A Guide to Equity Compensation for Business Owners
Equity compensation is a popular way businesses attract, retain, and motivate employees by offering them a stake in the company’s success.
However, there are several ways to structure equity compensation, each with unique tax consequences. This guide will explain what you need to know.
What is equity compensation?
Equity compensation is a non-cash payment to employees (and sometimes independent contractors) offering them an ownership interest or stake in company profits in exchange for their services. It’s a popular option for start-ups that want to retain talent but don’t have the budget to pay huge salaries.
Types of equity compensation
Equity compensation can take several forms.
Stock options
Stock options allow employees to buy a certain number of shares at a set price—usually lower than market value. If the value of the company's stock increases, employees can sell the stock at a gain.
Stock options come in two flavors:
Non-Qualified Stock Options (NSOs). These options allow employees to purchase company stock at a predetermined price. Employees pay taxes on NSOs when granted if the option has a readily ascertainable fair market value (FMV). Otherwise, they pay taxes when they exercise the option. The employer gets a tax deduction when employees receive vested shares upon exercising the option.
Incentive Stock Options (ISOs). ISOs offer tax benefits if certain conditions are met. Employees generally don't owe tax on ISOs when they exercise the options, although alternative minimum tax (AMT) may apply. When the employee sells the stock, they pay capital gains on any increase in price from the time of exercising to the sale. That gain may be short-term or long-term, depending on how long they hold it. Employers get a tax deduction for ISOs only upon a disqualifying disposition, which is a sale within two years or less from the grant or one year or less from exercise.
Restricted Stock Units (RSUs) and Restricted Stock Awards (RSAs)
RSUs and RSAs are company shares promised to employees who achieve specific milestones or remain with the company for a certain length of time.
Employees pay taxes on RSUs and RSAs when they vest. The income is considered ordinary income, based on the excess of the fair market value (FMV) on the vesting date over the amount paid for the award (if any). They may also own capital gains when they sell the shares.
For employers, the tax deduction corresponds with the employee's income recognition. Employers report the compensation the employee needs to recognize on their W-2.
Performance shares
Performance shares are tied to company performance. They’re only granted when the employee or the company achieves specific performance goals.
Performance shares are taxed similarly to RSUs and RSAs, with the employee recognizing ordinary income on the value of the shares when granted (i.e., when the employee meets performance targets). The employee also pays capital gains on any future gains or losses from selling the shares.
The employer gets a tax deduction when the employee recognizes income. They should report that amount on the employee's W-2.
Profits interest
This type of equity compensation is available only to partnerships. A profits interest entitles the employee to a share of future profits but not the company's capital.
Granting an employee a profit interest in exchange for services isn't taxable as long as the transaction is structured appropriately. However, once the employee receives the profit interest, they're subject to pass-through taxation of partnership income.
How to select the right form of equity compensation
Equity compensation isn't a one-size-fits-all decision. Different forms of equity compensation come with pros and cons; what works for one company might not be the right fit for another.
Here are some factors to consider when selecting the type of equity compensation that aligns with your business goals and your employee's expectations.
Your business structure. Any business structure can grant equity compensation, but not all forms are available to every entity. For example, corporations can issue common stock, preferred stock, stock options, and restricted stock units as part of their compensation package. Limited liability companies (LLCs) don't have stock. Instead, they can offer membership units or profits interests.
IRC Section 409A. Equity compensation is taxable to employees as wages unless an exception applies under Internal Revenue Code (IRC) Section 409A. If your equity compensation plan doesn't comply with or meet an exception under Section 409A, the employee's deferred compensation is immediately taxable and subject to a 20% excise tax. Complying with Section 409A is critical when setting up any equity compensation plan.
ERISA Compliance. The Employee Retirement Income Security Act (ERISA) of 1974 covers equity compensation awards. One requirement is that the equity award be granted according to a written plan document containing details about eligibility for the award and information on vesting. Employers should work with an attorney to design and administer an equity compensation plan that complies with ERISA requirements.
Need help choosing an equity compensation plan?
Equity compensation can be a powerful tool for aligning employee interests with company goals, but it has complex tax implications. For personalized advice and to ensure you’re making the most of your equity compensation plan, contact Slate. We’re here to help you navigate complexity and optimize your compensation strategy.