Equity Awards in the United States

According to the Pearl Meyer Report 2023, nearly all publicly traded companies provide their senior executives with long-term incentive awards, with minimal cash components (10%) and a strong emphasis on equity-based components. These include restricted stock, performance shares, and stock options.

For privately held companies, approximately one-third of them grant equity awards to their executives.

Equity awards are a form of non-cash compensation that give employees an ownership stake in the company. They come in various forms and are crucial for attracting and retaining top talent. 

Why use equity awards in your company?

Equity awards offer significant benefits for both employers and employees, like:

For employers

• Equity awards help attract and retain top talent by making the company’s compensation package more competitive.
• They incentivize high performance by directly linking rewards to the company’s success.
• Equity awards align employees’ interests with the company’s goals, ensuring that everyone is invested in the organization’s long-term success.

Almost all HR leaders (95%) consider equity compensation to be the most effective method for maintaining employee motivation and engagement. This consensus has been consistent over the years, with 97% in 2023, 95% in 2022, and 93% in 2021. Furthermore, 80% of employees share this viewpoint in a study by Morgan Stanley.

For employees

• Employees have the opportunity to share in the company’s potential growth and financial success.
• Over time, they can build substantial wealth through their equity holdings.
• They develop a greater sense of ownership and commitment to the company, as their personal success is tied to the company’s performance.

In 1999, Mark Cuban sold Broadcast.com to Yahoo for  $5.7 billion in stock, making 91% of his employees into millionaires.

In a poll of over 3,000 NVIDIA employees, more than one-third reported having a net worth exceeding $20 million.

Types of equity awards

Equity awards come in several forms, each offering unique features and advantages tailored to different needs and objectives:‍

1. Stock options

a. Mechanics: These options provide employees with the right, but not the obligation, to purchase a specific number of shares at a predetermined price, known as the strike price, within a set timeframe.

b. Advantages: Employees benefit from stock price appreciation if the company's stock price exceeds the strike price. Additionally, they have the flexibility to choose when to exercise their options, which can be advantageous for managing tax implications and maximizing gains.

c. Disadvantages: If the stock price does not rise above the strike price, the options can become worthless. Additionally, the potential for tax implications upon exercise and sale can be complex, and there’s no guarantee of financial gain.

Stock options are divided into two types:

1.a. Incentive Stock Options (ISOs)

Incentive Stock Options (ISOs) are options granted by a company to its employees that give them the right to purchase company stock at a fixed price (known as the exercise price or strike price) within a certain period. If the company’s stock price increases, employees can purchase shares at the lower exercise price and potentially realize a profit when selling them at the higher market price.

a. Eligibility: Only employees of the company are eligible to receive ISOs. ISOs cannot be granted to board members or external consultants.

b. Tax benefits

Qualified tax treatment:  To get favorable tax treatment, the employee must hold the stock for at least:

Two years from the grant date (the date the option is given)

One year from the exercise date (the date the stock is purchased)

Long-term capital gains: If the employee meets these holding periods, any profit made when selling the stock is taxed at the long-term capital gains rate, which is generally lower than the ordinary income tax rate.

c. Alternative Minimum Tax (AMT)

AMT considerations: Exercising ISOs can trigger AMT, which might require additional tax payment, especially if there’s a significant difference between the exercise price and the stock’s market value.

Exercising ISOs can trigger AMT, which is a separate tax system designed to ensure that high-income earners pay a minimum amount of tax. AMT is calculated differently from regular income tax and may apply if the difference between the exercise price and the stock's fair market value is substantial.

1.b. Non-Qualified Stock Options (NSOs)

Non-Qualified Stock Options (NSOs) are options that allow employees, consultants, and board members to purchase company stock at a fixed price (known as the exercise price or strike price). Unlike Incentive Stock Options (ISOs), NSOs do not qualify for special tax treatment but are more flexible in terms of who can receive them.

a. Eligibility: NSOs can be granted to a broader range of individuals, including employees, consultants, and board members, unlike ISOs, which are limited to employees only.

b. Tax treatment

At exercise: When NSOs are exercised, the difference between the exercise price and the market price of the stock (known as the “spread”) is considered ordinary income and is subject to income tax and payroll taxes (such as Social Security and Medicare).

At sale: Any additional gain or loss from the sale is taxed as either short-term (profits from selling stocks or shares held for one year or less) or long-term (profits from selling stocks or shares held for more than one year) capital gains, depending on how long you hold the stock after exercising the options.

c. Flexibility

No holding period requirements: Unlike ISOs, NSOs do not have specific holding period requirements to qualify for tax benefits. NSOs are taxed as ordinary income at the time the options are exercised. 

‍2. Stock Appreciation Rights (SARs)

Stock Appreciation Rights (SARs) are a form of compensation that allows employees, consultants, and board members to benefit from the increase in the value of company stock without having to purchase it. SARs provide a way to benefit from the company’s stock price appreciation without actually acquiring stock.

a. Eligibility: SARs can be granted to employees, consultants, and board members, similar to the flexibility seen with Non-Qualified Stock Options (NSOs). They are often used as a form of performance-based compensation or incentives.

b. Tax treatment

At exercise: When SARs are exercised, the holder typically receives either cash or shares equivalent to the appreciation in stock value from the grant date to the exercise date. This difference, or "spread," is treated as ordinary income and is subject to income tax and payroll taxes (such as Social Security and Medicare).

‍At sale: If SARs are settled in stock, any additional gain or loss from the sale of the stock is taxed as either short-term or long-term capital gains, depending on the holding period of the stock after the SARs are exercised. If SARs are settled in cash, there is no additional tax upon the sale of stock because no stock is received in that case; the entire gain has already been taxed at the exercise point.

c. Flexibility

No purchase requirement: SARs do not require the holder to purchase stock; instead, they provide a benefit based on stock appreciation, which reduces the financial risk compared to stock options.

No holding period requirements: SARs themselves do not impose holding period requirements for tax treatment. The tax event is triggered at the time of exercise, and if stock is received, any subsequent sale of the stock will be subject to capital gains tax depending on the holding period of the stock post-exercise.‍

3. Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) are a form of compensation where a company grants employees, consultants, or board members shares of company stock that vest over time or upon meeting certain performance criteria. Unlike stock options, RSUs do not require the recipient to purchase shares; instead, the shares are granted outright upon vesting.

a. Eligibility: RSUs can be granted to a wide range of individuals, including employees, consultants, and board members. They are often used as a form of long-term incentive compensation and are typically subject to vesting schedules or performance conditions.

b. Tax treatment

At vesting: When RSUs vest, the recipient receives shares of stock or a cash equivalent based on the market value of the shares at the time of vesting. The fair market value of the shares at vesting is considered ordinary income and is subject to income tax and payroll taxes (such as Social Security and Medicare). The company typically withholds taxes at this point.

At sale: Once the shares have vested and taxes have been paid, any subsequent gain or loss from the sale of the stock is treated as either short-term or long-term capital gains, depending on the holding period of the shares after vesting. The holding period for capital gains purposes starts from the vesting date, not the grant date.

c. Flexibility

No purchase requirement: RSUs do not require any purchase or exercise by the recipient. Shares are granted once the vesting conditions are met, simplifying the process for recipients and eliminating the need for them to invest their own funds.

Vesting requirements: RSUs are subject to vesting schedules, which could be based on time (e.g., a certain number of years) or performance milestones. Until the shares vest, the recipient does not own the stock and cannot sell it.

4. Restricted Stock Awards (RSAs)

Restricted Stock Awards (RSAs) are a form of equity compensation where a company grants shares of its stock to employees, consultants, or board members, subject to certain restrictions.

Unlike Restricted Stock Units (RSUs), RSAs involve the immediate transfer of stock ownership to the recipient, although the shares are typically subject to vesting conditions and other restrictions.

a. Eligibility: RSAs can be granted to a variety of individuals, including employees, consultants, and board members. They are often used as a long-term incentive and can be part of a compensation package that aligns the interests of recipients with those of the company.

b. Tax treatment

At grant: When RSAs are granted, the recipient receives actual shares of stock, though these shares are subject to vesting conditions. The recipient may be taxed on the fair market value of the shares at the time of grant if the shares are not subject to substantial risk of forfeiture. 

If the shares are subject to substantial risk of forfeiture, it means that there are conditions attached to the shares (like vesting schedules or performance targets) that must be met before the employee fully owns the shares. If these conditions are not met, the employee forfeits the shares.

If the shares are subject to vesting, the recipient typically does not recognize income until the shares vest, although they may elect to make an 83(b) election.

The 83(b) election is a provision in the U.S. Internal Revenue Code that allows employees or startup founders to pay taxes on the fair market value of restricted stock at the time of grant, rather than when the stock vests.

‍At vesting: If the recipient does not make an 83(b) election, they will be taxed on the fair market value of the shares at the time they vest. The value of the stock at vesting is treated as ordinary income and is subject to income tax and payroll taxes (such as Social Security and Medicare).

At sale: Once the shares have vested and any applicable taxes have been paid, any additional gain or loss from the sale of the stock is taxed as either short-term or long-term capital gains, depending on how long the stock is held after vesting. The holding period for capital gains purposes begins on the vesting date.

c. Flexibility

Immediate stock ownership: Unlike RSUs, where the recipient does not own the stock until it vests, RSAs result in the immediate transfer of stock ownership. This means recipients can potentially benefit from stock appreciation from the grant date.

‍Vesting conditions: RSAs are subject to vesting schedules or performance criteria. Until the shares are fully vested, they remain restricted and cannot be sold or transferred. If the recipient leaves the company before vesting is complete, they may forfeit the unvested shares.

‍83(b) election: Recipients of RSAs have the option to make an 83(b) election within 30 days of the grant. This election allows them to recognize income at the time of grant based on the fair market value of the stock, potentially reducing the amount of income recognized at vesting if the stock value increases.

5. Employee Stock Purchase Plans (ESPPs)

Employee Stock Purchase Plans (ESPPs) are programs that allow employees to purchase company stock at a discount through payroll deductions. ESPPs are designed to encourage employee ownership and participation in the company’s success, often offering shares at a favorable price compared to the market value.

a. Eligibility: ESPPs are generally available to a broad range of employees, though specific eligibility criteria may vary depending on the company’s plan. Some plans may require a minimum length of service or exclude employees who own a significant percentage of the company's stock.

b. Tax treatment

At purchase: Employees typically purchase stock through payroll deductions over a specified offering period. The purchase price is usually discounted from the market price. For tax purposes, the discount received on the purchase price in an ESPP is generally not taxed at the time of purchase.

‍At sale: The tax treatment of shares purchased through an ESPP depends on whether the plan qualifies as a "qualified" ESPP under Section 423 of the Internal Revenue Code.

For a qualified ESPP, the tax treatment is as follows:

‍Qualifying disposition: If the employee holds the shares for at least one year after the purchase date and two years after the offering date, the discount received is taxed as long-term capital gains, and any additional gain beyond the discount is also taxed as long-term capital gains. This provides favorable tax treatment.

‍Disqualifying disposition: If the employee sells the shares before meeting the holding period requirements, the discount received is taxed as ordinary income, and any additional gain or loss from the sale is taxed as short-term or long-term capital gains, depending on the holding period after the sale.

c. Flexibility

‍Purchase discounts: ESPPs often offer a discount (commonly up to 15%) on the stock price, which can make buying stock through the plan financially attractive.

‍Payroll deductions: Employees contribute to the plan through payroll deductions, which makes it easy to accumulate shares over time without requiring a significant upfront investment.

‍Offering and purchase periods: ESPPs typically have defined offering periods (e.g., 6 months to 2 years) during which employees accumulate deductions and purchase stock at the end of the period, often at the lower of the market price at the beginning or end of the offering period.

‍Qualifying vs. Disqualifying dispositions: Employees have flexibility in how long they hold the shares. To benefit from favorable tax treatment, shares need to be held for the required periods. If the holding periods are not met, the tax treatment changes, but employees can still sell shares based on their personal financial needs.

6. Phantom stock

Phantom stock is a form of compensation that provides recipients with benefits similar to owning company stock without actually granting real shares. It is designed to mimic the value and performance of actual stock, providing employees with financial rewards based on the company's stock performance, but without diluting ownership.

a. Eligibility: Phantom Stock plans can be granted to employees, consultants, and board members. These plans are often used as a long-term incentive to align the interests of key personnel with those of shareholders, particularly in companies that prefer not to issue additional stock or where stock ownership is not practical.

b. Tax treatment

‍At vesting or payout: Phantom Stock units do not involve actual shares, but instead represent a right to receive a cash payment or stock equivalent based on the value of the company’s shares.

When the phantom stock vests or when the payout occurs (typically upon a liquidity event like a sale or IPO), the recipient receives a cash payment or shares equivalent to the value appreciation of the phantom stock units. This payout is considered ordinary income and is subject to income tax and payroll taxes such as Social Security and Medicare.

‍At sale: Since phantom stock does not involve the actual transfer of shares, there is no additional tax upon the sale of stock. The payout or gain from phantom stock is fully taxed as ordinary income when received.

c. Flexibility

No actual stock issuance: Phantom Stock does not involve the issuance of actual company stock. Instead, it provides a financial benefit equivalent to the stock’s value, which avoids issues related to stock dilution or the need for stock administration.

‍Valuation tied to stock performance: The value of phantom stock units is tied to the performance of the company’s actual stock, so employees benefit from stock price increases without needing to buy or hold real shares.

‍Payout timing: The timing of payouts can be flexible and often occurs upon specific events such as a company sale, merger, or IPO, or after a predetermined vesting period. This flexibility allows companies to structure the plan to align with their financial goals and liquidity events.

‍No voting rights or dividends: Since phantom stock does not involve actual shares, recipients do not have voting rights or receive dividends. The benefit is purely financial and based on the stock's performance.

Each type of equity award serves distinct purposes and can be used strategically to meet specific compensation and motivational goals, benefiting both the company and its employees.

Determining the size of the employee equity pool

This is one of the most important aspects of equity management.
‍
A typical option pool size is about 20% of a company's stock. However, for earlier stage companies, the pool can be smaller, around 10% or 15%. Prudent companies reserve only what they anticipate needing for the next 12 months or so.

The below chart by Index Ventures shows the evolution of ownership in U.S startups across funding rounds and how it is allocated among various employee types.

While this is what we have largely noticed, the following factors may influence the size of your ESOP pool.

1. Industry standards

Industry norms and competitive landscape can dictate pool size. High-tech and high-growth industries tend to offer larger equity pools.

‍2. Talent acquisition and retention goals

‍A larger pool can be a powerful tool for attracting and retaining top talent, especially in competitive fields. The general logic is that the more skilled your employee base needs to be, the more equity you should set aside.

For instance, companies needing highly specialized talent, like rocket scientists or engineers, will require a more substantial equity pool to attract these scarce resources.

‍3. Future hiring plans

Anticipated hiring needs should be considered. Companies planning to scale rapidly will need a larger pool to accommodate new hires. Benchmarks suggest that early employees (excluding founders) typically receive between 0.3% and 5% of the company, depending on their role and the company's stage.

‍4. Investor expectations and dilution tolerance

‍Some investors may prefer smaller pools to minimize dilution. Companies must balance the need for an attractive equity pool with the desire to limit dilution of existing shareholders.

Handling employee departures or terminations

1. Equity award treatment upon termination

a. Voluntary resignation: Typically, employees forfeit unvested shares. Vested shares may be subject to repurchase by the company, depending on the plan terms.

‍b. Involuntary termination: Unvested shares are usually forfeited. Vested shares may either be retained or repurchased by the company.‍

2. Vesting upon departure

‍a. Immediate forfeiture: Unvested shares are forfeited upon departure.

‍b. Cliff vesting: Employees must stay with the company for a specified period (usually one year) before any equity vests. After the cliff period, the remaining equity typically vests on a regular schedule.

‍c. Accelerated vesting: In certain situations, such as change of control or specific negotiated terms, vesting may be accelerated.

‍3. Options exercise periods

‍a. Post-termination exercise period: Standard practice allows employees a set period (usually 90 days) to exercise vested options after leaving the company. Some companies also offer a 10-year extended vesting period.

b. Extended exercise periods: Some companies offer extended exercise periods to make it easier for employees to benefit from their equity.

For example, NSOs may offer more flexible exercise periods compared to ISOs, which have stricter tax implications.

‍4. Handling departures in equity planning

‍a. Reallocation of forfeited shares: Reallocate forfeited shares back into the equity pool for future grants.

‍b. Planning for turnover: Maintain a buffer in the equity pool to account for potential turnover and the need to reissue equity to new hires.

Vesting schedules

What is a vesting schedule?

A vesting schedule is a timeline that dictates when employees gain full ownership of their equity awards. This schedule is designed to incentivize employees to stay with the company for a certain period or until specific performance milestones are met. Vesting schedules are crucial for aligning employee interests with the long-term goals of the company.

Types of vesting

‍1. Immediate vesting

^‍Employees gain full ownership of their equity awards as soon as they are granted.

‍Implications

a. Retention: Provides no retention incentive since employees can leave immediately with their full equity.

b. Use cases: Rarely used for most equity grants but may be used for small bonuses, awards to advisors, or very senior hires as part of a negotiation.

2. Graded vesting

Equity vests in increments over a set period. For example, a four-year vesting schedule with 25% of the equity vesting each year.

Implications

a. Retention: Encourages long-term retention by gradually granting ownership.

b. Employee morale: Provides ongoing rewards, boosting morale and commitment.

c. Use cases: Commonly used for stock options and restricted stock units in startups and established companies.

‍3. Cliff vesting

No equity vests until a specific initial period (the "cliff") has passed, after which a lump-sum vests, followed by graded vesting. For example, a one-year cliff followed by monthly vesting over the next three years.

Implications

a. Retention: Strong initial retention incentive, as employees must stay through the cliff period to receive any equity.

‍b. Risk management: Protects the company from losing equity to short-term employees.

‍c. Use cases: Standard in many startups, ensuring employees are committed for at least the first year.

‍4. Performance-based vesting

Equity vests when specific performance milestones are achieved, rather than after a set time period.

Implications

‍a. Alignment: Directly aligns employee incentives with company performance goals.

‍b. Motivation: Highly motivating for employees who can directly influence milestone achievement.

‍c. Uncertainty: Creates uncertainty for employees if milestones are not clearly achievable.

‍d. Use cases: Often used for executive compensation, sales roles, and special project teams where performance can be clearly measured.

Choosing the best equity award

For the company

Factors to consider when selecting equity award.

‍1. Company stage and valuation

a. Early-stage companies:Stock options are often preferred due to their potential for significant appreciation. They are more attractive when the company's valuation is low, offering higher upside for employees.

‍b. Growth-stage companies: At this stage, RSUs are particularly appealing as stock options have high strike prices that might make them less immediately valuable to employees. Unlike stock options, RSUs do not require the employee to purchase the shares at the strike price. The employee simply receives the shares, which have value based on the current market price of the stock.

‍c. Mature companies: May use a mix of RSUs, stock options, and performance shares to balance incentives and retention goals.

‍2. Cash flow and tax considerations

a. Stock options: Employees face no tax liability until they exercise the options, which can be delayed until a liquidity event.

‍b. RSUs: Trigger tax liability upon vesting, which may necessitate the company offering tax assistance programs. 

‍c. Performance shares: Vesting is based on achieving specific performance goals. Taxation occurs upon vesting, which aligns tax events with the achievement of business milestones.

For example, an employee is granted performance shares that will vest if the company achieves a 20% increase in revenue over the next two years. After two years, if the company meets or exceeds the 20% revenue increase, the performance shares vest, and the employee receives the shares. The employee is taxed on the value of the shares at the time they vest, aligning the tax event with the accomplishment of the company’s performance milestone.

‍3. Retention and incentive goals

a. Stock options: Align employee interests with long-term company growth, as they only become valuable when the company’s stock price increases.

‍b. RSUs: Provide immediate value upon vesting, offering strong retention incentives, especially when stock price appreciation is uncertain.

‍c. Performance shares: Encourage employees to meet or exceed performance targets, fostering a high-performance culture.

‍4. Regulatory and compliance issues

a. Stock options: Subject to favorable tax treatment under certain conditions (e.g., Incentive Stock Options).

‍b. RSUs: Easier to administer from a compliance standpoint as they do not have strike prices and offer simpler tax implications.

‍c. Performance shares: Performance shares must be carefully structured to comply with SEC and tax regulations. This involves proper disclosure of terms, adherence to anti-fraud provisions, and compliance with Section 16(b) for executives. For tax purposes, companies must follow IRC Section 409A and consider Section 83(b) elections and Section 162(m) deductibility limits. 

Clear, objective, and measurable performance criteria should be set to ensure genuine achievement. Proper documentation and record-keeping are essential to maintain compliance and facilitate audits, maximizing the effectiveness of performance shares as an incentive tool while avoiding legal and financial pitfalls.

For the employees

Considerations when choosing between different equity award.

‍1. Risk and reward assessment

a. Stock options: Offer higher potential rewards but come with the risk of becoming worthless if the stock price doesn’t exceed the strike price. There’s also the cost of exercising the options and potential tax implications.

‍b. RSUs: Provide guaranteed value upon vesting, with no need to pay a strike price. However, employees must prepare for the tax liability that arises when the RSUs vest.

‍c. Performance shares: Risk depends on performance targets. High reward if targets are met, but potential for no reward if targets are missed.

‍2. Tax implications

a. Stock options: Employees can control when to exercise and potentially manage their tax liability. Incentive Stock Options (ISOs) may also offer favorable tax treatment.

‍b. RSUs: Subject to income tax upon vesting. Employees need to plan for this tax liability, which can be substantial.

‍c. Performance shares: Taxed similarly to RSUs, but only if performance targets are met and shares vest.

‍3. Liquidity and timing

a. Stock options: Usually require a liquidity event (e.g., IPO or acquisition) for value realization and involve a potentially long and uncertain wait. to realize value. 

‍b. RSUs:  Generally vest on a set schedule, offering more predictable timing for receiving shares and facing tax implications. Companies may adjust the vesting schedule around significant events to optimize tax outcomes.

‍c. Performance shares: Vesting depends on meeting performance milestones, which can provide clarity on timing if targets are realistic and achievable.

Companies like Uber, Airbnb, and Pinterest opted for extended periods of private funding before their IPOs, creating challenges for traditional stock options.

In response, these companies have increasingly adopted RSUs to offer more immediate and tangible compensation value. For example, companies may implement special rules delaying RSU vesting until a significant liquidity event to manage tax implications for employees.

By carefully considering these factors and understanding the different types of equity awards, companies can design effective compensation plans that align with their strategic goals and market conditions. Employees can make informed decisions about their equity compensation, balancing risk and reward in line with their personal financial goals and career aspirations.

Taxes and deductions for employee equity

Understanding the tax implications of employee equity is crucial for both employees and employers to maximize benefits and avoid unexpected liabilities. 

In this section, we will explore the different tax considerations associated with employee equity, including income tax, exercise costs, long-term capital gains (LTCG), and short-term capital gains (STCG).

A. Income tax on stock options

‍1. Incentive Stock Options (ISOs)

a. Grant and vesting: No tax implications at the time of grant or vesting.

b. Exercise: No regular income tax, but the difference between the exercise price and the fair market value (FMV) of the stock at exercise may be subject to the Alternative Minimum Tax (AMT).

‍c. Sale: If shares are held for at least one year after exercise and two years after the grant date, the sale is subject to long-term capital gains tax. If these holding periods are not met, the gain is treated as short-term capital gain.

‍2. Non-Qualified Stock Options (NSOs)

a. Grant and vesting: No tax implications at the time of grant or vesting.

‍b. Exercise: The difference between the exercise price and the FMV of the stock at exercise is taxed as ordinary income.

c. Sale: Subsequent sale of the stock is subject to capital gains tax, with the basis being the FMV at exercise.

3. Restricted Stock Units (RSUs)

a. Grant: No tax implications at the time of grant.

‍b. Vesting: The FMV of the shares at vesting is taxed as ordinary income.

‍c. Sale: Any gain or loss from the sale of the shares after vesting is subject to capital gains tax. The holding period starts at vesting.

4. Restricted Stock Awards (RSAs)

a. Grant: Employees can choose to make an 83(b) election, which means they will be taxed on the stock's fair market value (FMV) at the time of the grant. If the 83(b) election is not made, the FMV of the stock at the time of vesting will be taxed as ordinary income.

‍b. Vesting: If an 83(b) election was made, there will be no additional tax at vesting. If no 83(b) election was made, the FMV of the stock at vesting will be taxed as ordinary income.

‍c. Sale: Any gain or loss from the sale of the stock is subject to capital gains tax. The holding period for calculating capital gains starts at the time of the grant if the 83(b) election was made, or at the time of vesting if no 83(b) election was made.

5. Performance shares

‍a. Grant: No tax implications at the time of grant.

b. Vesting: The FMV of the shares at vesting is taxed as ordinary income.

‍c. Sale: Any gain or loss from the sale of the shares after vesting is subject to capital gains tax.

B. Exercise costs

1. Stock options

ISOs and NSOs: Employees must pay the exercise price to purchase the shares. This outlay can be substantial. 

‍2. RSUs and performance shares

No exercise costs, as these shares are granted and vest without the need for the employee to purchase them.

3. RSAs

a. 83(b) election made: If an 83(b) election is made, the exercise cost is based on the fair market value (FMV) of the stock at the time of the grant. This means you pay taxes on the FMV at the grant date and no additional costs are incurred at vesting.

‍b. No 83(b) election made: If the 83(b) election is not made, you do not incur any additional costs at the time of vesting. Instead, the FMV of the stock at the time of vesting is taxed as ordinary income. This means you will be taxed on the value of the shares when they vest, which could potentially be higher than the FMV at the grant date.

C. Long-Term Capital Gains (LTCG)

Gains from the sale of equity held for more than one year. LTCG rates are generally lower than ordinary income tax rates, often 0%, 15%, or 20%, depending on the taxpayer's income.

Application

1. ISOs: If the holding period requirements are met, the sale of ISO shares results in LTCG.

2. NSOs: The holding period starts at exercise. If shares are held for more than one year post-exercise, gains are treated as LTCG.

3. RSUs: The holding period starts at vesting. If shares are held for more than one year post-vesting, gains are treated as LTCG.

4. RSAs: The holding period starts at the time of grant (if 83(b) election is made) or at vesting (if 83(b) election is not made). Gains from sales after holding the shares for more than one year are treated as LTCG.

5. Performance shares: The holding period starts at vesting. Gains from sales after holding the shares for more than one year are treated as LTCG.

D. Short-Term Capital Gains (STCG)

Gains from the sale of equity held for one year or less. STCG is taxed at the same rate as ordinary income.

Application

‍1. ISOs: If the shares are sold before meeting the holding period requirements, the gain is treated as STCG and taxed as ordinary income.

2. NSOs: If the shares are sold within one year of exercise, the gain is treated as STCG.

3. RSUs: If the shares are sold within one year of vesting, the gain is treated as STCG.

4. RSAs: If the shares are sold within one year of the 83(b) election or vesting, the gain is treated as STCG.

5. Performance shares: If the shares are sold within one year of vesting, the gain is treated as STCG.

By understanding these tax implications, employees can make more informed decisions about their equity compensation and optimize their financial outcomes. Companies can also structure equity awards to align with their goals while considering the tax impacts on their employees.