What Is a Stock Plan? Types, Lifecycle, and Taxes

Stock plans are a form of employee compensation that allow employees to own a part of their company and share in its growth. They align employee interests with business success. Offering a stake motivates employees and fosters shared purpose. They are a component of compensation packages.

Companies use stock plans to attract, retain, and reward talent. These arrangements provide employees an opportunity to benefit financially from the company’s long-term performance. Structures vary, but the goal is to link employee contributions and shareholder value.

Fundamental Concepts of Stock Plans

Several core terms apply to stock plans. A “grant” is the initial award, where the company communicates terms to an employee. It specifies the number of shares or options. The “grant date” marks the official beginning of the award period.

“Vesting” is when an employee gains full ownership rights to their stock award. Before vesting, employees cannot sell or control the shares or options. Vesting schedules are structured in two ways: “cliff vesting” and “graded vesting.”

Under “cliff vesting,” an employee gains full ownership of the entire award on a single, predetermined date, often after one year. If employment terminates early, the employee forfeits the unvested award. In contrast, “graded vesting” allows employees to gain ownership of a portion incrementally over several years. For example, an employee might vest in 25% each year over four years.

For stock options, “exercise” is purchasing company stock at a predetermined price. This “strike price” or “grant price” is set when the option is granted. The “fair market value (FMV)” represents the current trading price of the stock. The difference between FMV and strike price at exercise can be a gain.

Common Types of Stock Plans

Companies offer various types of stock plans with distinct features. Two forms of stock options are Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). Both grant the right to purchase company stock at a fixed price, but differ in tax treatment and regulations.

Stock Options

Non-Qualified Stock Options (NSOs) are flexible and can be granted to a broader range of individuals. No specific holding period requirements exist for NSOs before exercise.

In contrast, Incentive Stock Options (ISOs) are subject to Internal Revenue Code rules. ISOs can only be granted to employees and must meet certain criteria, such as specific exercise periods.

Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) represent a promise to deliver shares or cash equivalent at a future date, typically upon vesting. Employees do not own shares until vesting conditions are met. During the restricted period, employees usually lack voting rights, though some plans may pay dividend equivalents.

Once RSUs vest, shares are delivered. RSUs retain employees, as their value is realized upon vesting without requiring purchase.

Employee Stock Purchase Plans (ESPPs)

Employee Stock Purchase Plans (ESPPs) allow employees to purchase company stock, often at a discount, through payroll deductions. These plans involve an “offering period” for contributions and a “purchase period” when shares are bought. Discounts range from 5% to 15% off the stock’s market price.

Many ESPPs include a “look-back provision,” allowing the purchase price to be based on the lower of the stock’s price at the beginning or end of the offering period. This feature provides an advantage. Employees enroll, contribute funds over a set period, and purchase shares regularly.

The Lifecycle of Stock Plan Awards

Stock plan awards follow a sequence from grant to sale. The first stage is the “grant phase,” where the company awards stock options or restricted stock units to an employee. On the grant date, terms are established, including shares/options, strike price, and vesting schedule.

Following the grant, the award enters the “vesting phase.” This period requires the employee to satisfy specific conditions, usually continued employment, to gain full rights. During this time, the employee cannot fully own the stock or exercise options. Vesting schedules can span several years, encouraging retention.

Once vesting conditions are met, the award moves into the “exercise/settlement phase.” For stock options, this involves the employee “exercising” options, purchasing company stock at the predetermined strike price. This converts the option into shares. For Restricted Stock Units (RSUs), this phase is “settlement,” where the company delivers shares after vesting.

After shares are acquired, the award enters the “holding/sale phase.” The employee owns the shares and can hold or sell them. Company policies or regulations may dictate when shares can be sold. Employees consider market conditions and financial goals when deciding to hold or sell.

Basic Tax Implications

Stock plan taxation involves two main income types: ordinary income and capital gains. Ordinary income is taxed at an individual’s marginal rate, similar to wages. Capital gains arise from selling an asset, like stock, above its cost basis.

Non-Qualified Stock Options (NSOs)

For NSOs, the difference between the stock’s fair market value and strike price at exercise is ordinary income. This income is subject to federal income, social security, and Medicare taxes. Any subsequent gain or loss from selling shares is a capital gain or loss, depending on the holding period.

Incentive Stock Options (ISOs)

ISOs have different tax treatment. For regular tax purposes, no ordinary income is recognized at exercise. However, the difference between fair market value and strike price at exercise may be an Alternative Minimum Tax (AMT) adjustment. If ISO shares are held for at least two years from grant date and one year from exercise date, profit upon sale is a long-term capital gain.

Restricted Stock Units (RSUs)

RSUs are taxed when they vest and shares are delivered. The fair market value of shares on the vesting date is ordinary income, subject to income and payroll taxes. Any subsequent gain or loss from selling vested shares is a capital gain or loss.

Employee Stock Purchase Plans (ESPPs)

ESPPs have specific tax considerations. When ESPP shares are sold, tax treatment depends on the holding period. If shares are sold after holding for at least two years from the offering date and one year from the purchase date, a portion of the discount may be ordinary income, and additional profit is a long-term capital gain. If these holding period requirements are not met, more of the gain may be ordinary income.