By David D’Albero
When you reach a company’s top management or executive ranks, your compensation is often multifaceted. Smart employers recognize that high-caliber executives are pivotal in steering the company toward success. This is why executive compensation packages are carefully designed to attract, retain, and motivate top executive talent.
Typical executive compensation packages include base salary, bonuses, stock options, deferred compensation, and additional benefits and perks, such as health insurance, retirement plans, and even personal use of corporate resources. In recent years, stock compensation has become increasingly popular because of its ability to align management performance with company performance while also cultivating a personal investment in the company’s success among leaders and key personnel.
Understanding the details of your equity compensation empowers you to directly tie your performance to company growth. This alignment then accelerates both organizational success and your own financial interests.
How Stock Compensation is Paid
Equity compensation serves as a long-term incentive, rewarding employees for their dedication over time. To receive full ownership of the stock, you must meet “vesting” requirements – essentially gaining a vested interest in the company through service over a defined period. Your vesting terms will outline when and how your equity compensation is paid out.
Vesting is structured in portions, typically following either a “cliff vesting” schedule or a “graded vesting” schedule.
With cliff vesting, you become 100% vested all at once after a set timeframe, usually three years. This structure requires you to stay with the company for that period before your incentive fully kicks in.
Graded vesting takes a phased approach, distributing ownership gradually at regular intervals over a timeframe of typically three to six years. For example, a five-year schedule might give you 20% equity per year. If you leave after three years under this model, you would vest 60% of the total compensation.
Now that we’ve covered some vesting basics let’s look closer at the different types of equity compensation and how they factor into your overall pay.
Restricted Stock, Restricted Stock Units, and Performance Shares
Equity programs serve strategic purposes like incentivizing loyalty and performance, as well as enhancing shareholder value. Companies offer various equity-based awards as part of executive pay. Let’s break down some key options.
Restricted Stock (RS)
With Restricted Stock, you receive actual company shares upfront, becoming a shareholder with voting rights and dividends. However, the shares get placed into an escrow account. You cannot access or sell them until vesting conditions are met.
Vesting terms often involve tenure thresholds, performance goals, or major company milestones such as a successful major product launch, merger, acquisition, sale, or IPO. These conditions encourage loyalty and achievement tied to shareholder interests.
You incur taxes on restricted stock when granted based on the fair market value. Additional tax events can follow at vesting triggers. Failing to meet vesting conditions (e.g., leaving the company before the shares vest, goals set are not met, or violating SEC trading restrictions) may forfeit the shares.
Restricted Stock Units (RSU)
Restricted stock units differ from restricted stock, as they are typically reserved for executive-level members and board of directors only. However, RSUs still aim to incentivize loyalty, usually based on a time-based vesting schedule without other performance conditions.
Think of RSUs as a company’s promise to deliver a certain number of shares of company stock at a future date per the vesting terms. During the vesting period, you don’t participate in voting or dividends. The share transfer and tax obligations only happen at completion.
RSUs are treated as ordinary income in the year the award vests, as opposed to when they are awarded. They focus on tenure-based loyalty over added performance milestones. But, leaving the company early can still result in forfeiture.
Performance Shares take a results-driven approach. Rather than time-based vesting, earning these rights hinges on achieving predefined targets – tying rewards directly to company and individual performance.
The better you perform against set objectives, the more shares you receive. This links compensation to strategic goals beyond just retention incentives.
The tax process aligns across equity compensation programs. To calculate ordinary income, subtract the purchase cost or exercise price from the fair market value (FMV) at vesting.
If you sell the stock later, the difference between the sale price and FMV gets treated as a capital gain or loss. The holding period past vesting categorizes it as short or long-term.
Stock options give employees the right (but not requirement) to purchase company shares at a set price within a defined timeframe. They aim to attract and retain top talent.
Allocation is often tied to role seniority. For instance, a standout VP prospect could receive options equating to 1-2% ownership, while CEO packages may encapsulate 5-10% or more. These numbers fluctuate widely depending on factors like company stage, industry, and specific hiring needs.
Non-Qualified Stock Options (NQSOs)
Non-qualified stock options (also called non-statutory options) provide the right to buy company shares at a set “exercise” or “strike” price. These options face fewer tax and vesting restrictions than incentive stock options.
Incentive Stock Options (ISOs)
Incentive Stock Options also grant purchase rights at predetermined prices. But ISOs come with special IRS rules around vesting periods and holding times which are designed to incentivize you by linking your financial benefit to the company’s long-term performance. You need to meet the requirements to receive preferential tax treatment.
The main variance between NQSOs and ISOs comes down to taxes. With non-qualified options, the spread between fair market value and your exercise price gets treated as immediate ordinary income. This amount is subject to ordinary income tax and, in some cases, Social Security and Medicare taxes as well.
But incentive stock options become more advantageous if you hold the shares for at least one year post-exercise and two years after receiving the options. Hitting these milestones unlocks preferential long-term capital gains rates at sale or trade, allowing you to maximize gains.
Stock Appreciation Rights (SARS)
SARs are a form of employee compensation that provides the potential upside of stock value gains without having to purchase shares. You receive the appreciation between grant and exercise prices, settled in either cash or stock.
Company X grants 1,000 SARs when shares trade at $20. After three years, the stock reaches $40 and the rights become vested and exercisable.
At that point, you could take $20,000 cash (1,000 x $20 price appreciation). Or 500 shares via the share equivalent ($20,000 at $40 per share).
Either way, the profit gets taxed as ordinary income when you exercise SARs. These rights aim to incentivize holders through stock growth without diluting ownership.
Employee Stock Ownership Plan (ESOP)
ESOPs are a type of retirement plan that enables employees to become partial owners of the company by acquiring shares of company stock. ESOPs aim to foster a sense of ownership and align employee interests with company performance.
Shares get awarded into an ESOP trust and then allocated to individual accounts per a predetermined formula factoring criteria like salary and tenure.
Upon leaving the company, employees receive the value of their vested ESOP shares, distributed in cash, stock, or both. These disbursements count as ordinary income, except for IRA rollovers or utilizing Net Unrealized Appreciation (NUA).
NUA allows unique tax treatment where just the initial stock cost basis faces income tax while gains qualify for long-term capital rates. For example, an employee retiring after 30 years has a $1M ESOP balance with a $250k cost basis. They could take $250k as income and $750k at preferential capital rates.
The NUA strategy has many complexities, so guidance from financial and tax advisors is critical for proper execution.
Managing Your Stock Compensation
Equity awards unlock immense wealth potential through company ownership and preferential tax treatment. When strategically managed, they can accelerate reaching your biggest financial goals.
Deferred compensation programs, in particular, let you postpone income tax while holdings potentially appreciate over the long term. This has the potential to compound gains dramatically compared to immediate income recognition.
The key lies in navigating vesting milestones, tax implications, holding periods, and more to optimize these programs for your situation. With the right guidance, equity compensation can shift your finances into overdrive.
As specialists in executive wealth management, Strata Capital understands both the immense opportunities and complexities of equity compensation. We help corporate leaders maximize the value of their compensation package through strategic tax planning, deferred income optimization, and other financial strategies. If you are ready to unlock the full potential of your shares, options, or performance awards, contact us today to schedule a complimentary consultation.
Strata Capital is a wealth management firm serving corporate executives, professionals, and entrepreneurs in the New York Tri-State Area, focusing on corporate benefits and executive compensation. Co-founded by David D’Albero and Carmine Coppola, the firm specializes in making the complex simple to ensure clients feel confident in their financial decisions. They can be reached by phone at (212) 367-2855, via email at email@example.com, or by visiting their website at stratacapital.co.
Cornerstone Planning Group, Inc., (“CSPG”) is an SEC registered investment advisory firm. The information contained herein should not be construed as personalized investment advice and should not be considered as a solicitation for investment advisory service. The information (e.g., tax ) provided is believed to be accurate however CSPG does not guarantee or otherwise warrant such information. For more information regarding CSPG you can refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov) and review our Form ADV Brochure and other disclosures.
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