Executive Compensation: What is the tax picture?

Depending upon the role and sector, more than three-quarters of senior executive compensation tends to be paid in equity.

That weighting brings with it the potential for significant financial windfalls, depending upon the conditions attached and type of equity involved, but it is important for both parties – company and executives – to also be aware of the tax implications of whatever is being proposed when negotiating compensation packages.

Here, we look at a selection of the most frequently used types of executive equity compensation, how they tend to work in practice, and how the tax scenario typically plays out with each.

Incentive stock options (ISOs)

With ISOs, the holder has the right to purchase company stock at a pre-determined strike price, with that price usually set close to the fair market value (FMV) of shares at the time the options are granted. Typically, ISO grants come with vesting conditions attached. Recipients earn the right to purchase shares either gradually over time (graded vesting), or all at once after a specified number of years (cliff vesting). Whatever the vesting schedule attached to the award, once the options vest, the holder is then free to purchase the relevant shares at the agreed price. Ideally, the value of shares will have increased between the grant date and the vesting moment. The recipient isn’t obliged to purchase the shares immediately upon vesting. Usually, ISOs remain valid for 10 years, so, in theory, a recipient can choose to exercise their options at any time between vesting and that cut-off point.

Depending upon how the scenario plays out, there may be no tax implications for the individual until the shares are eventually sold (i.e., no liability at grant, vesting, or exercise). The only potential tax liability prior to sale will arise in the event that the FMV exceeds the strike price at the time that the options are exercised. In that instance, the individual may face an alternative minimum tax (AMT) bill, based upon the difference between those two values.

More information on how AMT can impact upon ISOs is available here.

When shares are eventually sold, the funds raised in that transaction may be taxed in a favorable manner. When shares are held for a) more than two years after the initial grant and b) more than one year after the exercise date, the subsequent sale will be treated as a long-term capital gain. If these terms are not adhered to, income generated will be taxed at the less favorable ordinary capital gain rate, and the difference between the strike price and the FMV at exercise will be taxed as ordinary income.

Non-qualified stock options (NSOs)

NSOs are similar to ISOs in many respects, e.g., pre-determined exercise price, vesting schedule, and 10-year exercise window before the options expire. However, a key difference between the two relates to how and when they are taxed.

Specifically, whereas ISO holders only face the prospect of AMT on the spread between strike price and FMV at exercise, NSO recipients may be liable for ordinary income tax. In practice, the company will usually withhold the relevant taxes for NSO holders when they exercise their options.

As for the tax implications of selling on shares, that will depend upon the timing of the transaction:

• Exercise and sell immediately: Ordinary income tax on the difference between strike price and FMV.
• Sell within one year of exercising: Short-term capital gains on profit made.
• Hold for at least one year and then sell: Long-term capital gains on profit made.

In practice, individuals with NSOs can likely end up paying more in tax than those granted ISOs.

Restricted stock

Restricted stock is a grant with certain conditions attached. Even though the recipient basically owns the stock from day one, in practice their rights in relation to it are limited until the shares vest.

Vesting conditions typically relate to continuing to remain employed with the company and the passage of time. In the event that those conditions are not met (i.e., the individual leaves the company before a specified period of time has elapsed), the grant may be forfeited.

However, once the vesting conditions are met, then all restrictions are removed, and the individual will have full control over the shares. At that point, they will be free to sell if they wish.

On tax, the default position is that no liability becomes due until the shares vest. The taxable amount of income is assessed based on the difference between the FMV at vesting minus whatever amount the individual paid for the stock at the outset. At that point, tax withholding will be assessed based on the supplementary wage rate (22% up to $1 million and 37% for greater amounts – as of the time of writing, in July 2023) or regular payroll tax.

Once the stock vests, the holding period formally begins. From there, if the stock is held for more than one year, any profit derived from a subsequent sale will be treated as a long-term capital gain.

There is one notable exception to the tax scenario laid out above. If individuals opt to make a Section 83(b) election, they knowingly choose to bring forward the moment of tax liability from exercise to grant. A detailed explanation of Section 83(b) is outside the scope of this article (see more on it here), but the core logic of making the election is that by effectively pre-paying your tax obligations at a time when the stock may have a relatively low valuation (the hope is always that FMV will increase over time), you will give yourself a lower tax bill than if you wait until exercise. It is important to stress that there is no guarantee that it will work out that way. Making the election may pay off, but there is risk involved, in that if the FMV were to decline over time, no tax refund would be forthcoming from the IRS. In that scenario, the individual would lose rather than gain.

Restricted Stock Units (RSUs)

Whereas with restricted stock, a formal grant is made at the outset, an RSU constitutes a promise to award stock at some point in the future (i.e., the vesting date) as long as certain conditions are met, usually related to remaining with the company and/or achieving specified performance goals.

Those goals can relate to company performance, subsidiary/group performance, and/or (in the case of the highest-ranking senior executives) individual performance.

Another key difference is that while a recipient may pay for restricted stock, this will never be the case with RSUs. If an individual satisfies the conditions set down at the outset, the company will then complete the process of assigning that stock to them, thus following through on the initial promise.

On taxation, because no stock is issued at the outset, no Section 83(b) election is allowed. This means that individuals with RSUs become liable for tax at vesting. As with restricted stock, tax withholding is assessed based on the supplementary wage rate or payroll tax. However, the taxable amount at that point will be the FMV of the entire award. This contrasts with how restricted shares are treated, where, when assessing taxable income, whatever an individual pays for the stock upfront is subtracted from the total value at vesting. Arising from this treatment, RSUs may play out less favorably for recipients than restricted shares.

Performance Shares

Performance shares are similar to restricted stock in many respects; however, a key point of distinction is that while with the latter vesting is usually linked to time served with the company, with the former, the number of shares ultimately received by the employee is linked to the company’s overall performance.

A performance shares award is taxed as ordinary income at the point when the shares are delivered to the individual, i.e., when they vest.

As with RSUs, capital gains tax will apply if the eventual sale price of shares exceeds FMV at the time of vesting.

The above are merely some of the most well-known equity compensation plans that companies use to incentivize/reward executives. For information on other approaches or any related topics, feel free to contact Global Shares now and speak to a member of our experienced team

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JPMorgan Chase & Co., its affiliates, and employees do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal and accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any financial transaction.​