What Is Equity Based Compensation and How Does It Work?

Equity-based compensation represents a non-cash form of remuneration that grants employees an ownership interest in the company. This compensation method serves to align the interests of employees with the long-term success and growth of the business. By providing a stake in the company, employees are motivated to contribute to its overall performance and value.

This form of compensation has become increasingly common across various industries, supplementing traditional salaries and bonuses. Companies, particularly startups and high-growth firms, use equity to attract and retain talent, especially when cash resources might be limited. The underlying principle is to foster a sense of shared ownership and incentivize employees to work towards collective financial goals.

Core Elements of Equity Compensation

Equity compensation provides employees with a future ownership stake or a right to acquire shares. Awards include specific terms dictating how and when value can be realized.

The “grant date” is when an employee is awarded equity compensation. This date establishes the starting point for conditions that must be met before the equity is realized, and a period begins during which the employee earns their awarded shares or rights.

“Vesting” is the process by which an employee gains full ownership or the right to exercise their equity award. Until vested, awards are typically forfeited if the employee leaves, encouraging retention and long-term commitment.

Common vesting schedules include:
Time-based vesting: A portion of the award vests by remaining employed for a specified duration, such as 25% each year over four years.
Cliff vesting: Requires completing an initial, uninterrupted service period, often one year, before any portion vests, with the remainder typically vesting monthly or quarterly thereafter.
Graded vesting: Allows a specific percentage of the award to vest at regular intervals, providing gradual accumulation of ownership.
Performance-based vesting: Ties vesting to specific company or individual performance metrics, such as revenue targets or project completion, directly linking compensation to strategic objectives.

For stock options, the “exercise price” (or strike price) is the predetermined price at which an employee can purchase vested shares. This price is typically the stock’s fair market value on the grant date. The difference between the market price at exercise and the exercise price is the option’s intrinsic value.

“Fair Market Value” (FMV) refers to the current market price of the company’s stock, a crucial factor in valuing equity awards at grant, vesting, or exercise. For publicly traded companies, FMV is generally the closing price on a given trading day. For private companies, FMV is determined through periodic valuations by independent third parties.

Equity compensation impacts the company’s share structure. Granted or exercised awards affect “shares outstanding,” which are shares held by all shareholders. “Fully diluted shares” include all outstanding shares plus shares from convertible securities and exercisable options, providing a comprehensive view of total potential ownership.

Different Forms of Equity Compensation

Equity compensation comes in various forms, each with distinct operational mechanics. Understanding how each type is granted, vests, and converts into value or shares helps employees assess potential benefits. These forms offer different structures for employees to gain ownership or a financial benefit tied to the company’s stock price.

Stock Options

Stock options give an employee the right, but not the obligation, to purchase company shares at a predetermined exercise price within a certain timeframe. Their value becomes apparent if the stock price increases above the exercise price. If the stock price falls below the exercise price, options are “out-of-the-money” and may expire worthless.

Incentive Stock Options (ISOs)

Incentive Stock Options (ISOs) are a specific type of stock option that can offer potentially favorable tax treatment compared to other options. ISOs are granted with an exercise price typically equal to the fair market value of the stock on the grant date. They usually come with a vesting schedule, meaning the employee must remain with the company for a certain period before they can exercise the options.

Once vested, an employee can exercise ISOs, purchasing shares at the exercise price. ISOs must meet specific Internal Revenue Code requirements for special tax treatment, including limits on exercisable value. Shares acquired through ISO exercise can generally be held for future sale, with their value tied to company stock performance.

Non-Qualified Stock Options (NSOs)

Non-Qualified Stock Options (NSOs) are more flexible than ISOs and do not have the same strict IRS requirements. Like ISOs, NSOs grant the right to purchase company stock at a fixed exercise price after a vesting period. The exercise price is typically set at the fair market value on the grant date, but it can sometimes be set lower or higher.

Upon vesting, an employee can exercise NSOs, buying shares at the exercise price. NSOs have broader applicability and fewer company restrictions than ISOs. Unlike ISOs, there are no specific limits on the value of NSOs that can be granted or become exercisable in a year.

Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) represent a company’s promise to deliver shares to an employee at a future date. Unlike stock options, RSUs do not require share purchase. Instead, they are granted as units that convert into actual shares upon vesting.

RSUs are subject to a vesting schedule, which is typically time-based, such as four years with a one-year cliff. Once vested, the RSU units are settled, meaning the company transfers the actual shares to the employee’s brokerage account. The value an employee receives from RSUs is directly tied to the fair market value of the company’s stock at the time of vesting.

Restricted Stock Awards (RSAs)

Restricted Stock Awards (RSAs) involve the actual grant of company shares to an employee at the time of the award, rather than a promise of future shares. However, these shares are subject to certain restrictions, typically a vesting schedule, during which the shares cannot be sold or transferred. If the employee leaves the company before the vesting period is complete, the unvested shares are usually forfeited back to the company.

With RSAs, the employee becomes a shareholder from the grant date, potentially having voting rights and receiving dividends on restricted shares, unlike RSU holders. Upon vesting, restrictions lapse, and the employee gains full ownership.

Employee Stock Purchase Plans (ESPPs)

Employee Stock Purchase Plans (ESPPs) allow employees to purchase company stock, often at a discounted price, through regular payroll deductions. Employees typically enroll in an offering period, which can last from three to 24 months, during which their contributions accumulate. At the end of the offering period, the accumulated funds are used to purchase company stock.

ESPPs commonly offer a stock price discount, often 5% to 15% of fair market value. Some plans include a “look-back” provision, basing the purchase price on the lower of the stock’s fair market value at the beginning or end of the offering period to maximize employee benefit. Shares purchased through an ESPP are immediately owned by the employee.

Stock Appreciation Rights (SARs)

Stock Appreciation Rights (SARs) give an employee the right to receive a payment, in cash or company stock, equal to the stock’s appreciation over a set period. Unlike stock options, SARs do not require share purchase or an exercise price. The employee receives the difference between the stock’s fair market value on the exercise date and a predetermined base price.

SARs typically vest over time, similar to stock options or RSUs. Once vested, the employee can “exercise” them, triggering payment of the appreciated value. This allows employees to benefit from stock price increases without an upfront investment or direct ownership of underlying shares.

Phantom Stock

Phantom stock plans are a deferred compensation form mimicking actual company stock value. Employees are granted “phantom” shares that track real stock value. No actual shares are issued; instead, phantom share value increases or decreases with the company’s stock price.

Upon a specified future date or event, such as vesting or a liquidity event, the employee receives a cash payment equal to their phantom shares’ value. This allows employees to participate in stock appreciation without diluting existing shareholders or requiring new share issuance. Phantom stock is often used by private companies without publicly traded stock.

Taxation of Equity Compensation

Understanding the tax implications of equity compensation is important, as different forms are taxed at various stages and rates. The key distinction is between ordinary income and capital gains, both triggered by equity awards. An event creating a taxable gain is a “taxable event.”

Ordinary income is generally taxed at an individual’s marginal income tax rate, which can be as high as 37% for the highest earners, plus Medicare and Social Security taxes, where applicable. Capital gains, on the other hand, are typically taxed at lower rates, depending on whether they are short-term (assets held for one year or less, taxed as ordinary income) or long-term (assets held for more than one year, taxed at preferential rates, such as 0%, 15%, or 20% for most taxpayers). The timing of these taxable events—whether at grant, vesting, exercise, or sale—significantly impacts the overall tax burden.

Non-Qualified Stock Options (NSOs)

NSOs are taxed primarily at two points: exercise and sale. At exercise, the difference between the stock’s fair market value on the exercise date and the exercise price is taxed as ordinary income. This “bargain element” or “spread” is subject to federal, Social Security, Medicare, and applicable state and local taxes.

Companies typically withhold these taxes at exercise by selling shares or requiring a cash payment. The employee’s cost basis for acquired shares is the sum of the exercise price paid and the ordinary income recognized. Upon subsequent sale, any gain or loss is treated as a capital gain or loss, short-term if sold within one year of exercise, long-term if held longer.

Incentive Stock Options (ISOs)

ISOs offer a unique, potentially more favorable tax treatment than NSOs, but with specific rules. Generally, no regular income tax is due at grant or exercise, a primary benefit. However, the bargain element at exercise (difference between fair market value and exercise price) is an adjustment for Alternative Minimum Tax (AMT) purposes.

This AMT adjustment means a taxpayer might owe AMT if their total income, including this adjustment, exceeds certain thresholds. To qualify for preferential long-term capital gains treatment, ISO shares must be held for at least two years from the grant date and one year from the exercise date. If these holding periods are met, any gain upon sale is taxed as a long-term capital gain, calculated as the difference between sale price and exercise price.

A “disqualifying disposition” occurs if ISO shares are sold before meeting both holding period requirements. In such cases, the difference between fair market value at exercise and exercise price becomes taxable as ordinary income in the year of sale, up to the actual gain realized. Any remaining gain or loss is treated as a capital gain or loss, which can result in a less favorable tax outcome by reclassifying a portion of the gain from capital gain to ordinary income.

Restricted Stock Units (RSUs)

RSUs are taxed when they vest, not at grant. Upon vesting, the fair market value of received shares is recognized as ordinary income. This amount is subject to federal, Social Security, Medicare, and applicable state and local taxes.

Companies typically withhold taxes at vesting by selling shares or requiring a cash payment. The employee’s cost basis for received shares is the fair market value recognized as income at vesting. Any subsequent gain or loss upon sale is treated as a capital gain or loss, depending on the holding period from the vesting date.

Restricted Stock Awards (RSAs)

Restricted Stock Awards (RSAs) are generally taxed when the restrictions lapse, which is typically at vesting. At this point, the fair market value of the shares is recognized as ordinary income, subject to regular income tax, Social Security, and Medicare taxes, similar to RSUs. However, RSAs offer a unique tax planning opportunity through an 83(b) election.

An 83(b) election allows an employee to choose to be taxed on the fair market value of the restricted stock at the time of grant, rather than at vesting. This election must be made within 30 days of the grant date. If the election is made, the employee pays ordinary income tax on the fair market value of the shares at grant, which is often very low, especially in early-stage companies. No further ordinary income tax is due when the shares vest.

By making an 83(b) election, future appreciation from the grant date until sale is treated as a capital gain, not partially taxed as ordinary income at vesting. This can be advantageous if the stock is expected to appreciate significantly. However, if the stock declines or is forfeited before vesting, the employee cannot recover taxes paid on the initial ordinary income.

Employee Stock Purchase Plans (ESPPs)

ESPPs have specific tax rules for the discount received and subsequent share sale. The purchase price discount is generally taxed as ordinary income. If shares are sold after meeting holding period requirements (two years from offering date, one year from purchase date), the discount is taxed as ordinary income in the year of sale. Any additional gain above the fair market value on the purchase date is taxed as a long-term capital gain.

If shares are sold before meeting holding period requirements (a disqualifying disposition), the ordinary income component is the lesser of the actual gain on sale or the discount amount, recognized in the year of sale. Any remaining gain or loss is treated as a capital gain or loss. Complexity often arises from calculating ordinary income and capital gains, especially with look-back provisions.

Stock Appreciation Rights (SARs)

SARs are taxed when exercised. At exercise, the value received (cash or company stock) is taxed as ordinary income. This amount equals the difference between the stock’s fair market value on the exercise date and the SAR’s predetermined base price. This ordinary income is subject to federal, Social Security, and Medicare taxes.

If payout is in company stock, the employee’s cost basis for those shares is the fair market value on the exercise date. Any subsequent gain or loss upon sale is treated as a capital gain or loss, depending on the holding period from the exercise date. SARs generally do not involve an upfront employee investment, making taxation straightforward at value realization.

Phantom Stock

Phantom stock plans are taxed when the cash payout is received. The entire payout, typically based on “phantom” share appreciation, is taxed as ordinary income in the year of receipt. This income is subject to federal, Social Security, and Medicare taxes.

Since phantom stock does not involve actual share issuance, there are no capital gains implications from stock sale. Taxation is deferred until payment, aligning with the deferred compensation nature of these plans.

Reporting

Income and gains from equity compensation are reported on various tax forms. Ordinary income from NSOs, RSUs, RSAs (without an 83(b) election), SARs, and phantom stock is typically reported on an employee’s Form W-2. For shares acquired through ISOs, NSOs, RSUs, RSAs, or ESPPs and subsequently sold, proceeds and cost basis are usually reported on Form 1099-B, issued by the brokerage firm. This information helps taxpayers calculate and report capital gains or losses on Schedule D of Form 1040.

Taxation of Equity Compensation

By making an 83(b) election, any future appreciation in the stock’s value from the grant date until sale is treated as a capital gain, rather than being partially taxed as ordinary income at vesting. This can be advantageous if the stock is expected to appreciate significantly. However, if the stock declines in value or is forfeited before vesting, the employee cannot recover the taxes paid on the initial ordinary income.

Employee Stock Purchase Plans (ESPPs)

Employee Stock Purchase Plans (ESPPs) have specific tax rules related to the discount received and the subsequent sale of shares. The discount on the purchase price is generally taxed as ordinary income. If the shares are sold after meeting certain holding period requirements (two years from the offering date and one year from the purchase date), the discount is taxed as ordinary income in the year of sale. Any additional gain above the fair market value on the purchase date is taxed as a long-term capital gain.

If the shares are sold before meeting these holding period requirements (a disqualifying disposition), the ordinary income component is the lesser of the actual gain on sale or the discount amount, and it is recognized in the year of sale. Any remaining gain or loss is treated as a capital gain or loss. The complexity often arises from the calculation of the ordinary income and capital gains components, especially with look-back provisions.

Stock Appreciation Rights (SARs)

Stock Appreciation Rights (SARs) are taxed when they are exercised. At the time of exercise, the value received, whether in cash or company stock, is taxed as ordinary income. This amount is equal to the difference between the fair market value of the stock on the exercise date and the predetermined base price of the SAR. This ordinary income is subject to federal income tax, Social Security, and Medicare taxes.

If the payout is in the form of company stock, the employee’s cost basis for those shares is the fair market value on the exercise date. Any subsequent gain or loss upon the sale of these shares will be treated as a capital gain or loss, depending on the holding period from the exercise date. SARs generally do not involve an upfront investment from the employee, making their taxation straightforward at the point of value realization.

Phantom Stock

Phantom stock plans are a form of deferred compensation that mimics the value of actual company stock. Employees are granted “phantom” shares, which track the value of the company’s real stock. However, no actual shares are issued to the employee. Instead, the value of the phantom shares increases or decreases with the company’s stock price.

Upon a specified future date or event, such as vesting or a company liquidity event, the employee receives a cash payment equal to the value of their phantom shares. This structure allows employees to participate in the appreciation of the company’s stock without diluting existing shareholders or requiring the company to issue additional shares. Phantom stock is often used by private companies that do not have publicly traded stock.

Reporting

The income and gains from equity compensation are reported on various tax forms. Ordinary income recognized from NSOs, RSUs, RSAs (without an 83(b) election), SARs, and phantom stock is typically reported on an employee’s Form W-2, Wage and Tax Statement. For shares acquired through ISOs or NSOs and subsequently sold, or for shares from RSUs, RSAs, or ESPPs that are sold, the proceeds and cost basis are usually reported on Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, issued by the brokerage firm. This information helps the taxpayer accurately calculate and report their capital gains or losses on Schedule D, Capital Gains and Losses, of Form 1040.