A brief overview of compensation in stock and options.
Table of Contents
Edited November 27, 2023
Equity compensation is a large and somewhat technical subject. It’s helpful to have an overall picture of how it works before getting into gritty details. We divide the subject into four areas summarized below. First, there are key concepts that apply to the entire area. Second, we look at compensation you may have when you acquire restricted stock units (RSUs) from an employer. The third topic is nonqualified stock options, and the fourth is incentive stock options.
It’s worth noting that each topic builds on the previous one to some extent. You can skip around, but you’ll find that the rules for incentive stock options build on the rules for nonqualified options, and those rules build on the rules for acquiring stock from an employer.
The following points are important in connection with all of the subtopics for equity compensation.
- It’s important to know whether your stock is vested, and if not, when it will become vested. The rule here is somewhat technical, but the main idea is that it’s vested when you’ve earned the right to retain the full value of the stock even if your employment terminates.
- Your tax consequences depend on the fair market value of the stock. Generally this is the price at which shares would change hands in a transaction between unrelated persons.
- Equity compensation received by employees may be subject to withholding, which must be paid in cash even if the compensation is in the form of stock or other property.
Special rules apply when you acquire stock from an employer. These rules apply also if you aren’t an employee, but provide services in some other capacity such as a consultant or a member of the board of directors. You need to be familiar with these rules if you receive stock without paying (a stock grant or award), or if you buy stock in connection with your job.
- If the stock is fully vested when you receive it, you have to report compensation income at that time, equal to the value of the stock minus the amount paid for it, if any.
- If the stock isn’t vested, it’s treated as taxable income at the time it vests. You have to report income equal to the value of the stock as of the time it vests.
- There are some tricky rules that can apply when you buy stock from your employer. Sometimes you can end up paying taxes even if you paid full value for the stock when you bought it.
- If you acquire stock that isn’t vested, you have 30 days to make a section 83b election under which the value of the stock is reported as income when you acquired the stock instead of the year it vests. This election can be very beneficial if you paid full value or if the stock is expected to rise in value.
Nonqualified stock options
The nonqualified stock option is a popular form of equity compensation.
- You have nothing to report at the time you receive a nonqualified stock option, or at the time it becomes exercisable.
- When you exercise a nonqualified stock option you report compensation income equal to the difference between the value of the stock you receive and the amount you pay to exercise the option. If you’re an employee, this income is subject to withholding.
- When you sell the stock, you report capital gain or loss. Your basis includes the amount you paid for the stock plus the amount of compensation income you reported at the time of the exercise.
Incentive stock options
If an option granted to an employee meets certain requirements, it’s an incentive stock option, or ISO. These options are available only to employees — you can’t have an ISO if you’re a non-employee director or consultant. They can provide special tax advantages to the option holder, but at the cost of great complexity and some tax disadvantage to the employer.
- You have nothing to report at the time you receive an incentive stock option, or at the time it becomes exercisable.
- You don’t report compensation income when you exercise an incentive stock option. But you must do an alternative minimum tax (AMT) calculation, and may end up paying a significant amount of tax because of that calculation.
- If you sell the stock before a special holding period elapses, you’ve made a disqualifying disposition and must report compensation income at that time.
- If you satisfy the special holding period rule, you’ll report capital gain or loss — no compensation income — when you sell the stock. At that time you may be able to claim a credit for some or all of the AMT you paid in the year you exercised the option.
This summary omits many details that are spelled out in other pages of this online guide and in our books on the subject.