Equity Compensation 101: The 7 Different Types of Equity Awards
Estimated Time to Read: 7-10 minutes
If you don’t understand all the details of your equity compensation plan, you’re not alone. It’s a complicated topic. However, a thorough understanding can help you get the most out of your equity awards—and possibly reduce the sting of taxes along the way!
Before strategizing, you need to understand the equity awards you currently hold or expect to receive. Let’s take a look at the seven types of equity awards your employer may grant and how they work.
Share-Based Awards
These first three award types may be worth something at vesting (so long as the company still exists), but you have little to no control over the timing of taxation. These are your “share-based” awards.
1. Restricted Stock
The name “restricted stock” comes from the fact that it represents actual shares of the employer’s stock, but you are restricted from selling them until your shares vest. In other words, you can’t do anything with the shares until you vest, and they convert to unrestricted shares.
One appeal of restricted stock is that it is guaranteed to be worth something at vesting. Along the way, you are also eligible to receive dividends if your company pays them, even on your unvested shares. Those dividends are typically used to purchase additional shares of restricted stock, which vest on the same schedule as the shares those dividends were attributed to previously. Lastly, as a shareholder, you also have voting rights in some of the company’s future decisions.
One of the biggest frustrations of restricted stock for recipients is their lack of control over when they will be taxed on their shares. Restricted stock awards are taxed as wages when they vest.
2. Restricted Stock Units (RSUs)
RSUs are the most common form of equity compensation used today. In short, RSUs are pretty much the same as restricted stock, with the following differences:
- RSUs aren’t actual shares of company stock; they are a promise to deliver a specified number of unrestricted shares on the vesting date.
- There are no voting rights.
- They are not eligible for dividends, but some employers do a “dividend match” in the form of additional RSUs.
- They are not eligible for an 83(b) election, or the ability to tax at the time of granting.
Just like restricted stock, RSUs are taxed as wages when they vest.
3. Phantom Stock
Phantom stock is simply an RSU that can be settled in cash or company shares at vesting, based on the employer’s plan design. While privately held companies more commonly use phantom stock plans, publicly traded companies will use them to avoid putting additional shares of company stock into circulation or if the administrative costs of setting up another plan are too high.
Options-Based Awards
The following three award types allow you to control when you are taxed, but they could expire worthless if the stock price drops or remains unchanged. These are your “options-based” awards.
4. Incentive Stock Options (ISOs)
An ISO represents a contractual right to buy employer stock at a predetermined price (the “strike price”) within a certain period, regardless of the stock’s price at the time of exercise. That period can be up to 10 years from the grant date, but ISOs typically can’t be exercised until they vest.
One of the most attractive features of ISOs is that they are the only type of equity award eligible for long-term capital gain treatment. To qualify, you must hold the stock for at least one year from the date you exercise the ISO and at least two years from your grant date. This is what’s called a “qualified disposition.” In terms of the timing, ISOs provide recipients with the most control of any equity compensation award because there’s no taxation until the shares are sold or cashed out. In other words, you’re not taxed at vesting or when you exercise ISOs.
There are, however, a few disadvantages to ISOs:
- The difference between the stock’s price at exercise and the strike price is subject to the Alternative Minimum Tax (AMT).
- The maximum value of ISOs you can vest during a calendar year is $100k. This limit is based on the stock’s price when the ISO was granted (typically the strike price), with any portion over the limit being converted to nonqualified stock options (NSOs).
- Vested ISOs must be exercised within three months or less of termination of employment.
- The most considerable risk is that your ISOs can expire worthless if the stock’s price is lower than the strike price at expiration—or if you fail to exercise them.
5. Nonqualified or Nonstatutory Stock Options (NSOs/NQSOs)
NSOs are essentially ISOs with three key differences:
- NSOs are allowed to be issued at a discount, but they typically aren’t because of adverse tax implications.
- NSOs aren’t subject to the $100k annual vesting limit.
- NSOs have less favorable tax treatment, but they aren’t subject to the AMT.
Unlike their ISO counterparts, NSOs are taxed when you exercise them. The taxable amount is the difference between the strike price and the stock’s price at the time of exercise and is taxed as income.
6. Stock Appreciation Rights (SARs)
SARs are equity awards whose value is determined by the amount your employer’s stock increases (or “appreciates”) between the grant date and whenever you exercise them.
Depending on how your employer designs the plan, your SARs are exchanged for cash or shares of company stock when you exercise them. For share-settled plans, divide the current value of your SARs by the company’s stock price at the time, and that’s how many shares you can gain when you exchange them. Think of them as stock options with no cash outlay required at exercise.
Just like NSOs, SARs are taxed as wages when you exercise them.
Equity Awards Plus Performance
This last one is a modified version of any one of the six awards types above.
7. Performance Awards</h3 > At its core, the primary reason a company includes equity awards as part of an employee’s compensation package is to give that employee a vested interest in the company’s success—and performance awards take this to the next level.
The six equity awards outlined above can be issued as performance awards. When this happens, a “multiplier” is applied to the number of shares/options at vesting, based on performance relative to a target goal. While the multiplier can increase the award amount, it can also decrease or eliminate it. The idea here is to set goals for the recipient that, if achieved, will help the company grow. These can be company-wide metrics, such as earnings per share or peer group ranking, but they are often more centered around key performance indicators (KPIs) the recipient has some degree of control over. Examples of this could be tying a sales director’s award to the gross sales for their region or cycle time for a software developer. Performance awards are fully customizable and can include more than one metric in the multiplier’s calculation.
A performance award will look and feel just like your traditional cash-based performance bonuses, with one exception: the value at vesting is determined by the company’s stock price. With cash-based plans, you know exactly how much your bonus will be worth, based on performance relative to the target. With performance awards, that dollar amount is converted to shares of company stock (or stock options), using the stock price on the grant date to calculate the number of shares being awarded. Then, at vesting, the multiplier is applied to those shares or options.
The taxation of a performance award follows the tax treatment of the actual award type. For example, share-based awards are taxed at vesting, while option-based awards are taxed at exercise or sale for ISOs.
What’s the Best Type of Equity Award?
Restricted stock is typically the best share-based award, and ISOs are the most advantageous options-based award. What about share-based versus options-based awards? One-to-one, the share-based awards normally win, but companies often award three to four times as many options to compensate for the risk that the options could expire worthless or of little value. The determination as to which type of award is best depends on the specific situation. For a more detailed, side-by-side comparison, see our Equity Award Comparison Chart.
Now that you have a basic understanding of what you have or may receive, you can start exploring strategies for integrating your equity awards with the rest of your finances, creating a cohesive financial plan. If you don’t have the time or energy to do it on your own or simply want some help creating a roadmap, an advisor with a deep understanding of equity compensation planning can help you make the most out of what you have. Contact us to learn how Traverse Planning can help you on your journey.
Legal Disclaimer: We put a great deal of time into researching the information we write about to ensure that it is accurate and current. Nonetheless, the content on this website is not intended to provide tax, legal, accounting, financial, or professional advice and readers are advised to seek out qualified professionals that provide formal advice on these topics and for your specific circumstances. In addition, while we attempt to update information as legislation changes, we cannot guarantee that the information on this website has not been outdated or otherwise rendered incorrect by subsequent new research, legislation, or other changes in laws. Furthermore, tax implications discussed in our articles are related to federal taxation; state-specific tax implications may be different. Traverse Planning and its affiliates shall not have any liability or responsibility to any individual or entity with respect to losses or damages caused, or alleged to be caused, directly or indirectly, by the information or resources contained on this website.
