Equity compensation can be one of the most valuable benefits offered by your company, but it’s important to understand how it works—and how it’s taxed. Here’s what you need to know.
One of the keys to successfully building wealth over time is making sure you’re able to retain much of what you earn—and that requires paying attention to the tax impact of all your financial decisions. Among the biggest of those financial decisions is the way that you manage your compensation from work, including—for many—equity awards.
Understanding how equity compensation impacts your taxes is an important step in using that equity to help you meet your financial goals. Anyone who receives equity-based compensation may find it to be one of the most valuable benefits offered by their company, yet also one of the more complex—especially when it comes to how it’s taxed. The type of equity compensation and the length of time you hold the actual shares will impact the tax treatment of your equity compensation, and determine whether you may owe ordinary income tax, alternative minimum tax, and/or capital gains tax (both short- or long-term).
Here’s a high-level overview of the tax implications of your equity-based compensation and which tax forms you’ll need to collect for your annual tax filing.
The first step is knowing what kind of equity compensation you’re dealing with, as that will have an impact come tax time. Here are three common types of equity awards:
- Stock options give employees the right—but not the obligation—to purchase shares at a pre-determined price within a fixed period of time. Stock options typically come in two variations: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs). The difference between ISOs and NQSOs is that you may owe taxes only at sale or at both exercise and sale, so it’s important to know which kind of options you’re receiving as part of your equity compensation.
You typically don’t owe taxes on ISOs when you exercise (purchase) your options, but you generally must include the difference between the exercise price and the fair market value (FMV) at exercise in your alternative minimum tax (AMT) calculation that year. NQSOs are much simpler, since there’s no AMT calculation. For NQSOs, the difference between the exercise price and the FMV of the stock at exercise is taxed as ordinary income. Additional taxes may apply when you sell the shares.
- Restricted Stock Units (RSUs) are a promise from your company to deliver shares to you after your RSUs vest. When your RSUs vest, you’ll owe ordinary income tax on the FMV of the shares delivered to you, and your company will likely withhold applicable taxes at vest/delivery. Additional taxes may apply when you sell the shares.
- Employee Stock Purchase Plans (ESPPs) are an optional benefit that allow you to use after-tax payroll deductions to purchase company stock at a discount. The length of time before you sell your shares matters, as does the value of your shares when you sell them. If you sell your shares more than one year from the date the shares were purchased and two years from the commencement of the offering period, a portion of any gain over the purchase price may be treated as a long-term capital gain. Long-term capital gain is usually taxed at a lower rate than a short-term capital gain, which would apply if you sell your shares in one year or less. If you are planning to sell your shares, be sure to have a plan for exactly which shares you wish to sell based on when you acquired them—this can have a significant impact on the tax treatment of your disposition.
Once you start receiving equity-based compensation, your taxes may get a bit more complicated. If you sell any equity compensation throughout the year, you’ll likely receive a Form 1099-B. You will also need to complete Form 8949 and Schedule D (Form 1040) to report capital gain and loss transactions.
If you exercise an ISO during the year, you’ll also receive a Form 3921. You may receive a Form W-2 if you exercise NQSOs or recognize ordinary income as a result of certain ISO dispositions.
If you receive RSUs, their value at vest/delivery will be reported on your Form W-2 as part of your ordinary income. Finally, if you purchase shares through an ESPP, you’ll also receive a Form 3922 and upon sale of the shares, you may receive a Form W-2.
No matter what type of equity you receive, it’s highly recommended that you work with a professional tax advisor to understand how your equity impacts your tax situation. The tax treatment of equity compensation is complex and may be subject to additional rules and exceptions that are not discussed here. It’s important that you understand the types of taxes you may be subject to when you receive equity, provide the right documents to your tax preparer to submit an accurate annual tax filing, and know how you can use equity value gains (and losses) as part of your winning financial game plan. Learn more about equity compensation and how Morgan Stanley can help.