Whether it’s in the heart of Silicon Valley, an NYC borough or an up-and-coming Midwest region, start-ups and tech companies have been popping up around the country at a rapid pace. And while an up-and-coming company typically requires the expertise of programmers, marketers, developers and other highly talented, qualified individuals, it can’t always offer the high salaries these employees have come to expect.
Companies recognize the need for incentivizing and encouraging motivated individuals to join their team. To accomplish this goal, many start-ups and established companies alike turn to equity compensation.
What Is Equity Compensation?
Equity compensation represents a share of the company’s future profits and may include stock options, stock appreciation rights, phantom stock, employee stock purchase plans, restricted stock or restricted stock units. Each equity option has a different set of opportunities, costs and taxes associated with it.
How Does it Benefit Me?
Being offered a portion of your company’s future profits is an exciting opportunity and an important incentive for loyal employees to stick with the company. If the company is successful, there’s an opportunity for equity compensation to provide a bigger payout than a standard salary would.
What Should I Watch Out For?
Where there’s a chance for reward, there’s a risk as well. Equity compensation positions a portion of employees’ pay at the mercy of the market and the company’s performance. It can be hard to remember that nothing is guaranteed. Employees often experience lifestyle creep - a rise in spending or standard of living in parallel with a rise in income - and may neglect to plan ahead for the possibility that their equity compensation may not perform as well as they would like.
Additionally, it’s important for employees to understand the potential tax implications that equity compensation will have on their future earnings. These implications will depend on the structure and specifics of the company offering the compensation. When cashing out your equity compensation, it's important to recognize that taxes may take a sizeable chunk out of the payout you receive.
What Are RSUs?
Below, we'll take a closer look at one popular form of equity compensation: RSUs, or restricted stock units. RSUs have gained in popularity in recent years as an appealing equity compensation choice for both employers and employees.
Restricted stock units are shares of company stock awarded to employees upon meeting certain conditions and/or a vesting schedule. A vesting schedule defines when employees receive the shares. A common structure used is a "graded" vesting schedule, meaning a portion of the shares vest after one year, a portion after two years, and so on. Awards may also be subject to "cliff" vesting, in which 100% of the award vests when a specified length of service is met. Vesting may also be performance-based, meaning that it is tied to certain performance goals or targets.
RSUs do not convert to actual shares until delivery, hence the term "restricted". These restricted units do not come with voting rights or dividends prior to vesting (though companies may pay dividend equivalents), and may not be sold until they vest. Upon vesting, the shares are delivered to the employee, who may sell or hold them. Units are tax-deferred until they vest, meaning that no tax is due until units are delivered to the employee.
Show Me An Example
Let's say Company XYZ offers you, a new employee, 10,000 restricted stock units on a five-year vesting schedule: 2,000 units per year, over five years. For each of five years that you work for Company XYZ, you receive 2,000 shares of company stock. If you stay with the company for one year, you receive a total of 2,000 shares. If you stay three years, you receive a total of 6,000 shares, and so on.
Company XYZ hopes that by offering you these RSUs, you will be motivate to do your best work and help the company succeed. You hope that the success of the company drives the share price upward, yielding a tidy sum when the shares vest. You may choose to take profits immediately upon vesting, by selling shares, or you may hold the shares for later sale, if you think the company share price is likely to rise. As these units are not actual shares until they are delivered to you, you do not have to purchase the shares. Therefore, there is no risk that you will invest your own funds in company stock, only to see the value decline. Unless Company XYZ's value goes to zero, your RSUs will always have value upon delivery.
Don't Spend It All Just Yet...
As with all forms of equity compensation, tax must be considered as part of the equation.
RSUs are reported on your W-2 in the year in which shares are delivered, and are subject to withholding for ordinary income tax as well as payroll taxes (Social Security and Medicare taxes). Your company may require or allow you to cover withholding by "surrending" shares at delivery, or other methods of withholding may be offered. Tax is calculated based on the market value of the shares at the time of delivery. It's important to consult with a qualified tax professional to ensure proper tax planning, as different approaches to withholding for tax on RSUs may result in tax being over- or under-withheld. Proceeds on sales of RSUs are also subject to capital gains tax if the recipient holds and sells shares at a higher share price after they vest. Let's return to our example:
Let's say you receive your first 2,000 shares after Year 1, when the company share price is $10. The shares would be reported as $20,000 (2,000 shares x $10 share price) of income on your W-2, and are subject to Federal and state (if applicable) income tax at your marginal rate, along with payroll (FICA) taxes.
If you believe that the share price will continue to rise, you may choose to hold the shares and sell later. Let's say you sell them the next year at a share price of $15. At the sale, you would realize a capital gain of $10,000 (2,000 shares x $5 gain per share). You would report the capital gain on your tax return, and would pay the applicable capital gains tax rate (0 - 23.8% currently, 15% for most people).
Complexity Is Part Of The Package
While many consider RSUs to be one of the simpler forms of equity compensation, all forms of equity compensation are more complex than salary and come with tax and risk considerations. Understanding the basics can help you determine the value and tax implications of RSUs as part of your compensation package, but it's best to consult with a qualified financial advisor and/or tax professional to help unpack how equity compensation can affect your financial plan, spending, and taxes.
This content is developed from sources believed to be providing accurate information as of the date of publication, and is intended for informational purposes only. Please consult your financial professionals for specific information regarding your individual situation. Past performance does not guarantee future results. All investing involves risk, including risk of loss.