Employer benefits can be an incredible incentive to attract and retain top tier talent. So, what are a couple different benefits to get the best of the best employees? By giving these individuals equity compensation!
When joining a company, besides just a higher salary, health and retirement benefits, employers are able to increase their employee's total compensation with equity. There are several different types of employer stock benefits, but two of the most common ones I'll be discussing are Restricted Stock Units (RSUs) and Employee Stock Purchase Plans (ESPPs). These are typically a mutually beneficial form of compensation. What do I mean by that? By owning stock in the company you work for, you are incentivized to work harder to help increase revenue and profitability for your employer, which in turn can help the stock price increase. If your employer stock goes up in price while you own it, you become wealthier.
How are these stock benefits given to employees? What are the tax consequences or benefits? ?How do you know when to sell the stock? Let’s start first with Restricted Stock Units.
Restricted Stock Units (RSUs) are a form of stock compensation typically offered by companies to their employees as part of their overall remuneration package. RSUs represent a promise by the company to grant the employee a specific number of company shares at a future date, subject to certain "vesting" conditions being met.
Here are some key features of RSUs:
- Grant: When RSUs are awarded to an employee, they do not receive actual shares immediately. Instead, the employee receives a promise or "grant" of a specific number of shares in the future.
- Vesting: RSUs are subject to a vesting schedule, which is a predetermined period during which the employee must remain employed with the company to receive the shares. Vesting schedules can vary but are commonly structured over several years, with portions of the RSUs vesting gradually over time. For example, an RSU grant might have a four-year vesting schedule with 25% of the RSUs vesting each year. This somewhat forces you to stay at the company long-term in order to get the full payout of the RSUs.
- Restricted Period: During the vesting period, the RSUs are considered "restricted" because the employee cannot sell or transfer them. They are typically held in an account on the employee's behalf.
- Conversion to Shares: Once RSUs have vested, they are converted into actual shares of the company's stock. At which point, you now have some flexibility to sell or hold your shares.
- Tax Implications: When RSUs vest and are converted into shares, the employee will incur taxable income based on the value of the shares at that time. For example, if 100 shares of your employer stock valued at $50 per share vests on a specific date, you are required to pay ordinary income tax on the vested RSUs, which in this case is $5,000. The company may withhold taxes or require the employee to pay taxes on the value of the vested RSUs. Keep in mind, when you receive your 1099-B tax form for the RSUs, even if your employer withheld shares, it may show up as “0” taxes withheld. On your W-2, it will indicate how many RSUs were given and withheld, so make sure you show your CPA or tax advisor both tax forms so that you are not double taxed.
- Holding Period: Another tax implication has to do with how long you hold the stock AFTER the vesting date. If you hold the stock for less than 1 year before selling it, any appreciation you accumulate from the vesting date to the sale date is ALSO taxed as ordinary income. However, if you hold the stock for 1 year or more, you get the more favorable long-term capital gains tax treatment on the capital gains once you sell the stock.
Another form of equity compensation is through an Employee Stock Purchase Plan (ESPP). Instead of giving employees shares of stock based on a vesting schedule, employees have the option to participate in this program. More often than not though, it makes sense to participate in this program. The reason for this is that an ESPP is a program that allows employees of a company to purchase company stock at a discounted price, typically somewhere in the 5-15% discount range. ESPPs are another form of benefit to employees which also provides them with an opportunity to become shareholders of the company they work for. Here are some key features of ESPPs:
- Enrollment: Employees who are eligible to participate in the ESPP can choose to enroll during a specified enrollment period. Not all employees may be eligible, as certain criteria, such as length of employment or job classification, may apply.
- Purchase Periods: ESPPs operate through periodic offering periods, which are usually six months in duration. During these periods, employees can contribute a portion of their salary, up to a specified limit, to purchase company stock at a predetermined price.
- Discounted Price: One of the primary benefits of an ESPP is that employees can buy company stock at a discounted price. The discount is typically a percentage below the fair market value of the stock on the purchase date (we usually see 5-15%). The specific discount amount and calculation method are determined by the company and outlined in the ESPP plan.
- Accumulation of Funds: During the offering period, the employee's contributions are accumulated in a designated account. At the end of the period, the accumulated funds are used to purchase company stock on behalf of the employee at the discounted price.
- Purchase Mechanics: The specific mechanics of the stock purchase can vary. In some ESPPs, the purchase price is set at the lower of the discounted price or the fair market value at the beginning or end of the purchase period. In other plans, the purchase price is based on the fair market value at the end of the purchase period.
- Tax Considerations: The discount received on the stock purchase may be subject to ordinary income tax, and any gains or losses from the sale of the stock may be subject to capital gains tax.
- Holding Period: In addition, there are two different types of tax treatments “qualifying disposition” and “disqualifying disposition.” A qualifying disposition occurs when you sell your shares at least 1 year from the purchase date and at least 2 years from the ESPP offering date. In this situation, any discount offered to the original stock price is taxed as ordinary income, but the remaining gain is taxed at a long-term capital gain tax (0-20% on the federal level). With a disqualifying disposition, if you don’t follow the above holding period, all of gain and discount can be taxed as ordinary income (up to 37% on the federal level).
Similar to RSUs, ESPPs provide employees with an opportunity to participate in the company's growth and financial success. They can be an attractive benefit for employees, as they allow them to purchase company stock at a discount, potentially benefiting from any future appreciation in the stock price.
With both RSUs and ESPPs, it doesn’t always make sense to hold the stock just to get the long-term capital gains tax treatment. There are times where an employee may have a majority of their retirement assets in their employer stock, which means they are probably not properly diversified and have single stock risk. That means they are vulnerable to potentially more volatility than a diversified basket of stocks. We typically like to advise clients on only having roughly 10% of their retirement assets in one single stock. However, that is just a rule of thumb and is definitely not for everyone. There are times where it may make sense to holder a greater % weighting in the employer stock, it primarily depends on your risk tolerance and goals. ?
As always, speak to your tax advisor or CERTIFIED FINANCIAL PLANNER? about your goals and objectives.?The information in this article is solely informational and is not intended to be legal or tax advice.?
1) https://www.schwab.com/public/eac/resources/articles/rsu_facts.html
2) https://www.investopedia.com/terms/e/espp.asp
disclosures: clarkgroupam.com/disclosure
