Apart from options discussed previously, companies can also grant employees with non cash compensation in the for of stocks as an incentive for performance. Some of these could have option like characteristics and some may be offered to employees on a ‘non-discriminatory fashion ie. they are not restricted to only highly compensated executives. Employee stock purchase plans is one such example of both. The following are two popular stock based compensation.
Employee stock purchase plans (ESPP): Under this plan, employees are offered the option to purchase employer stock at a discount to market value. After-tax contributions are made through payroll deductions during an enrollment period, which usually lasts for 12-18 months with 2-3 six-month purchase periods. Contributions are generally up to the lesser of 15% of the employee compensation or $25,000. Employees can purchase employer stock at a discount of 15% to the lower of the market price of the stock on first or the last day of the six-month purchase period.
Enrolling and contributing to a ESPP offers the employee a sure-shot benefit if the stock is sold immediately after purchase. Assuming the employee can manage the cash flow, it is highly recommended that she/he participate in it. While the easiest no risk strategy is to sell the stock immediately after purchase to pocket the definite benefit, depending on several factors the employee could do better. If the stock is held for more than one year after purchase and more than two years after the beginning of the offer period, the gains above the discount are taxed as capital gains, long term capital gains- if the holding period requirement is satisfied. The gain attributed to the discount is always taxed at ordinary income tax rates. To take advantage of the lower capital gains tax the employee would have to the bear the risk of a decline in the stock price, therefore the decision must be based on expectation for the stock price. The employee should also consider the overall exposure to the company stock through other forms of stock or option compensation the employee may have received.
Restricted stock: These are employer stock granted to an employee with a vesting period. (Another similar form of compensation is the Performance Stock award which is specifically tied to the employee performance. The treatment of performance stock is similar to restricted stock). The stocks are forfeited if the employee’s performance is not satisfactory or the employment terminates before a requisite period. Since the stock granted has a ‘substantial risk of forfeiture’, the employee is not taxed at grant. On vesting, the employee is taxed at ordinary income tax rates. If the stock is held after vesting, any further gain is taxed as capital gains, short term or long term depending on the holding period. Like in other stock based compensation, the decision to hold after the restricted stock has vested depends on the employee’s view on the expected stock price and her overall exposure to the stock.
Section 83(b) election: If an employee makes a section 83(b) election, then she could elect to be taxed on the compensation (Ordinary income tax rates) immediately at grant rather than at vesting. This election must be made within 30 days of receiving the restricted stock. As a result of this election, any further appreciation in the stock (After the grant) is treated as capital gain and depending on the holing period, may be taxed at the lower long-term capital gain rate when the stock is sold. However, the risk of this election is that if after making the election (And paying the tax at grant) if the executive forfeits the stock, she is not allowed a deduction or refund of tax paid on previously reported income. In addition, if the executive has paid no money to acquire the stock, she cannot realize a capital loss when the substantial risk of forfeiture expires.
An adviser working with a tax consultant can help manage equity based compensation in an optimal way with a holistic approach.
PLEASE NOTE: SARSI, LLC DOES NOT PROVIDE TAX ADVICE. THE ABOVE IS FOR INFORMATION PURPOSES ONLY. PLEASE CONSULT YOUR TAX ADVISER FOR HELP WITH YOUR TAX MANAGEMENT.