Navigating equity compensation requires understanding the pros and cons of different compensation offers, as well as an appreciation for the alphabet soup of acronyms you may encounter. While it may be tempting to just look at the offer and assume that you'll get the best possible value for the options and awards you're offered, it's crucial to look closer. Different types of equity compensation can dramatically change your tax exposure, as well as the dates when those tax obligations are due. There are a variety of common structures, as well as a few approaches that are gaining popularity. Here are a few you can expect to see on the table the next time you're negotiating a compensation package.
Non-Qualified Options
Among the most common types of equity compensation are non-qualified options, or NQOs. These options are leveraged assets that can provide you with a great deal of value. They also usually come with a long expiration date, typically ten years out. However, NQOs come with drawbacks. As far as equity compensation goes, NQOs are very risky: they can lose all value and wind up underwater. Predicting the future is impossible, of course, but be as cautious as possible when considering NQOs. The vesting and expiration timelines can draw out that risk. NQOs are also taxed as regular income, which can minimize the actual value you receive.
Incentive Stock Options
Incentive stock options, or ISOs, are also commonly seen types of equity compensation. ISOs offer some of the same benefits as NQOs — they're both leveraged assets that can offer you great value and they both usually have a ten year timeline before expiration. But while NQOs are always taxed as regular income, ISOs can be taxed as regular income or long term capital gains depending on how you exercise your option. The spread value (or the difference between the exercise price and the stock's current value), can also trigger the alternative minimum tax at time of exercise, making them less appealing in terms of taxes. A key drawback also mirrors NQOs: ISOs also run the risk of going underwater, making them a risky proposition. You'll face vesting and expiration deadlines when dealing with ISOs, as well.
Restricted Stock Awards and Units
Restricted stock awards (RSAs) and restricted stock units (RSUs) are two similar types of equity compensation. In both award types you are granted whole shares of stock that will vest over a predetermined time period. The key benefit that differentiates between the two is that RSAs provide the option of utilizing a unique tax strategy unavailable to RSU holders. RSAs can use an 83(b) tax election to potentially reduce tax exposure, effectively paying taxes on your equity before it vests (and, hopefully, before it increases in value). However, the 83(b) election strategy does come with some risks. By choosing to accelerate the tax liability, you run the risk of the equity position decreasing in value by the time of vesting which would have had a lower tax implication. You will not have the ability to go back and amend your tax return to take advantage of the most beneficial option. In effect you could actually end up paying more in taxes than you would have had you not made the 83(b) election.
Performance Share Units
While performance share units, or PSUs, are not yet common in equity compensation packages, they are increasing in popularity. They work in much the same way that RSAs and RSUs work, but are tied to a performance calculation that can increase value. A PSU's value is multiplied based on business unit or company performance. You can see some tax advantages in accepting PSUs, but they're specific to certain situations: a properly structured deferral strategy could lower your state income tax obligations under certain circumstances and structures. Most often, PSUs are taxed as regular income. And, unless your company allows deferral, you can't control when that tax obligation is due. PSUs also come with their own vesting timelines.
Digging Deeper into Equity Compensation
While we've given you an overview of the types of equity compensation you're most likely to encounter in this post, be aware that there are other structures out there you might encounter. Every company has different expectations and goals when the time comes to hire an executive and they'll tweak their executive compensation as they see appropriate. Different components of a given equity compensation package may also be negotiable, offering you more options for both increasing your compensation and limiting your tax liability. In order to protect your own interests, have an expert in negotiating executive compensation review the offers you receive. If you would like to better understand the equity compensation you have or feel that it may be time for high quality executive financial planning of your own, head on over to our Contact Us page to request time to chat with a member of our team.
Tim Golas, Partner