Businesses of all sizes, from brand new startups to large blue-chip enterprises, like to use equity compensation for key employees. This ties the employee’s financial interest to that of the company and can provide the company with a creative additional way of compensating individuals. Depending on the type of plan a business sets up, this compensation may be better tax wise for employees than traditional compensation. In all situations, your employees will appreciate you taking the time to mitigate and minimize taxes on equity compensation.
- Income Tax: Grants of stock can be subject to income tax either in the year they are granted or when the stock vests. The amount of this tax varies depending on the individual’s tax bracket.
- Capital Gains Tax: When you sell assets such as stock, so long as you’ve held that stock for more than a year, it typically gets preferred tax treatment. Again, the amount of tax varies, but is generally lower than the ordinary income tax rate.
- Alternative Minimum Tax: The AMT is a slightly more complicated option where employees are required to pay either their tax or their alternative minimum tax, whichever is higher. This means that stock options can create a tax liability where none would otherwise exist.
- Net Investment Income Tax: For employees with income above a certain threshold, a 3.8% tax applies to investment income and other sorts of passive income.
Types of Employee Stock Grants
- Issuing Stock: Many businesses have stock in several categories including preferred and common stock. Directly issuing this type of stock to employees means that the tax rate is going to depend on how long they hold the stock. It will be subject to a combination of ordinary income tax and long-term capital gains tax.
- Incentive Stock Options (ISOs): This type of stock must be held for at least two years from the date of grant and one year from the date of exercising the stock option to qualify for long-term capital gains tax. Otherwise, ISOs taxed as ordinary income. The employee is not subject to withholding when exercising the stock options. In order to minimize the tax impact, it may be wise to exercise ISOs early, before their value increases substantially, but this is a decision each employee can make after talking to their accountant or financial advisor.
- Non-Qualified Stock Option: When an employee chooses to exercise non-qualified stock options, they are taxed as ordinary income. Further, income is subject to withholding at this time. If the stock is then sold, any appreciation is then subject to either short-term or long-term capital gains tax, depending on how long the stock was held. Employees may choose to make an 83(b) election for early exercise of their options, which starts the capital gains clock running, but can also mean employees face income taxes even before the options have vested.
- Restricted Stock Unit (RSU): When this type of stock vests, it is taxes as ordinary income and requires withholdings. As with non-qualified stock options, when this stock is sold, it’s subject to either short- or long-term capital gains tax.
It’s important for an HR organization to understand the different options employees have when faced with equity compensation, even if they aren’t in a position to give specific tax advice. This helps them construct plans that offer the most advantages to their key team members.