Year end is around the corner, so as you wrap up decisions about your equity compensation for the year it could be helpful to think about how you will be taxed when April 15th rolls around. So here’s a brief summary of equity compensation taxes.
Events in the Lifespan
There are several events in the equity compensation lifespan. The grant, vest, exercise (for options), and sale. Now there are different types of taxes for each.
Upon grant, when you receive Restricted Stock Units (RSUs) or stock options, there are typically no taxes.
At vest, you will have to pay taxes on RSUs, but not on stock options.
Exercise is only for stock options. When you exercise, you will have a taxable event.
At sale, for both RSUs and stock options, you will have to pay taxes as well.
The lifespan has four distinct phases when it comes to equity compensation taxes.
Equity Compensation Taxes
The word taxes can be vague. Simply, it’s a bill due to the IRS, but there are different types of equity compensation taxes paid at different times.
For example, ordinary income taxes are the taxes you pay on your income/wages and RSUs.
Next, capital gains taxes are taxes you pay on your company shares when you sell them. The type of tax – short term or long term depends on the holding period of the investment. You pay short term capital gains taxes on an investment held for less than a year. This rate is the same as your ordinary income tax rate. Long term capital gains taxes are for investments held longer than one year. These rates are usually lower than short term capital gains taxes.
Then, the Alternative Minimum Tax (AMT) has different aspects to it. For our purposes, Incentive Stock Options (ISOs) go along with the AMT. So if you are exercising ISOs, it’s something to pay attention to.
Finally, the Net Investment Income Tax (NIIT) is for high earners. It’s a 3.8% tax on investment income if your adjusted gross income exceeds $250,000 for married filing jointly or $200,000 for single filers.
Scenarios for Equity Compensation
One approach is once your shares vest, you sell them right away. Your ownership is quickly turned to cash. This can be done for RSUs, Nonqualified Stock Options (NSOs), and ISOs. You will have to pay ordinary income taxes in this scenario.
Another framework is to have your shares vest and then hold onto them, especially if you are optimistic about the company’s prospects. This is riskier because you take on more company share ownership. On the other hand, it could be more tax efficient if you hold your ISOs for the required time period.
So the decisions you make now will impact your equity compensation taxes in the future, whether it’s in April or another year down the road. How you decide what to do and how it fits into your financial system are specific to you.