Your equity compensation plan may be the best part of your benefits package.

Getting a competitive salary is important, but prospective employees should look at their employer’s benefits package as part of their compensation. Equity (or stock) compensation plans, if provided, are potentially among the most valuable features of your package.  Several different plans can be meaningfully additive to your compensation and net worth while boosting your motivation and confidence at work. We will explain the four most common equity compensation plans.

If Offered, Consider Yourself Fortunate

Most plans come with lots of letters–ESOPs, ESPPs, ESOs, and RSUs– and it’s easy to get confused about them. That is not a good reason to avoid participating in them. There is often low enrollment when given a choice, like for a company’s employee stock purchase plan (ESPP). Studies show that when more employees participate rather than opt-out, they enroll automatically in a 401K plan. With that in mind, we will explain what these plans are, how they differ, benefits and drawbacks. If you are working at a place that offers such programs, consider yourself fortunate. Learn about these plans and what it means for you. All of these plans contemplate stock ownership in your company. 

Two Recommendations Upfront

 

1. Consult A Tax Expert For Strategic Efficiencies

Taxation may occur upon granting the option or the stock and selling the option and stock. You should consult a tax specialist to understand potential tax consequences.

2. Diversification Is Essential

Concentration in any one stock is risky. However, it is hazardous if it is company stock where you are employed. Reduce your exposure to a comfortable level by fully diversifying your portfolio, primarily if your ownership represents retirement assets. You should not have more than 10% of your retirement or investment assets in your employer’s stock. Diversification of your equity and all your assets is a prudent strategy.

How the employee equity compensation plan varies:

  • Who is a closely-held private company or a public company represented by the shares?
  • What: stocks, options, cash, or a combination.
  • Understand the specifics: grant dates, prices, expiration dates, and vesting periods.
  • Taxation: Tax consequences may be tricky, requiring you to consult with a tax expert.

 

1. Employee Stock Ownership Plan or ESOP

An ESOP is a stock benefit plan and is among the most common forms of employee ownership. This plan covers 14.2 million people working predominantly for privately held companies. Departing owners of a closely-held company often create ESOPs. ESOPS motivate and reward employees and allow employees to borrow money for acquiring new assets.

How ESOPs Work

Your employer makes tax-deductible gifts of company stock, not options, into a trust allocated into individual employee accounts. Typically, there is no public market for these shares. Upon leaving or retiring from the company, an employee gets their stock and then sells them back to the company for cash. From the employee’s perspective, they are not purchasing the shares. They receive a cash contribution from the company, which is part of their compensation. This compensation is like a retirement fund since they don’t receive the proceeds until they leave. 

 Who Participates? All Employees

Generally, all full-time employees over the age of 21 participate in the plan. Employees receive allocations based on relative pay or some other equal basis. 

Vesting Period

ESOPs are regulated more than some other plans, particularly when it comes to vesting. Vesting refers to the amount of time an employee must work at the company before earning the stock benefit. As such, an ESOP must comply with one of two minimum schedules. There is no vesting until the employee has worked for three years and becomes fully vested or staggered vesting beginning in the second year of service with 20% vesting each year until reaching 100% vested in the sixth year.

Distributions If You Are Still Working

There may be certain times when participants may receive benefits from the ESOP while still working at the company. Your employer may choose to pay dividends directly to participants. Separately, if the employee is an owner of 5% of the company stock and is 70.5 years, the plan must distribute benefits, even the employee is still working there.

Essentially A Retirement Fund

Earlier, we mentioned that employees don’t receive their ESOP shares until they leave. If you stay at an ESOP-based company for a long time, you will essentially be going with retirement assets.

The average worker at a US company with an ESOP has accumulated $134,000 in wealth for their account. A study by Joseph Blasi and Douglas Kruse of the Institute for the study of Employee Ownership and Profit Sharing at the Rutgers School of Management and Labor Relations researched employees who accumulated wealth from ESOPs. These employees may have additional retirement assets from other accounts they set up separate from the company. According to the Economic Policy Institute, employees of ESOP-based companies have more retirement assets than the average amount of working families have in retirement savings of $95,776.30.

Tax Treatment Is Favorable

Employees don’t pay taxes at the time stocks are put into their accounts. Instead, taxes are due when distributions to departing employees are made and at potentially capital gain rates. Employees can roll over cash distributions into an IRA or another retirement account or pay current tax at the capital gains rate. However, if employees receive distributions below 59.5 years, they may be subject to a 10% penalty similar to the early withdrawal in a typical 401K plan.

From the company’s perspective, contributions of stock, cash, or dividends are tax-deductible.

A Major Drawback Is Concentration Risk So Diversify When You Are Eligible

With ESOPs, the concentration of owning a stock of the company where you work is a significant drawback. Therefore, you should seek to diversify when you are eligible. Participants have the right to diversify up to 25% of company stock during the next five years after reaching age 55 and are on the plan for ten years. The ESOP must offer at least three alternatives. Although well-regarded, ESOPs’ concentration risk is high. Therefore, participants need to diversify their portfolios outside of this ownership to avoid this risk.

 

2. Employee Stock Purchase Plan or ESPPs

An ESPP, a relatively common company-run program, is broadly offered as a component of employee benefits. Unlike the ESOPs given by private employers, public companies offer ESPP. With an ESPP, the employees purchase shares usually at a discount based on an offering plan.

Companies Can Boost Low Employee Participation 

Employee participation in  ESPPs is relatively low. According to the 2018 Global Equity Insights report, 70% of North American companies surveyed have implemented share discount plans, with 42% of employee participation. A 2018 Deloitte Survey of Global Trends reflect a wider disparity between company offering ESPPs (75%) versus employee participation (28%).

Both surveys point to employee participation, which is below the 48% rate targeted by employers. Companies can boost this low rate with increased employee awareness through human resource professionals.

Is The Complexity A Deterrent?

Employee stock purchase plans may seem technical or intimidating to employees. If employees could better understand how ESPPs work, it may raise participation and provide incentives for employees to be involved in the plan. We have been intrigued by ESPPs as an opportunity for employees who may be leaving money on the table. To boost participation, companies can automatically enroll their employees into the program. Companies should explain how ESPPs work so employees can be comfortable with the plan.

What Is An ESPP?

An ESPP plan allows employees to buy their company’s stock at a discount price up to 15% of their salary but no more than $25,000 annually. Employees contribute via their paycheck. Contributions typically are 1-10% of wages. It is a good way for employees to participate in the success of their company.

Similar to employer-sponsored 401K retirement plans, ESPPs are usually:

  • broad-based programs offered to all employees,
  • participation is voluntary; and
  • handled by payroll deductions.

 

Qualified and Unqualified Plans

According to the National Association of Stock Plan Professionals (NASPP), 82% of companies with ESPP plans are tax-qualified plans under Sec 423 of the Internal Revenue Code. A qualified plan has more restrictions but favorable tax treatment. Non-qualified programs have fewer restrictions but less favorable tax benefits.

To put a qualified ESPP in place before the plan’s implementation, a majority of shareholders must vote to approve.  All employees must have equal access to the program.

A qualified plan allows employees to purchase company stock up to a 15% discount. As such, your share purchase is 85% of its price in the stock market. The plan’s purchase date must be within three years of the offering date, that is, when the company announces its ESPP.

The maximum offering term allowed for employees to participate is 27 months unless purchases are at market value (the company offers no discount). If so, the company can offer the plan for as long as five years.

Favorable Tax Treatment For Qualified Plans

As mentioned above, if you are participating in a qualified employee stock purchase plan (ESPP), you may reap the benefits of tax-advantaged treatment. If you sell shares at a higher price than your purchase price, you will have income (rather than a loss).

For tax purposes, the income you generated came from two sources. Treatment for the first source-difference between the employee’s share discount and the market price- is taxed as ordinary income. On the other hand, the income differential between your sale of shares and purchase price is dependent on the shares’ holding period if the shares’ sale price of the shares is higher than the holder realizes appreciation.

A qualifying disposition would get the more favorable capital gains treatment  if you have held the shares:

  • a year and a day from the purchase date AND
  • at least two years from the offering date.

Taxation for qualified plan holders is during the year of the sale of shares. The tax would be at a higher level if you held shares for less time. Satisfying the required time provides the more desirable capital gains rate.

How The Tax Treatment Works

Significantly, taxation of the qualifying disposition depends on when you sold the stock. Income, the discount from market value, is ordinary income if you hold shares short term, your sale-generated income is a regular income, taxed at a higher tax rate. However, if you own shares longer, satisfying the qualifying disposition rules, your income receives the more favorable capital gain.

An Example

Carol bought one share with a 15% discount offered by her company. The stock has a $20 market value, and she pays $17 per share based on her 15% discount. She held the stock for more than a year and a day from her purchase date and more than two years from her company’s offering date.

She sells the stock at $30 per share. Carol earned $13 per share ($30 less $17) with two different tax treatments. The difference between $20 less $17 or $3 will be recognized as ordinary income and taxed at her 33% tax bracket. The remaining $10 will be taxed at the capital gain rate of 15% because she held the shares long enough according to the rules above.

Carol enjoyed a pretty favorable return on her investment or 13/17 or 76% before calculating the tax impact. Her after-tax return is effectively 62%. This return is based on using the $3 x (1-.33)= $2  plus $10 x (1-.15) =$8.50. As such, it equates to $10.50/17 or 62% after-tax.

Long Term Holding Period For Tax Advantages

Most plans allow the employee to immediately sell their shares upon their purchase without requiring vesting or holding period. However, if you sell your shares before the required holding period, then your entire income is taxed as ordinary income at a higher rate. You might want to annualize your return if you held the shares for less than one year. To calculate your return on an annual basis, use a formula like here.

However, a 2017 NASPP Deloitte Consulting Survey reported that two-thirds of companies that offer an ESPP say participants hold their purchased shares under Section 423 for at least one year and a day and get the favorable capital gains treatment.

The unqualified plan has fewer restrictions, except the plan still requires majority shareholder approval. These plans do not have tax advantages like the qualified plan. Instead, employees are taxed at the ordinary income rate.

Most Plans Have 15% Discount From Market Price

According to surveys, the employees’ discount price for shares is 5%-15% lower than the market price, with 15% being the most prevalent discount. Employers usually impose a limit of 10% of after-tax pay. In any case, the IRS allows purchases up to $25,000 of stock annually.

Lookback provisions are standard. These provisions mean that the employer will calculate the stock price as the lower between the offering date or the purchase date.

Eligibility

Offering periods are generally six months- twice per year though some companies have shorter periods of 1-3 months up to 18 months.

An employee cannot participate in a plan if they own 5% or more of company shares.

Companies may require that an employee work at the company for a specific duration, such as one year before participating in the plan.

The ESPP may exclude contractors, part-time employees, and those highly compensated for participation.

Benefits For Employees

 

Easy To Purchase Stock

Companies make it relatively straightforward for all employees to participate in the plan, purchasing the stock through their paychecks on favorable terms assuming employees get a discount.

Potential for Higher Returns On Stock

ESPPs can provide employees increased compensation, especially if there is a 15% discount offered by the company, even if there is a look back. Most plans have purchase periods of 6 months.

So your purchase price is discounted either at the beginning of the end of the period. Assume the stock price is $15 at the beginning of the purchase period. Let’s say it goes up to $20 at the end. The lower of the two-time frames is $15, but you will pay $12.75 per share at a 15% discount. If you sell your shares at $20, that is a 57% return. Not too shabby!

On the other hand, if the stock price stays at $15, you pay $12.75, and the market price for your stock remains $15, and you decide to sell. Your gain is not 15% but a  built-in profit of 17.6%. The calculation is ($15 less $12.75 purchase price)/$12.75=17.6%.

Dollar-Averaging

If the stock goes down, you can hold on to the shares or do dollar-averaging. Investors use dollar-averaging when they can buy purchases at lower prices, potentially reducing their cost basis.  You should only do this if you remain comfortable with your company’s future and can afford more shares.

Favorable Tax Treatment

Contributions to the ESPP are deducted from your paycheck and taxed at ordinary rates like your salary. If you have a qualified plan, you will be eligible for tax advantages if you hold the shares long enough according to IRS rules discussed above.

Stock Appreciation + Dividends + Long Term Holding = Rewarding

If you can afford to buy shares at a successful company discount, holding for the long term may be beneficial. In addition to stock appreciation, your company may also pay dividends generating more income. If qualified, taxation of your income may be at capital gain rates.

All stocks are risky but generally are in an asset class with higher returns than other securities such as money markets or bonds.  Ensure you have a diversified group of stocks besides the company shares to reduce the risk of being too concentrated.

Buying a stock at a discount through your employer’s stock purchase plan is an excellent way to begin investing and benefit from compounding growth. The magic of compounding is a significant financial concept we explain here.

Better Confidence And Control Over Your Financial Well-being

Fidelity Investments found positive benefits for employees by buying company shares through an ESPP. Among the findings in the two-year study released in 2016, employees:

  • feel more in control over their financial well-being,
  • were less likely to borrow from their 401K retirement account,
  • showed improved productivity and morale at work; and
  •  held the shares they bought with a great sense of ownership.

The ESPP provides employees with a boost to earnings and a psychological boost of feeling more valued. Workers tend to stay in companies longer when they are better compensated, and morale is strong. For companies, ESPPs are often an excellent recruitment and retention tool.

 Drawbacks

While employee participation in an ESPP has many benefits, notably additional compensation to their salary and feeling more valued as an employee, there are some drawbacks.

No Guarantees Of A Higher Stock Price

It is not predictable when or if the company stock price will rise above your purchase price. You are not required to sell your share at a predetermined price or time. However, you may want to cash out your shares for greater liquidity to buy a home or pay for your child’s college education.

Consider making only the purchases you can afford.

Concentration In One Stock Is Risky

Employees like buying their employer’s stock, especially when the company is doing well. However, be careful about having too much concentration in one stock when the company is paying your salary. Concentration can be hazardous. Companies go through downturns due to the economy, increased competition, increased regulation, management changes, and potential fraud. This risk is present in every equity compensation plan. Those that worked at companies like Worldcom and Enron received generous compensation, including discounted stock purchase plans. Employees were loyal to these companies, benefiting the companies with lower turnover. Many employees stayed on for many years, grateful for the knowledge that they owned many shares in those companies and would retire with significant net worth.

Enron and Worldcom filed for bankruptcy in late 2001-mid-2002, rendering their respective stocks virtually worthless. Many employees lost the vast majority of their savings and investments through ESPPs. As a result of that debacle, Restricted Stock Units or RSUs (discussed below) became more popular as equity compensation for employees.

Diversification of your portfolio is important for all investors. You should own stocks in multiple industries and different asset classes, such as various bonds and real estate.

3. Restricted Stock Units (RSUs)

Restricted Stock Units or RSU’s have been around for decades. Private or public companies may offer this popular form of employee compensation. RSU’s are the most common equity award granted to all employee levels regardless of industry (92%) based on a 2019 Domestic Stock Plan Design Survey by Deloitte. They are also the most common form of time-based full value awards (84%) by companies. Given these statistics, employees may seek these performance-based awards.

How RSUs Work

RSUs are stocks given as an award to you by your employer. Employees do not purchase their shares, and it may take several years before employees see value from its award. They represent a contractual right to receive shares or a cash equivalent amount as an allotment. Essentially, the company is promising to pay you with awarded shares on a vesting schedule. The grant date is the allotment date. As an employee, you are not getting stock transferred to you on the grant date. You are issued shares that you don’t yet own until you meet the vesting conditions.

Typically, vesting of a percentage of shares will occur over the years as you achieve performance benchmarks.  Graded vesting, or awards in equal parts,  are most common.  Once that tranche of shares are vested, they are no longer restricted and will have a fair market value. It is at the employee’s discretion as to when they sell the shares.

While RSU’s are stocks, they do not have dividends or voting rights like common shares. Some companies may pay dividend equivalents on the RSU’s, paid in cash. Unlike stock options, which may remain “underwater” as explained below, vested RSU’s are worth something of value.

Tax Treatment At Vesting And Share Sale

Taxation is at the time of vesting when you receive the shares at ordinary income rates. As such, your taxable income is the market value of the shares at vesting. The most common practice for tax purposes is taking the value of the newly issued shares based on their stock price upon vesting. The calculation of RSU value determines your ordinary income, which will be taxed that year. When you later sell the stock in the market, your taxation is at the capital gains rate on any appreciation.

A Few Drawbacks

While you don’t pay for the RSU’s, you will be liable for taxes at a higher tax rate. If RSU’s were issued when the company is private and remains so, you can’t sell your shares, even if vested, to cover the taxes. RSUs are less liquid if the company remains private. You would need to consult with someone familiar with selling private shares, such as on the NASDAQ Private Market or Yieldstreet. Even so, this avenue is not likely to provide much in the way of liquidity.

Having RSUs from a private company going public will enhance your liquidity, and if vested, you might benefit from the initial public offering. However, if the IPO occurs when your shares are not yet vested, you may not reap the benefit.

 

4. Employee Stock Options (ESOs)

Many employers grant stock options to attract and retain select employees, particularly in start-ups or fast-growing companies. If you are among those employees at the company’s early formation, you may be in an enviable position to benefit from a potential public offering. A potential windfall may be within your grasp and part of the high risk/ high reward benefit when working for a start-up.

How ESOs Work

An employee stock option is a gift similar to receiving a bonus from the company. The employee is not purchasing the option but may benefit from the appreciation of their employer’s stock. Employers are not giving the employee the stock directly. Instead, employers are offering employees call options. The employee has the right and opportunity to buy the stock at the exercise price for a specified period.

The grant of options will tell you what kind of stock options you get, how many shares it represents, and your exercise or strike price. For terminology’s sake, the exercise or strike price is the price you can buy the underlying stock. If the company’s stock rises above the exercise or strike price. The option is considered “in the money”  and, if exercised, will be profitable.

An Example

Let’s say you had options to buy 1,000 shares of your employer’s stock at the exercise price of $25. If that stock rises to $35 a share, the options are worth $10 a share in the money. If you exercised the option and sold the shares simultaneously at $35, you would realize a pretax income of $10,000 (option for 1,000 X $10 per share). Of course, the stock could fall to $15, meaning the option is “out of the money” or “underwater.” The options would have no intrinsic value and would make no sense to exercise.

Vesting

There usually is a vesting schedule that tells when you are allowed to exercise your shares and not before that time. Usually, it is at least a year before your options are fully vested and exercised. The company wants to retain you, so the grant is incenting you to stay for a certain amount of time. If you leave before the vesting period, your option is worthless and doesn’t travel with you.

Different Tax Treatment Depending On Type Of Option

There are two main types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). They are taxed differently. NSOs are considered more advantageous from the company’s perspective and are more common. The option holder usually has to pay taxes when you exercise the option and sell the shares.

On the other hand, ISOs qualify for special tax treatment if you hold onto the shares for the required time. The specified time for favorable tax treatment is at least one year after exercising and two years after your grant date. If you meet that requirement, you may only have to pay taxes when you sell the shares. The tax treatment is a bit complex, and you can read more about it here though consulting a tax expert on options is a good idea.

Drawbacks

ESOs are great to receive from your company. However, unlike the other plans, you may not realize value if your strike or exercise price remains above the share price. As such, stock options on their own are difficult to value. Tax treatment is involved and the burden is notably more difficult on the NSOs, which are more common.

Final Thoughts

Increasingly, an equity compensation plan is a valuable part of your company’s benefits. Prospective employees often seek an equity compensation plan as an incentive to work at the company. We examined four of the most common plans–ESOPs, ESPPs, and RSUs–which vary in how they work, how employees can benefit, and respective drawbacks. All are potentially valuable, and if offered, you are fortunate to get this opportunity. You should consult with your professional as taxation, and other provisions are pretty complex.

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