Equity Compensation: A Glossary

Equity compensation can be a key part of your total financial picture. But there are a number of terms particular to this benefit that can be unfamiliar even to experienced investors. To get the most from your company equity, it helps to gain an understanding of these key concepts. 

To Start, What Exactly Is Equity Compensation?

Equity compensation can include many types of compensation arrangements, but it usually means a non-cash payment, generally in the form of company stock or other company ownership interest, that can be part of an employee’s total compensation package. It can also include awards that are based on the value of company stock, but that are paid out in cash. It allows employees to benefit from the growth in the value of the company and can motivate employees to be invested in one another’s success.

Terms to Know

Following are some common terms associated with equity compensation. Keep in mind, details can vary from company to company. Please consult your employer’s plan documents for the specifics of your benefit.

• Automated clearing house (ACH) – An automated clearing house is an electronic network that facilitates transactions—direct deposits and direct payments—between participating financial institutions.

 

• Capital gains tax – Capital gains tax is a tax on the profit made from the sale of an investment, such as shares of a stock. The amount of time the asset was held before the sale will impact how the gains are taxed: short-term capital gains tax is used when the asset was held for one year or less, and long-term capital gains tax is used when the asset was held for longer than one year. In general, the long-term capital gains tax rate tends to be lower than the short-term capital gains tax rate. State and local taxes on capital gains may also apply.

 

• Cash-settled stock appreciation rights (CSARs) – Cash-settled stock appreciation rights are stock appreciation rights (as defined below) that pay out in cash upon exercise, rather than shares of stock.

 

• Disqualifying disposition – A disqualifying disposition is the sale, transfer or exchange of stock that occurs before meeting the holding-period requirements—more than two years after the stock was granted and more than one year after it was exercised. A disqualifying disposition is a taxable event, and the difference between the purchase price of the stock and the fair market value at the time of purchase is taxed as ordinary income and reported as compensation on Form W-2. 

 

• Dividend – A dividend is the distribution of company earnings to eligible shareholders. Dividends are often paid at a set frequency—such as monthly or quarterly—and they can be in the form of cash or additional stock. Dividends are taxed at the ordinary income rate, unless they are considered “qualified” dividends, which are taxed at the long-term capital gains rate.

 

• Employee stock purchase plans (ESPPs) – An employee stock purchase plan allows you to purchase shares of your company’s stock through payroll deductions, usually at a discounted rate. Once you have enrolled in the plan, your company will typically collect your payroll contributions to purchase shares on a specific date, and the shares are then deposited into an account.

 

• Exercise – Exercising options means buying shares of company stock at the price set by the option within a fixed period of time. Prior to exercising, options don’t convey an ownership right in shares of the company. Options are often subject to vesting requirements and cannot be exercised until the vesting period is complete.

 

• Expiration date – Options have an expiration date and cannot be exercised after such date. This date can be found in the company plan documents. Options typically expire 10 years after the grant date or, for an employee who has left the company, 90 days after the termination of employment.

 

• Fair market value (FMV) – Fair market value is the value of a share of stock on the open market (or, in the case of a private company, what the value would be if the stock were available to trade on the open market).

 

• Grant – A grant is another term for an award of equity compensation, and the grant date is the date on which the award is considered made. 

 

• Incentive stock options (ISOs) – Incentive stock options offer a federal tax incentive and are typically granted only to U.S. taxpayers. They have the following characteristics:
  • ISOs can receive preferential tax treatment under the Internal Revenue Code. If the shares are not sold for more than one year from the date of exercise and more than two years from the date of grant, any gain at sale will be taxed as a capital gain rather than ordinary income. If shares are sold prior to the required holding period, the sale will be deemed a disqualifying disposition and treated for tax purposes as an NQSO.

   

  • Typically, no U.S. federal income and payroll taxes are due when ISOs are granted.

   

  • When ISOs are exercised, no federal income taxes are due, but the spread is a tax adjustment item for purposes of calculating the alternative minimum tax. ISOs are not subject to payroll tax withholding.

   

 

• Issue date – The issue date is the date that you receive your options or other equity compensation, also referred to as the grant date.

 

• Market price – The market price is the price of one share of company stock, at that specific moment in time.

 

• Non-qualified stock options (NQSOs) – Non-qualified stock options have the following characteristics for U.S. taxpayers:
  • Typically, no U.S. federal income tax or payroll tax is due when income is recognized, and no taxes are due when NQSOs are granted.

   

  • When NQSQs are exercised, the difference between the fair market value (FMV) on the exercise date and the exercise price (the “spread”) is reported as federal ordinary income on your Form W-2 in the year of exercise.

   

  • Federal income and payroll taxes are withheld at the time of exercise on the spread and reported on your Form W-2 in the year of exercise.

   

  • When you sell shares you purchased from an NQSO exercise, if the sale price is higher (or lower) than the FMV at exercise, you will have a federal capital gain (or loss).

   

  • State and local taxes may apply.

   

 

• Qualifying disposition – A qualifying disposition is the sale, transfer or exchange of stock that occurs more than two years after the stock was granted and more than one year after it was exercised. Meeting these two holding periods qualifies the sale or transfer for favorable federal tax treatment. You may have both ordinary income and capital gain when you dispose of your shares.

 

• Restricted stock awards (RSAs) – A restricted stock award is an award of shares of company stock that is subject to transfer restrictions and a substantial risk of forfeiture until certain vesting conditions are met. Restricted stock awards are subject to transfer restrictions, and you may not transfer, sell or otherwise dispose of the shares until they are no longer subject to transfer restrictions (typically, when a vesting event occurs). They are also subject to a substantial risk of forfeiture until certain vesting targets are met, such as employment length or stock performance.

 

• Restricted stock units (RSUs) – A restricted stock unit is a promise to deliver shares of company stock to the holder on a specified event or date. Generally, an award of restricted stock units entitles you to stock or cash (with a value equal to the number of units awarded) upon vest. RSUs may include a right to receive dividend equivalents; RSUs that have vested and been converted to shares may receive dividend payments.

 

• Stock appreciation rights (SARs) – Stock appreciation rights entitle you to exercise a right to receive a payment in cash or shares of a value equal to the appreciation in the company’s stock from the date of grant to the date of exercise. Similar to stock options, SARs gain value if your company’s stock rises. However, unlike with stock options, you are not required to pay an exercise price. SARs usually have a specific term during which they can be exercised and after which they expire.

 

• Stock options – A stock option is the right, but not the obligation, to purchase a company's stock at a fixed price during a fixed period of time. When the company’s stock price rises above the grant or exercise price, the award is “in the money.” When the stock price drops below the grant or exercise price, the award is “underwater” and may not be worth exercising. The primary difference between the two types of stock options—non-qualified stock options and incentive stock options—lies in their federal tax treatment.

 

• Strike price/exercise price/grant price – The strike price of a stock option, also known as the exercise price or grant price, is the predetermined price at which you are able to purchase one share of your company’s stock. This is typically the fair market value of the stock on the day the option is granted, but your plan documents will provide details applicable to your awards.

 

• Vesting period – The vesting period is the required period of time before your equity awards are no longer subject to substantial risk of forfeiture and, in the case of options and stock appreciation rights, the period of time before your options or stock appreciation rights can be exercised. Vesting criteria may be time and/or performance-based and vary depending on the details of each company’s plan(s).

 

• Vesting schedule – Many equity compensation plans include multiple vesting events, which are described in a vesting schedule.

 

The Bottom Line

The language of equity compensation can be complex, but taking the time to understand your benefit may unlock a number of financial possibilities. If you have questions about your equity compensation plan and how it can help you meet your goals, consult your company’s plan documents and consider enlisting the help of a professional, such as a Financial Advisor or tax advisor.