Equity Incentives for Employees: Motivating Your Team and Saving Cash

Are you looking for ways to attract and retain top talent while also conserving cash for the company? Offering equity incentives to your employees may be an answer. In this article, we explore various equity incentives, including stock options, restricted stock, restricted stock units, and stock appreciation rights, and discuss the tax realities associated with each. By aligning the interests of your employees with those of the company, equity incentives can create a sense of ownership and long-term commitment, ultimately benefiting your business.

Stock Options

Stock options grant employees the right to purchase a specified number of shares of the company’s stock at a predetermined price (the “exercise price”) within a specific time frame. There are two primary types of stock options: non-qualified stock options (NSOs) and incentive stock options (ISOs).  

NSOs are the most common type and can be granted to employees, directors, or consultants. When NSOs are exercised, the “spread,” i.e., the difference between the exercise price and the stock’s fair market value (FMV), is treated as ordinary income and subject to taxes.  When the shares are eventually sold, any additional gain or loss is taxed as a capital gain or loss.

ISOs, on the other hand, are granted exclusively to employees and offer more favorable tax treatment. When exercised, the spread between the exercise price and FMV is not subject to ordinary income tax, provided the employee meets certain holding requirements. (However, the spread may be subject to the alternative minimum tax (AMT).)  When the shares are eventually sold, any additional gain or loss is also taxed as a capital gain or loss.

Restricted Stock

Restricted stock refers to shares of company stock granted outright to employees with certain restrictions, such as vesting over a specific period or based on performance milestones. Taxation occurs when the restricted stock vests—i.e., when it is no longer subject to substantial risk of forfeiture—and the FMV of the shares at that time is treated as ordinary income. Employees can, however, choose to be taxed upon grant by filing a Section 83(b) election, potentially reducing their overall tax liability if the stock appreciates between the time of grant and the time of vesting.  However, this comes with a risk—if an employee files a Section 83(b) election but forfeits the shares, the employee will not be able to obtain a refund of the taxes paid when the Section 83(b) election was filed.

Restricted Stock Units (RSUs)

RSUs are not shares of stock—instead, they are promises by the company to grant a specific number of shares, or an equivalent amount of cash, upon vesting.  RSUs offer greater flexibility to companies than options or restricted stock, because the issuing company can choose to settle the RSUs in cash or shares.  Taxation occurs when the RSUs vest and the cash or shares are issued.  If the RSUs are paid in shares, the FMV of the shares at that time treated as ordinary income.  Of course, if the RSUs are paid in cash, the cash is treated as ordinary income too. 

Stock Appreciation Rights (SARs)

SARs provide recipients with the right to receive the appreciation of the company’s stock value over a predetermined period without requiring them to purchase the stock itself.  The appreciation is typically paid in cash or shares, as determined by the company.  When SARs are exercised, the appreciation is taxed as ordinary income.

Conclusion

In conclusion, equity incentives can be a valuable tool for companies to attract and retain talented employees, without the need to increase cash compensation. By offering stock options, restricted stock, restricted stock units, and stock appreciation rights, companies can align the interests of their employees with the long-term success of the business. It is important for both employers and employees to understand the tax implications of these equity incentives, as they can have a significant impact on overall compensation. Overall, equity incentives can create a sense of ownership and commitment among employees, driving the success of the company and rewarding hard work.  

This is an overview and not legal advice for your specific situation. For tailored legal advice to your situation you can contact Jonathan at (925) 217-3255 or email him at jcw@eastbaybusinesslawyer.com.