Do You Know the Tax Implications of Equity-Based Compensation?

07 November 2022

Equity-based compensation often is associated with startup companies. But businesses in a cash crunch also might consider such awards in lieu of year-end cash bonuses. In addition to recognizing high performance, stock options and other types of equity-based compensation can boost retention. Before you jump in headfirst, it's important to understand the different types of awards and how they can affect taxes for your company and your employees.

The IRS defines equity-based compensation as any compensation paid to an employee, director or independent contractor that's based on the value of specified stock (usually the employer's stock). Different types of equity-based compensation are subject to different tax rules. Here's an overview of some popular examples.

Stock Options

Stock options are probably the most common form of equity-based compensation. They generally provide the right to purchase a specified number of shares at a fixed price for a certain time period and are usually subject to vesting.

The IRS recognizes two kinds of stock options:

1. Incentive stock options (ISOs). These can be granted only to employees. Neither the grant nor the exercise of ISOs produces federal income tax consequences for the employer or employee. But in the year of exercise, the excess of the fair market value (FMV) of the options over the exercise price is income to the employee for alternative minimum tax (AMT) purposes. If the AMT doesn't apply, the employee isn't taxed until the sale of the shares.

If the sale is a "qualifying disposition," the employee will recognize long-term capital gains. The gains are taxed at a rate significantly lower than the ordinary income rate. A qualifying disposition occurs after meeting the holding period requirements (two years after the grant and one year after the option is exercised). If sold early, the transaction is treated as a disqualifying disposition. The income to the employee is includible as compensation for that year and taxed as ordinary income.

2. Nonqualified stock options (NQSOs). These stock options offer greater flexibility than ISOs because they don't have to meet strict IRS requirements. For example, NQSOs can be provided to more than just employees. You can award them to directors, contractors and consultants. NQSOs also carry no AMT risk.

NQSOs generally aren't taxable compensation, and no taxable event occurs until they're exercised. At that point, the excess of the FMV over the exercise price is compensation that's taxable to the recipient as ordinary income and deductible by employer. The recipient may incur capital gains taxes when the shares are sold.

RSAs

A restricted stock award (RSA) is a grant of company stock where the employee's stock rights are restricted until the shares vest. Upon vesting, the employee owns the shares outright. RSAs can retain some value in circumstances where stock options would lose value because the stock price drops below the option price.

The excess of the FMV of the vested shares over the amount paid for the stock (usually zero) is compensation income. However, there's an exception: Under Internal Revenue Code (IRC) Section 83(b), the employee can elect when the award is granted to pay ordinary income tax on the FMV of the shares on the grant date (less any payment made by the employee) instead of when the stock vests.

The Sec. 83(b) election converts future appreciation into capital gains, which aren't taxed until the shares are sold. The election decision determines when the employer can claim a deduction (the grant year vs. the vesting year), as well as the amount of the deduction (generally, FMV at grant vs. FMV at vesting).

RSUs

Restricted stock units (RSUs) are unsecured and unfunded promises to pay cash or stock in the future, after a vesting period. Typically, one RSU equals one share.

RSUs generally aren't taxable when the award is granted, provided they satisfy certain requirements. A taxable event occurs when the employee receives the stock — the employee pays ordinary income tax on the FMV of the shares and the employer claims the deduction. RSUs aren't covered by IRC Sec. 83, so the employee can't make a Sec. 83(b) election with respect to an RSU award.

SARs

With stock appreciation rights (SARs), an employee or independent contractor has the right to receive the increased value of the employer's stock during a specified period. When exercised, the employee can receive cash, shares or a combination, depending on the terms of the plan.

Because the recipient can benefit only from appreciation in stock value, no taxable event occurs until the SAR is exercised. At that point, the amount received is includible in the recipient's income, creating a deduction for the employer.

Reporting Caveat

When awarding equity-based compensation, it's essential that you comply with your reporting obligations. You can claim a compensation deduction only in the year the compensation is includible in the recipient's gross income.

This parity holds true even if the recipient doesn't report the compensation to the IRS. Contact your tax advisor to help properly report the compensation to support your deduction.

We Can Help

Equity-based compensation can pay off for employees and employers. If correctly implemented, your business can improve employee retention and preserve cash flow. We can help you select the best option for your circumstances and comply with the reporting requirements.

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