If you receive some or even all of your compensation in the form of equity, you’re hardly alone. Equity awards have become increasingly popular among employers, as they can enhance employee retention, motivate performance, and be tied to metrics that align with broader company objectives. Tesla is currently considering a compensation package for its founder and CEO, Elon Musk, which would effectively make him the world’s first trillionaire, overwhelmingly in the form of Tesla stock awards. Major League Soccer team Inter Miami CF lured arguably the greatest soccer player in history, Lionel Messi, to the United States with a contract structure that allows Messi to buy into partial ownership of the club upon contract expiration. In this Insight, we’ll explore some common equity compensation structures you might encounter and some strategies for maximizing their value.

Types of equity compensation

Equity compensation is usually awarded in one of three ways: restricted stock units, stock options, and employee stock purchase plans. Below is a brief explanation of each.

Restricted stock units

With restricted stock units (RSUs), the company grants shares to the employee, but not all at once. Instead, the shares are typically subject to a vesting schedule and the employee won’t have access to them until a set period of time has elapsed. For instance, if you work for Nvidia, your RSUs vest each quarter.

Stock options

A stock option is when the company grants an employee a contract that gives them the right, but not the obligation, to purchase company shares at a specified exercise price on a future date. If the company’s share price on that future date is higher than the contract price, the employee can exercise their right to buy the shares at the lower price and then sell them at the higher price for a profit. If the company’s share price is lower on that vesting date than the contract price, there is no obligation to purchase and the contract expires.

There are two classes of stock options: nonqualified stock options (NQSOs) and incentive stock options (ISOs).

  1. NQSOs are taxed as ordinary income at the time of exercise. The amount of taxable income recognized is based on the difference between the exercise price and the grant price. After exercising, the employee can sell the shares and only recognize taxable income on any capital gains that result.
  2. ISOs are not taxable upon exercise. Instead, how they are taxed depends on how long the employee holds the stock after exercise. If the employee holds the shares for at least one year after the exercise date and two years after the grant date, they receive the benefit of long-term capital gain rates when the shares are sold; otherwise, any sale will be subject to higher ordinary income tax rates.

Employee stock purchase plans

An employee stock purchase plan enables employees to purchase company stock at a discounted price, typically through post-tax payroll deductions. Despite the plan’s appealing simplicity and benefits, it can easily lead to concentrated positions with all their attendant risks.

Understanding your equity awards

Vesting schedules

Vesting schedules are the periods of time employees must wait until their equity awards become available to them. There are three primary types of vesting schedules: time-based, performance-based, and cliff vesting. Companies utilize these various vesting schedules to incentivize specific employee behaviors. For example, a company may have a vesting schedule that awards most of an equity award in the later years of a schedule to encourage employee retention. Alternatively, a company could also allow an equity award to vest primarily in the earlier years of a schedule, enabling it to offer more competitive compensation packages and perhaps gain an edge in attracting top talent.

Financial asset custodians

Virtually all companies partner with a financial asset custodian, such as Fidelity or Morgan Stanley, to hold stock awards on behalf of their employees. These asset custodians are responsible for complying with the company’s vesting schedule, releasing equity awards in accordance with that vesting schedule, and facilitating the exercise of option contracts.

If an employee chooses to exercise an option contract, they may not have sufficient liquidity to buy their awarded shares. Custodians will generally offer these employees the option to utilize a “cashless exercise,” enabling them to borrow the necessary funds from the custodian for a fee, purchase the awarded shares at the exercise price, and then repay the loan with the proceeds from the purchased shares, which are immediately sold.

Planning for equity compensation

Section 83(b) elections

Understanding that shares are generally taxed once they vest is crucial for effective planning. However, one key exception is known as the Section 83(b) election. This election allows a taxpayer to accelerate the tax liability and pay before vesting. This can be very valuable if you expect the stock price to appreciate. The election must be made within 30 days of the grant; if you forfeit the shares or if the shares decline in value, the accelerated tax payments are lost forever.

Net unrealized appreciation

If a company awards its own stock to you within its 401(k) plan, it creates a unique opportunity to reduce your tax liability. These company shares are eligible for transfer from a qualified retirement account to a nonqualified brokerage account. However, the employee must recognize the cost basis of those shares as taxable income. This strategy is particularly effective if the company’s shares have experienced significant appreciation since they were awarded. Once these shares are housed within the brokerage account, the net unrealized appreciation can be recognized at the more advantageous long-term capital gain rates.

Special considerations

The tax complexity of equity compensation is somewhat counterbalanced by increased opportunities, but it takes familiarity with the former to appreciate the latter. For example, taxpayers with RSUs are often surprised to learn that the amount of tax withheld at vesting is typically either too much or too little because withholding is often based solely on that grant of equity and not inclusive of their annual income. Another surprise is often the alternative minimum tax liability specifically related to ISOs. As we approach the year end, it is key to discuss your equity compensation with your advisors, both tax and financial, to ensure your tax withholdings are properly calculated to alleviate surprises in April.

One benefit many stockholders often overlook is the ability to transfer those shares as part of their charitable contribution strategy. Generally, donor-advised funds and charitable organizations will accept stock as a donation, as it benefits the organization while the taxpayer receives a charitable deduction equal to the fair market value of the donated shares.

Last, many equity compensation holders end up with highly concentrated positions in their portfolio. The appreciation is impactful; however, a well-balanced portfolio is key to withstanding market changes. Our advisors are equipped to support clients in diversifying out of these concentrated positions while managing potential tax liabilities. One strategy in particular that may be effective for employees or executives with concentrated stock is long-short equity separately managed accounts.

Learn more about equity compensation

In summary, equity compensation can be a powerful tool for building lasting wealth, but the rules, tax consequences, and planning opportunities can be complex. Partnering with a financial advisor who understands the nuances of RSUs, stock options, employee stock purchase plans, and advanced strategies ensures that your equity works as hard as you do. At Cerity Partners, we help clients transform equity awards into a strategic asset that aligns both immediate needs and long-term goals. Reach out to your Cerity Partners advisor or request an introduction today.

Please read important disclosures here.