vest, they are taxable as ordinary income. Restricted stock is also eligible for 83(b) elections.
This is a powerful election that can allow an individual to pay taxes upfront on the grant, rather than when it vests and could potentially have appreciated in value.
Incentive Stock Options (ISOs):
This form of equity compensation is slightly more intricate than RSUs or PSUs.
ISOs offer an employee the right to purchase the employer’s stock at a specified price. Somewhat similar to traditional call options, but with a little twist.
These options are typically subject to a vesting schedule and usually have an expiration date associated with them, ranging up to 10 years from the grant. There is even the potential for preferential tax treatment with these instruments.
At a high level, ISOs will not be subject to typical taxation at the grant date, the vesting date, or even the exercise date.
However, exercising ISOs and the spread between the FMV and the option’s strike price can become an AMT preference item.
Upon exercising options, the individual would then have the ability to sell their position. But ISOs carry even more rules around this!
A sale will generally either be a qualifying or non-qualifying disposition. Each comes with a different tax implication.
Qualifying dispositions allow for the strike price to become the basis of the shares, with any gains being taxed as capital gains.
Two things must be met in order for a qualifying disposition:
The sale must occur at least 2 years after the grant date
The sale must occur at least 1 year after the exercise.
ISOs can be more in-depth and can be eligible for an 83(b) election as well.
Non-Qualified Stock Options:
Fun fact - ISOs can sometimes transition to NQSOs!
Non-qualified stock options are somewhat similar to ISOs, with slightly less favorable tax treatment, but are also slightly less complicated.
These options again give the individual the ability to purchase shares of company stock at a specified price.
When these options are exercised, the spread between the fair market value and the strike price is recognized as ordinary income, and the FMV becomes the basis for the shareholder.
After exercising, if the shares are sold, gains will be taxed as capital gains and can be eligible for long-term capital gains tax rates if they are held for longer than 1 year from exercise.
That does it for the brief overview of equity compensation. As this form of compensation becomes more prevalent, it is important to fully understand how it can impact someone’s financial picture. For young professionals, equity compensation can be one of the main reasons behind seeking out a financial advisor, in my experience!
This is for informational purposes only and is not intended as legal or investment advice or a recommendation of any particular security or strategy. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Opinions expressed in this commentary reflect subjective judgments of the author based on conditions at the time of publication and are subject to change without notice. Past performance is not indicative of future results.