If you have recently started receiving stock compensation from your employer or are considering going to work for a new firm that offers equity as part of their compensation package, here are eight terms that you may need to understand.
1) Stock Options:
If you receive employee stock options, your employer is offering you the right to purchase shares of the company stock at a predetermined price and for a specified period of time. There are two types of stock options: non-qualified stock options and incentive stock options (explained below). The main difference between them is how they are taxed.
Vesting is the time you need to remain employed at the company before you can realize the value of your options. A stock option vesting schedule incents employees to work for the company for a defined amount of time. For example, your option grants may vest over a 4 year period starting a year after the grant date. This means that after the first year you are 25% vested with an additional 25% of the shares vesting each year until you are 100% vested. Vesting schedules vary from company to company so it's important to understand what happens if you quit before your options are fully vested. These terms will be spelled out in your grant document.
Exercising is "purchasing" the shares of stock at the predetermined price (AKA: grant price or exercise price). You can only exercise your stock options after they vest and before they expire (generally 7-10 years after the grant date). Exercising your options is a taxable event which enables you to take ownership of the shares that can then be sold to realize their value.
4) Bargain Element:
This is difference between the grant price and the fair market value of the company stock on the day you exercise your stock options. The bargain element is the gain on your stock options when you sell the underlying stock. It also represents the taxable value depending on whether the options are categorized as non-qualified or incentive stock options.
5) Non-Qualified Stock Options:
Also referred to as NQSOs, these stock options are more common than incentive stock options. They are called "non-qualified" because they do not qualify for the special tax advantages of incentive stock options. Consequently, when you exercise a NQSO, you pay ordinary income tax on the bargain element because it is considered compensation income by the IRS even before you sell the shares. Although there is no real benefit to exercising NQSOs and holding the shares for appreciation (because it's the same as buying shares on the open market), the additional gain on shares held for over 1 year from exercise/purchase are taxed at long-term capital gains rates.
6) Incentive Stock Options:
Also known as ISOs, incentive stock options have more favorable tax treatment. When ISOs are exercised, you don't have to pay ordinary income taxes on the bargain element like you do with NQSOs. Instead, you only have to pay capital gains taxes when you eventually sell the underlying stock. However, there are limits and holding periods that must be met otherwise these options are treated as NQSOs for tax purposes. The limitation is that only $100,000 in total fair market value at the time they are granted (i.e. 10,000 share with a $10 exercise price = $100,000) can become exercisable in a given year. Also, you must hold ISOs for at least 2 years from the data of the grant and at least one year after exercising them.
7) Restricted Stock Awards:
Restricted stock is a grant of a specified number company shares at no cost that are subject to restrictions related to vesting periods or company performance measurements. Restricted stock is different from stock options. These grants have no exercise price and no expiration date. The recipient receives the shares outright after the restrictions are lifted and the value is taxed as ordinary income. If you hold on to these shares, you'll have to pay capital gains taxes when you sell them on the value above that when they vested.
8 Employee Stock Purchase Plans:
Employee stock purchase plans (ESPPs) are a form of stock compensation that makes it easy for employees to purchase company shares. ESPPs allow employees to accumulate after-tax payroll deductions to buy shares (often at a discount) at a specified purchase date (typically every six month). The taxation of these shares is fairly complex and generally includes both ordinary income and capital gains taxation based on holding periods and discounts. For more information on ESPP taxation refer to this article on Tax Tips for Employee Stock Purchase Plans.