Equity compensation can be a bit of an alphabet soup, with a long list of terms and acronyms to navigate. In this article, we’ll define some of the most common forms of equity compensation issued by startups and established companies alike, including RSUs, ISOs, NSOs, and more. By understanding these terms and concepts, you’ll be well on your way to having the knowledge you need to make informed decisions about equity compensation packages now or in your future, and understanding how Harness Wealth can help.
Table of contents:
- Restricted Stock Units (RSUs)
- Restricted Stock Awards (RSAs)
- Incentive Stock Options (ISOs)
- Non-Qualified Stock Options (NSOs)
- Qualified Small Business Stock (QSBS)
- 83(b) Election
Stock grants and awards
1. Restricted Stock Units (RSUs)
If you work for a publicly-traded company or a unicorn startup preparing for an IPO, chances are your equity compensation comes in the form of Restricted Stock Units (RSUs). RSUs are shares of common stock that are granted to an employee over a period of time known as a vesting period, which typically spans three to four years. The vesting period represents the time between the issuance date, when the shares are awarded, and the vesting date, when the RSUs are officially transferred to the employee.
Keep in mind that when you’re initially awarded RSUs, you don’t actually own the shares, because you need to wait until the completion of your vesting period. Additionally, because the shares are not your property until the vesting date, no taxes are owed until the vesting date. But depending on the value of your shares, and the growth of the company you work for, you could be on the road to a rather hefty tax bill.
How are RSUs taxed?
There are two distinct taxable events associated with RSUs.
- The first is when your RSUs vest, which will be reported as ordinary income and require you to pay standard income tax. That income will be reported on your W-2 form issued to you by your employer.
- The second taxable event is when you sell your RSUs, which will trigger either short or long-term capital gains tax, depending on how long you held the before selling. Income from the sale of RSUs will be reported on a 1099-B Form.
Taxes on RSUs have the potential to be very high, sometimes even exceeding the amount of cash that the benefitting employee has on hand. To account for this, companies will sometimes require—in addition to a vesting period—a liquidity event such as an IPO to take place before RSUs can fully vest. This is known as a double-trigger RSU and ensures the employee has an opportunity to sell their shares in order to cover their tax bills immediately on the vesting date.
One recent example of a company issuing double-trigger RSUs to its employees is Stripe, the payment processing platform. Stripe was founded in 2009 and has raised billions of dollars from investors over the years, but has remained a private company. In 2023, Stripe raised $6.5 billion to facilitate a tender offer for its early employees with double-trigger RSUs expiring in 2024.
2. Restricted Stock Awards (RSAs)
Restricted Stock Awards (RSAs) grant an employee shares of company stock upfront, subject to a vesting schedule, and certain restrictions. Unlike RSUs, RSAs represent immediate ownership in the company, which means the employee has voting rights even during the vesting period.
How are RSAs taxed?
RSAs are taxed at the time they vest. The fair market value of the shares on the vesting date is treated as ordinary income and subject to taxes. If the employee chooses to make an 83(b) election, they can elect to pay taxes on the total fair market value of the shares at the time of grant, rather than waiting for the shares to vest. This can be advantageous if the employee expects the value of the shares to increase significantly over the vesting period.
1. Incentive Stock Options (ISOs)
Incentive Stock Options (ISOs), and options in general, differ greatly from grants and awards, as they require employees to purchase the shares upfront, instead of just being issued them. ISOs, sometimes also referred to as Qualified Incentive Stock Options, are a type of option that can only be granted to employees.
ISOs have strike prices, which is a set price at which the employee is able to purchase company stock at a future date. Should the employee exercise and then later their stock, the capital gains will be calculated based on the difference between the strike price and selling price.
How are ISOs taxed?
ISOs are taxed as capital gains, and are only taxed when the shares are sold. As is typical with capital gains taxes, selling after less than one year will trigger the short-term capital gains tax rate, whereas holding for more than one year will result in the reduced long-term capital gain tax rate. The taxable amount owed is calculated based on the spread, or difference between, the strike price and selling price, or fair market value (FMV).
ISOs are not taxed as ordinary income. But, if your income from the sale of your ISOs outweighs your normal income for the year, you may have to pay Alternative Minimum Tax (AMT).
2. Non-Qualified Stock Options (NSOs)
Non-Qualified Stock Options (NSOs) are typically issued to non-employees, such as board members, advisors, or consultants. NSOs are also issued to employees if they reach the annual IRS limit for ISOs, which is currently $100,000 per employee per year.
There are a few key differences between ISOs and NSOs when it comes to taxes:
- NSOs are taxed both when they are exercised and when they are sold.
- NSOs are not subject to Alternative Minimum Tax.
- NSOs, unlike ISOs, are considered ordinary income, and taxed as such
Other factors to consider
1. Qualified Small Business Stock (QSBS)
QSBS is not a form of equity compensation, but rather a tax benefit that allows founders and certain early investors and employees to be subject to lower tax rates or even exemptions, potentially up to 100% of capital gains up to $10 million. To qualify for QSBS, companies must meet certain criteria including being a US-based based C corporation and not having more than $50 million in business assets. QSBS only applies to stock, and any options must first be exercised before converting into QSBS-eligible shares.
2. 83(b) Election
An 83(b) election allows employees to pay taxes on the value of their equity compensation at the time of issuance, rather than waiting for the equity to fully vest. An 83(b) election can be particularly beneficial if the value of the equity is expected to rise significantly during the vesting period. However, the 83(b) election carries risks and should be carefully considered with the help of a financial advisor.
Work with a Harness Wealth Advisor
If you’ve been offered equity compensation, or if you need help making the most of equity you’ve already been issued, work with an experienced financial advisor who can help you make sense of it all.
Harness Wealth specializes in working with startup employees, founders, and other modern workers on unique tax and financial planning strategies for the long term. By working with an advisor from Harness Wealth, you get the support and expertise you need to make informed decisions about your equity compensation package and work together on a financial plan that meets your unique goals and needs. Sign up today to get started, and get matched with your Harness Wealth advisor today.