By Tom Burleigh, CFP®, CTFA® and Landon Fritch, CFP®
Companies looking to attract and retain top talent have several tools beyond cash compensation. For executives and key contributors, these additional benefits could include stock awards, deferred compensation, specialized retirement plans, or long-term incentive plans. When structured well, these executive compensation benefits can serve to encourage alignment and retention for the employer and provide significant value to the employee.
Evaluating executive compensation packages can be challenging for employees as they are often left with several common struggles. These often include understanding the true value of their compensation plan, managing taxes, reducing concentration risk, navigating complex plan features, handling liquidity issues, or planning for a liquidity event.
Restricted Stock Units (RSUs)
RSUs are often used by large public companies with stock liquidity available on the open market. An employee is often granted RSUs at the beginning of employment and may receive additional grants in subsequent years. RSUs represent a promise of shares to be received in the future. As is the case with most other equity compensation plans, RSU grants are usually tied to a vesting schedule. Vesting schedules encourage employee retention and align employee incentives with company growth.
Vesting |
If the employee leaves the company, any unvested shares will be forfeited. For shares to vest, certain conditions must be met. These might include remaining with the company for a set amount of time, meeting specified performance criteria, or having a liquidity event, such as an IPO or company acquisition. In some cases, multiple conditions may be required. |
Taxes |
Upon vesting, shares are delivered to the employee and become taxable as ordinary income. Depending on the length of time that shares are held after vesting, subsequent appreciation may be subject to either short-term or long-term capital gains taxes upon sale. |
Performance |
The value of the RSUs is tied to the price performance of the company stock. |
Liquidity |
When dealing with private company stock, employees may struggle with liquidating their vested shares, often relying on liquidity events, such as a company acquisition or share buy-back. |
Restricted Stock Awards (RSAs)
RSAs are typically used in early-stage start-ups where cash may be limited – making cash compensation less attractive for workers. In lieu of higher cash compensation, companies can award RSAs, sometimes in higher quantities, to offset the volatility associated with start-ups. Unlike RSUs, these awards represent actual company stock – not merely the promise of shares upon vesting.
Vesting |
Like other stock-based compensation, there is a vesting period that must be met before the employee has full control of the awarded shares. Shares may be subject to the same vesting requirements as RSUs. |
Taxes |
The fair market value of the RSA shares is taxed as ordinary income when the shares vest. Since the employee is granted actual company shares, as opposed to the promise of shares as is the case with RSUs, that employee can file an 83(b) election. This allows the employee to pay ordinary income taxes on the shares at the time they’re granted instead of when they vest, creating a unique tax-planning opportunity and the potential for significant tax savings. After the vesting period is reached or 83(b) election is filed, the shares will be subject to capital gains rates. |
Performance |
The value of the RSAs depends on the fair market value of the company shares. For a newer venture, the risk-reward profile must be weighed. While these shares could have significant value in the future, they may also have limited-to-no value if the company cannot operate profitably or the employee does not stay long enough to realize any appreciation. An 83(b) election can lead to the pre-payment of taxes on stock that can end up holding no value – either due to the company going out of business or the shares not vesting. |
Liquidity |
Shares of private equity stock do not have a public market and may be difficult to liquidate. Sometimes, a liquidity event must occur, such as an IPO, acquisition, or stock buy-back. |
Employee Stock Purchase Plan (ESPP)
Compared to RSUs and stock options, an ESPP is more straightforward. An ESPP is a company-run plan that allows employees to purchase the company’s stock at a discount through payroll deductions. This kind of benefit is often widely available to employees across the company as opposed to being limited to key employees or executives.
Taxes |
The tax treatment depends on the length of time the shares are held after being purchased. This length of time will determine whether the sale of the shares is considered a qualified or disqualified disposition. To be considered “qualified,” the shares must be held for more than two years from the offering date and more than one year from the purchase date. If this holding period is met, the sale of shares will be treated as a capital gain. If the holding period requirement is not met, then the sale of shares will be a disqualified disposition, and gains will be treated as ordinary income. |
Purchase Period |
Cash withheld from the employee’s paycheck is usually set aside for a specified period, such as six months, and then used to buy shares at the end of the period. |
Liquidity |
Although they can be found at private companies, ESPPs are most common at public companies with liquid/easily traded stock. Purchasing shares reduces an employee’s take-home pay. While recently purchased shares can be sold to raise cash, the tax treatment is less favorable (as above). |
Stock Options (NQSOs and ISOs)
Options represent the right to purchase shares of company stock at a set price and set date in the future. As options vest, employees can choose to exercise – providing an opportunity to purchase shares at a discount if their “strike” or “exercise” price is lower than the current market value. Like RSUs, options are intended to encourage company alignment, as they provide a long-term incentive to contribute to company performance (as reflected by share price). Options come in multiple varieties with unique tax considerations – primarily non-qualified (NQSOs) or qualified stock options (also known as incentive stock options or ISOs).
Vesting |
An employee has the option, but not the obligation, to purchase shares at a future time. Since no shares are received until the options are exercised, no tax is due upon option grant or vesting. When exercising NQSOs, ordinary income tax is owed on the difference between the exercise price and the fair market value of the stock on the exercise date. That difference is known as “spread.” Once the shares are exercised, capital gains rates apply to further appreciation realized in future sales. With ISOs, no income tax is due on the spread, but the income is still counted in the Alternative Minimum Tax (AMT) calculation when filing taxes. If exercised shares are held for at least two years from the grant date and one year from the exercise date, those shares receive capital gains treatment on the spread between the grant price and sale price. As with RSAs, employees might be able to use the 83(b) election to exercise their shares before they vest. This can help with taxes owed on the spread but could result in paying taxes on shares that are later forfeited. |
Taxes |
Leaving the company prematurely generally results in the forfeiture of unvested options. Employees usually have 90 days to exercise vested options after leaving the company. |
Performance |
The value of the options will depend on the performance of the company. If the stock price (the 409A valuation for private companies) is lower than the exercise price on the exercise date, then the shares expire without any value. |
Liquidity |
Liquidity must be available to purchase shares, meaning that the employee needs to have the cash available to buy the shares. Some companies allow “cashless exercises,” in which options are exercised with a simultaneous sale of enough of the resulting shares to cover exercise and tax costs. This leaves the employee with fewer shares but the ability to harvest some value without a cash outlay. In a private company, the employee may own shares that they are unable to sell, since there may not be a market for the shares. |
Each of the above compensation plans comes with its own risks and rewards for employees and can be powerful tools to maximize lifetime earnings. Individuals should consider their unique timelines, tax situations, and risk tolerances when evaluating their incentive plan or planning for a liquidity event. Careful planning can ensure that these benefits serve as a powerful tool to meet long-term wealth goals. Partnering with a financial advisor and CPA can help you align your compensation strategy with your personal goals, maximizing your opportunities and avoiding costly surprises.
Up Next: In our next article in the series, we will explore deferred compensation, long-term incentive plans, and specialized executive retirement plans. At a high level, these are customized plans developed to defer income to a future period or when specific performance goals are achieved. These benefits can provide significant income and tax planning opportunities when executed properly.