When you work for a company, your pay package usually consists of basic components, including your wage, health care, retirement savings plan, 401(k), and potential bonuses based on results.  In tech, it’s commonplace to have equity compensation as another part of your overall compensation package. 

In simple terms, equity compensation means the company gives you a piece of ownership, most often in the form of shares of stock. 

The most common forms of equity compensation include ISOs, NQSOs, RSUs, and ESPPs, which we’ll explain in more detail. Understanding the nuances of equity compensation can significantly impact your

decision-making process when evaluating tech job offers. 

But it’s important to note that not all tech company equity plans are the same, and the variations can significantly alter how you assess their overall value to you.

As a wealth management firm in San Francisco, we specialize in helping successful tech sector employees manage and optimize their equity compensation packages while seeking ways to potentialy reduce tax liabilities.  

Need assistance with your equity package?  Schedule a complimentary 15-minute consultation HERE. 

Stock Options

Think of stock options as financial incentives to align your interests with the company’s goals for its future success. 

There are typically two types of stock options: Incentive Stock Options (ISOs), which are often used by startups, and Nonqualified Stock Options (NQSOs), which are typically found in publically traded firms.

Understanding the various tax consequences of each option type is crucial for both short and long-term financial and tax planning purposes. 

What are Incentive Stock Options (ISOs)?

ISOs are a common way start-up companies attract and retain top talent, offering employees the option to purchase company stock at a predetermined price, usually based on the stock’s market value at the time of the grant. 

For example, let’s say you are granted 1,000 ISOs at a strike price of $10 per share. These options might vest over four years, meaning you earn the right to exercise a portion of the options each year, typically 25% or 250 shares in this scenario.

The vesting process incentivizes you to stay with the company, as you only gain full ownership of the options as they vest. After exercising the options, once they vest, you can buy shares at the strike price, potentially selling them at a higher market value to make a profit.

Here are some tax consequences of ISOs to be aware of: 

1. There’s no immediate tax upon receiving or vesting the options. 
2. If you hold the shares for at least one year after exercise and two years after the initial grant date, any profit is taxed as long-term capital gains, which typically have a lower tax rate than ordinary income. However, if these holding periods are not met, profits may be taxed as ordinary income, potentially impacting your tax burden.
3. When ISOs are exercised, the difference between the market price and the exercise price (the “bargain element”) may trigger the Alternative Minimum Tax (AMT). This can result in a significant tax liability in the year of the exercise, even if no stock is sold.

What are Non-Qualified Stock Options (NQSOs)?

Non-Qualified Stock Options (NQSOs) are another form of compensation that businesses can offer employees, granting them the right to purchase company shares at a predetermined price, known as the exercise or strike price. 

Unlike ISOs, NQSOs are not provided preferential tax treatment under the U.S. tax code. The taxation of NQSOs occurs in two main stages:

1. When you exercise NQSOs, the difference between the market value of the shares at the time of exercise and the exercise price is considered taxable income after exercising. This amount is taxed at ordinary income tax rates and is subject to payroll taxes (Social Security and Medicare).
2. If you decide to sell your shares after exercising them, any further gain or loss from the sale price compared to the market value at exercise is treated as a capital gain or loss. The tax treatment of this gain or loss depends on the holding period of the shares. If held for more than a year, it’s taxed at long-term capital gains rates; if held for less or equal to a year, it’s taxed at short-term capital gains rates, which equal ordinary income tax rates.

What are Restricted Stock Units (RSUs)?

RSUs are company shares given to employees as compensation, but with a catch: they come with restrictions and vesting criteria. They are “restricted” because they are subject to a vesting schedule, which means you can gain full ownership of the shares only after certain conditions are met, typically involving time, performance, or a combination of both criteria. 

Once these conditions are met, the RSUs vest, and the employee receives the shares, making them the owner of the stock.

The taxation of RSUs is twofold and occurs at two distinct events: vesting and sale:

1. When RSUs vest, they are considered income, and their fair market value at the time of vesting is taxed as ordinary income. This means the amount is added to your income for the year and is subject to federal, state, and payroll taxes, just like a cash salary.
2. If you decide to hold onto your shares after they vest and later sell them, any increase in value from the vesting date to the sale date is subject to capital gains tax. 

The rate at which this gain is taxed depends on how long the shares were held post-vesting. If held for over a year, they are subject to long-term capital gains rates, which are typically lower than ordinary income tax rates. If sold within a year of vesting, the gains are taxed as short-term capital gains, which are equivalent to ordinary income tax rates.

What is an Employee Stock Purchase Plan (ESPP)?

Another popular way for companies to incentivize their employees is through Employee Stock Purchase Plans (ESPPs). This enables you to purchase company shares at a discount to the market price. 

It’s typical for ESPPs to have a set offer period when you can elect to participate in this financial benefit, which also sets your offer price. Once enrolled, you will usually have two purchase periods over a year.

The price often includes a discount of 15%. The price is discounted either at the offer period price or the current fair market value price, whichever is lower. This is called a lookback provision.

When you participate in an ESPP, two main tax events need consideration: the purchase of the stock and its eventual sale.

• Purchasing Stock: The discount you receive on the stock purchase is not taxed at the time of purchase if the plan meets certain IRS criteria. However, when you sell the stock, this discount may be subject to taxes.

• Sale of Stock: The tax consequences upon selling ESPP shares depend on how long you’ve held the stock. If you held the stock for one year after the offer period and one year after the purchase, it will be considered a qualified disposition. If you don’t meet either of these time periods it is considered a disqualified disposition.

Qualified dispositions have favorable tax treatments that follow these rules. 

Your ordinary income will depend on the lesser of your gain (sales price – purchase price) or the discount. Unlike the disqualified disposition, the purchase price discount is based on the hypothetical discount price on the offer date.  Whether your purchase price was calculated based on the offer date or the purchase date doesn’t matter. (You may need to read this multiple times for it to sink in!)  

The difference between the undiscounted price and your sales price is treated as capital gains or losses. For a qualified disposition, these capital gains/losses will be treated as long-term.

Disqualified disposition taxes are much more simple.

The difference between your purchase price and their fair market value on the day of the purchase price is considered ordinary income. The difference between the sale price and the fair market value price is considered capital gains, long or short, depending on your holding period from the date of the purchase.

Keep detailed records of your ESPP transactions to accurately report and calculate any tax obligations when you decide to sell your shares. If you want to know the detailed complexities of ESPP, read our blog HERE.  Because of the complexities of accounting for different tax treatments, we highly recommend you hold and sell your ESPPs at the brokerage firm they were granted to you. Your employer and the brokerage firm are responsible for providing the correct tax documents to make filing easier.

The Ins and Outs of Grants: Vesting Periods and Cliffs

The purpose behind grant vesting periods is twofold. First, they reward you for your contribution over time and encourage you to stay with the company longer. Second, if you leave the company before the end of the vesting period, you will forfeit any unvested options. 

The timing for when you may actually receive grants and the vesting schedule itself can vary significantly based on the terms outlined by your employer. Typically, there is a vesting period that must be met before the grant is fully earned and becomes your property. This vesting period is a set duration that you must remain employed with the company before gaining full access to the equity compensation. 

It can range from a single year to several years, and in some cases, the vesting may occur in increments over the period rather than all at once at the end.  The most common vesting schedule is three to five years, with a one-year “cliff.” 

This means that the first 25% of options vest after you have been with the company for one year (the cliff), and the remaining options vest monthly or quarterly over the next three to five years. Some schedules might include a graded vesting approach, where a specific percentage vests yearly.

It’s important for you to understand the specific terms of any grant you receive as part of your compensation, including the vesting schedule, exercise price (if applicable), and any other conditions or restrictions that may apply.

Understanding Grant Terminology

Here’s a list of some of the more common grant-related clauses or terms that you may come across during your employment: 

• Vesting Period: This refers to the timeframe over which employees earn the right to their granted equity, such as stock options. This period can be set by time-based milestones or tied to specific events, like a company going public (IPO). 

• Double Trigger Event:  In the case of a double trigger event, vesting might accelerate if two conditions are met, typically involving a change of control (like an acquisition) followed by you being terminated.

• If you are terminated, the fate of unvested shares often depends on the terms of the grant agreement. Generally, unvested shares are forfeited, while vested shares remain with you. However, there might be clauses that allow the company to buy back vested shares under certain conditions.

• Sale of Pre-IPO Shares: Many companies impose restrictions on this category of grants. You may be able to sell your vested shares in secondary markets or through specific programs offered by the company, but this is subject to the company’s transfer of rights policies and rights to first refusal agreements that are in place.

How to Manage Your Equity Grants

There are platforms designed to streamline the process for you to access your equity grants.  Some of the more popular platforms include Shareworks, Carta, eTrade/Morgan Stanely, and Fidelity. Each portal will provide a login and allow you to see what kind of equity compensation you have, grants awarded, vesting schedules, how many shares have vested, and more. They will also be the gateway for you to decide on your equity, such as exercising and selling shares.

About RHS Financial

One of the keys to building massive wealth in Silicon Valley is often your equity compensation. Many clients have sought our guidance to help them navigate the complex decisions in this wealth-building process and how to better navigate the tax bill.

Our team of experts employs specialized in-house software and methodologies designed specifically to help manage stock received from equity compensation. Additionally, we offer support for handling the emotional challenges that often accompany the accumulation of substantial wealth at a relatively young age.

Think of us as a blend of investment advisors, tax planning specialists, and financial counselors.

Ready to learn more about our equity compensation planning services? Connect today for an introductory meeting.