NSO, ISO, RSU, ESPP, and ESOP: Making Sense of Equity Compensation Alphabet Soup

Equity Compensation

NSO, ISO, RSU, ESPP, and ESOP: Making Sense of Equity Compensation Alphabet Soup

Is equity compensation part of your employee benefits package? With acronyms like RSU, NSO, ESPP, ISO, and ESOP, yours might seem more like alphabet soup than a benefit. Sure, you have the documents from human resources, but you might still be wondering what it is and how it works. 

Equity compensation comes in many forms, and offerings can differ not only from company to company but also from employee to employee. 

    • So Joe in accounting’s action plan may be based on an offering different from yours. 

And since many equity comp package decisions are heavily based in individuals’ unique income tax situations, there’s often no “blanket” advice on offerings that applies to all employees — even those with identical equity compensation packages.

Next week’s blog will focus more in-depth on how to handle equity compensation after an IPO, but we’ll start here with an overview. Here, you can learn what the letters in your equity compensation package stand for and better understand this type of employee benefit.

    • If you need more targeted guidance now, consider becoming a client and/or you can visit mystockoptions.com.

Equity Compensation Basics

Small, medium, and large private and public companies can offer ways for employees to gain ownership — aka equity. As ownership, equity compensation can help employees feel more invested — literally and figuratively — and loyal to their employers, since they actually earn an ownership stake of the company through their labor efforts. Yet, there are tradeoffs.

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If you …

    • Receive 100% regular salary, you know what you’re getting.
    • Receive 100% equity compensation, your equity’s value depends on the company’s financial success.
    • Are paid based on a hybrid scenario, you receive a regular salary with equity compensation as a bonus.

We sometimes notice clients who receive stock options and other forms of equity compensation begin to have top-heavy asset allocations. This means that the majority of their financial net worth is tied to the company they work for through their salary and ownership of company stock.

Pro Tip: Diversify your assets so you don’t overly lean on your company’s financial success for your personal financial success.

Understanding Equity Compensation

For a general introduction into this dense subject matter, here’s a video from TD Ameritrade as well as basic concepts and strategies below.

Stock Options

These benefits, or type of compensation, extend the right to buy a specific number of shares of a company stock at a pre-set price, known as the strike or exercise price. There’s usually a waiting period until these options are vested (i.e., available for you to exercise).

    • It’s important to know that you don’t own stock until you exercise the options. Stock options are merely the right to purchase the stock.

Pro Tip: When appropriate, do a cost analysis to gauge the value of a cashless exercise. This strategy is designed to allow employees to exercise options even if they don’t have the financial resources to pay for the shares.

There are two major categories of stock options.

▶︎ Nonqualified Stock Option (NSO)

— The most common form of stock options — NSOs may be granted to various stakeholders including employees, contractors, and directors of a company.

— NSOs feature relatively straightforward taxation.

    • When exercised, the difference between the exercise price and the underlying stock price is taxed as ordinary income and generally reported on a Form W-2.
    • When the stock acquired with the option is sold, the difference between the underlying stock price at the time of exercise and the sale price is taxed as a short- or long-term capital gain.

▶︎ Incentive Stock Option (ISO)

— Available only to employees and limited to up to $100,000 of vested/exercisable grant value per calendar year. 

— Special tax treatment that is not so straightforward.

    • When exercised, ISOs are not taxed as income, however, the difference between the exercise price and the underlying stock price (aka “the bargain element”) is subject to Alternative Minimum Tax (AMT).
    • When the stock acquired with the option is sold, the holding period relative to both the grant and exercise date of the ISO determines the tax character and consequences of the stock sale. 

Restricted Stock

The name seems relatively straightforward. However, the jargon can make things tricky. Restricted Stock and its very close cousin, Restricted Stock Units, are two very popular but decidedly different stock compensation plans.

▶︎ Restricted Stock 

— Actual shares of stock are granted to an employee with restrictions as to when the stock may be sold or otherwise disposed of. The vesting of restricted stock is typically based on specific performance goals and/or more commonly the time worked at the company.

— Because restricted stock involves actual shares of stock — the value of which is ascertainable as of the grant date — owners of restricted stock are allowed voting and dividend rights along with the ability to make a special tax election under IRC Section 83(b). 

Pro Tip: Consider making a Section 83(b) election within 30 days of receiving a grant of restricted stock. 

Section 83(b) Election

The election will make the value of the stock taxable to you as ordinary income (including Social Security and Medicare payroll taxes) based on the value as of the grant date. This allows for the reward of potential lower capital gains tax rates on the gain after the stock vests and you sell it (assuming that date is one year and a day after the grant date). 

The primary risks are:

    • The stock never vests because you leave the company or the company closes.
    • A significant decrease in the stock price between the grant and vesting/sale dates. 

In both risk cases, you end up recognizing and paying taxes on income you never realized.

Without an 83(b) election you will pay ordinary income and payroll tax on restricted stock as of the date the stock vests to you (aka the date it becomes unrestricted). Any gain from that date forward is taxed as a short- or long-term capital gain, depending on how long you own the then unrestricted stock.

For restricted stock of a pre-IPO company the rewards of a Section 83(b) election can be extraordinary but the risk significant. 

▶︎ Restricted Stock Units (RSU)

— At grant, an RSU is a company’s promise to give an employee shares of stock, in the future, which don’t exist at that time. The non-existence of the stock at the time of the grant is an important distinction between normal restricted stock and RSUs.

— Because RSUs are not actual shares of stock at the time of the grant, holders of RSUs are not entitled to voting rights or dividends (although many companies pay out dividend equivalents to RSU holders).

— The non-existence of stock at the time of grant also means that a Section 83(b) election cannot be made on an RSU.

    • RSUs are taxable — with taxes withheld similarly to wages — as of the date the RSU vests and the actual stock is transferred to you. Any gain from that date forward is taxed as a short- or long-term capital gain, depending on how long you own the newly issued shares of stock.

— However, Section 409A deferral is possible with RSUs, if the employer sponsors an appropriate plan type. 

    • Under certain circumstances, delivery of the actual stock can be deferred (along with the tax liability) even while the RSU itself vests.
    • This becomes an IOU within an IOU, as the election must be made within 30 days of the grant and the vesting date must be more than 12 months after the election.

Employee Stock Purchase Program (ESPP)

The stock plans above are explicitly forms of compensation. ESPPs are savings plans involving company stock. There are two types of ESPP plans: tax-qualified and non-qualified.

▶︎ Tax-Qualified ESPP

— Subject to an annual limit of $25,000 worth of non-discounted stock, per employee, tax-qualified ESPPs allow companies to offer a discount of up to 15% on purchases of the company’s stock through the plan.

— Taxation is in someways similar to ISOs but with key differences.

    • Although there are no AMT implications, there is a relationship between the ESPP plan’s grant date, the purchase date of the stock, and the sale date of the stock in determining whether a sale is a qualifying or disqualifying disposition.
    • In either case, there is some amount of ordinary income recognized with the disposition of tax-qualified ESPP stock.

Get to Know Your Equity Comp

Take a deeper dive into your equity compensation and what it means with our personal finance module! From understanding your stock plans and documents to need-to-know definitions and further resources, it’s all in Free Preview: Equity Compensation 101.

Pro Tip: When a 15% discount is offered, even disqualified dispositions of ESPP stock can provide more after-tax income than not participating in the plan at all. The primary risk to this strategy is the performance of the underlying stock.

▶︎ Nonqualified ESPP

— More flexible in plan design than tax-qualified ESPP plans, nonqualified ESPP plans can be offered in any amount and/or discount level.

— Nonqualified ESPP do not receive any favorable tax treatment.

    • Any discount offered through the plan is taxed as ordinary income, subject to payroll taxes, at the time of exercise.
    • The future sale of the stock is taxed as a short- or long-term capital gain depending on the number of days the stock is owned.

▶︎ Employee Stock Ownership Plan (ESOP)

— An ESOP is a type of retirement plan where employees are allocated shares of company stock, which can be held without tax-consequence until the shares are sold.

— As a retirement plan, ESOPs are subject to specific rules about vesting and the allocation of benefits.

— Gain can be deferred at sale under IRC Section 1042.

So what does your equity comp acronym stand for? Better understanding the alphabet soup of equity comp is only a piece of the puzzle. In next week’s blog, we’ll dive deeper into how you can develop an equity compensation action plan. From understanding your equity inventory and how to exercise to preparing for taxes and more, check out My Company Just Had Its IPO. Now What?


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Jason Speciner
Jason Speciner
jason@fpfoco.com

Jason Speciner is a CERTIFIED FINANCIAL PLANNER™ professional, an Enrolled Agent, and the founder of fee-only firm Financial Planning Fort Collins. He is also a member of the National Association of Personal Financial Advisors (NAPFA), Financial Planning Association (FPA), and XY Planning Network. Since 2004, he has served clients of all ages and backgrounds with unique experience working with members of generations X and Y. To learn more, check out Jason's blogs and see the media he's been featured in.