Equity Compensation: RSU’s and ESPP’s Explained

Employee stock compensation has emerged as a significant tool for attracting and retaining top-tier talent, particularly within the executive, tech, and director-level jobs. Among the many forms of equity-based compensation, two stand out due to their compelling features and benefits: Restricted Stock Units (RSU’s) and Employee Stock Purchase Plans (ESPP’s). While these can be financially rewarding, they also come with unique features, tax implications, and considerations that every employee should understand.

What Are RSU’s?

Restricted Stock Units (RSU’s) are company shares granted to an employee as part of their equity compensation package. However, these shares are not fully owned or vested until specific conditions, typically time-based, are met.

Key Characteristics of RSU’s

• Vesting Schedule: RSU’s usually vest over a multi-year period, such as in thirds, where a third of the RSU’s vest each year. For example, if granted 900 RSU’s, you might receive 300 shares after each year over three years.
• No Purchase Requirement: Unlike stock options, RSU’s do not require employees to pay to receive them. Once the shares are vested, they are yours to keep or sell.
• Fair Market Value: Upon vesting, RSU’s are treated as income based on the fair market value of the shares on the vesting date. For publicly traded companies, this value is the stock price on that day. For private companies, it is based on the last 409A valuation.

Taxation of RSU’s

• Ordinary Income Tax: At vesting, the fair market value of the shares is treated as ordinary income. They are subject to ordinary income tax and reported on your W-2.
• Capital Gains Tax: If the shares are held beyond the vesting date and later sold, any increase or decrease in value is subject to capital gains tax. Long-term capital gains tax is applicable if the shares are held for more than a year before selling.

Understanding ESPP’s

An Employee Stock Purchase Plan (ESPP) allows employees to buy company stock, often at a discount, through payroll deductions. This form of equity compensation can be classified as qualified, meaning they meet specific IRS rules. If they do not meet IRS rules, they are non-qualified with different tax implications.

Key Characteristics of ESPP’s

1. Purchase Discount: Many ESPP’s offer up to a 15% discount on the stock’s market price.
2. Look-Back Provision: ESPP’s have a defined offering period with an established beginning and end date. The look-back provision allows employees to purchase shares at the lower price, whether it’s the beginning or end date. This becomes advantageous if stock prices rise.
3. Payroll Deductions: Employees contribute a portion of their salary each pay period to accumulate funds for stock purchases. The purchase happens at a defined time, the end of the offering period.

Taxation of ESPP’s

Tax implications depend on whether the ESPP is qualified or non-qualified.

• Qualified ESPP’s: There’s no tax liability at purchase. Upon selling, tax treatment depends on whether it’s a qualifying disposition (held for two years from the offering period start and one year from purchase).
  • In a qualifying disposition, any discount up to 15% is taxed as ordinary income, while additional gains are taxed as long-term capital gains.
  • A disqualifying disposition happens if shares are sold earlier than the required holding period. Subsequently, the discount purchase is taxed as ordinary income and reduces the tax benefits.
• Non-Qualified ESPP’s: There’s no characterization of a disqualifying or qualifying dispositions. The purchase of shares at a discount is taxed as ordinary income at purchase. Any subsequent gains receive capital gains treatment (short-term or long-term).

Key Considerations with RSU’s and ESPP’s

Considerations with RSUs and ESPPs necessitates attention to several factors:

• Cash Flow: For RSU’s, taxes are due at vesting, potentially leading to significant tax liabilities. Employers may offer a “sell-to-cover” option to manage this. Essentially, a portion of the RSU’s are sold to cover tax obligations. For ESPP’s, payroll deductions reduce your take-home pay.
• Diversification: Both RSU’s and ESPP’s can result in a concentrated investment in your employer’s stock, which may not align with a diversified investment strategy.
• Market Volatility: Stock prices can fluctuate, impacting the value of your equity compensation. While a look-back provision in ESPP’s offers some protection, shares purchased at a discount can still lose value.
• Tax Planning: Proper tax planning is essential to avoid unexpected tax bills. Collaborating with a Certified Financial Planner like myself or can help manage taxation effectively and get in front of the tax bill. Some of these strategies could include:
  • Plan for RSU taxes. Do you “sell to cover” or withhold extra through paycheck withholdings.
  • Evaluate the best time to sell ESPP shares.
  • Incorporate tax-efficient strategies, such as tax loss harvesting or charitable giving.
• Company Performance: The financial health and stock performance of your employer directly impact the value of RSU’s and ESPP’s. Stay informed about company developments to make informed decisions about the direction of your firm.

Final Thoughts

While RSU’s and ESPP’s present opportunities for wealth-building, they involve complexities that require thorough understanding and strategic planning. From vesting schedules to tax treatments, grasping these aspects empowers you to make informed decisions that align with your financial goals. Consult with a Certified Financial Planner like myself and coordinate with your tax professional to navigate these details effectively and align your strategies with your financial objectives.