Tax-Efficient Equity Compensation Planning: Strategies for Maximizing After-tax Returns

Planning and managing your equity ownership is essential to your financial strategy and must be among your top financial objectives.  It will reduce your potential for overfocus and help you save money. You must know how to play the game when you have anything at stake. As a first step, familiarize yourself with the various forms of equity compensation used. 

So, what are the types of equity compensation? Are there any tax implications for equity compensation? We will learn all about them and the benefits of Tax-Efficient strategies for equity compensation in this article.

Tax Efficient Equity Compensation Strategies 

During your career, the equity compensation you get is one of the advantages that contribute to your success. In addition to being compensated for your skills and effort, you will also get an asset to increase your future financial security. However, the value of this perk is contingent on factors other than the growth of your company’s stock. Despite its obvious advantages, equity remuneration may have unintended tax repercussions and make it difficult for employees to grasp their total pay.

Importance Of Maximizing After-Tax Returns

You may gain more in the long run if you split your assets across tax-advantaged and taxable accounts. Consider prioritizing tax-advantaged investments and include taxable accounts in rebalancing only as a last resort. One tax-wise strategy for maintaining a portfolio is to invest in previously under-represented asset types.

Although it would be more advantageous from a tax standpoint to store bonds in tax-advantaged accounts, a desire for income might cause you to keep them in taxable accounts instead. In addition to lowering your tax bill, smart tax-efficient equity compensation strategies may increase your after-tax earnings.     

What is Equity Compensation?

When employees receive equity compensation, they have a vested interest in the company’s financial well-being. Employers like equity pay packages as a means of attracting and retaining top talent because they bring workers’ interests closer to the company’s overall objectives by giving them a stake in the company’s overall success. To understand the best tax-efficient equity compensation strategies, you must know how equity compensation works.

Employees are sometimes awarded equity compensation in addition to their regular salary. They can grant options, restricted stock, or performance shares, giving them a stake in the business. They may also benefit from the company’s growth through appreciation, and vesting requirements can further strengthen the incentive to stay on the job. Pay is sometimes accompanied by equity compensation when set below market rates.

How Does Equity Compensation Work? 

Equity compensation represents a form of remuneration offered by publicly traded entities and privately held firms in their nascent stages. Newly established companies face financial constraints or prioritize the investment of cash flow into expansion endeavors, thereby considering equity compensation as a viable strategy to entice top-tier personnel. Technology enterprises, whether in their early or established stages, have employed equity compensation as a means of incentivizing their workforce.

Types of Equity Compensation 

Equity compensation is a common strategy employers use to incentivize and retain skilled personnel. There can be restrictions on the circumstances based on the types under which you can exercise the option or trade the shares. The following are the most common types of equity compensation.

• Stock Options – Stock options are a kind of equity compensation where an employer grants an employee the right to acquire a certain number of shares of the company’s stock. Employees who have been with the firm for a specific time may eventually become the owners of this option as this right may vest. 
• Non-Qualified Stock Options (NSOs) – NSOs allow workers to purchase shares of business stock at a discounted rate for a limited time. In contrast to ISOs,NSOs require you to pay income and salary taxes on the spread between the selling price and the amount you spend on the shares.
• Incentive Stock Options (ISOs) – Stock options allow workers to purchase shares of their employer’s stock at a predetermined price (the “strike price”) over a certain time frame. Potential income tax benefits are another perk of ISOs that might come into play if the share price increases over the strike price. However, when you eventually decide to sell those shares, you will be subject to capital gains tax. 
• Restricted Stock – Restricted stock units (RSUs) are a commitment to provide you with shares of business stock at a future date at the current market price. Unlike options, RSUs don’t need you to buy the shares before you may sell them for a profit (if the stock price has grown). You can think of them as a future cash bonus. The value of your RSUs is subject to income and payroll taxes, however. 
• Performance Shares- Awards of performance shares are conditional on the achievement of predetermined goals.These include targets for earnings per share (EPS), the return on equity (ROE), and the overall performance of the organization’s stock compared to an index. Typically, performance spans many years.

Tax-Efficient Strategies for Equity Compensation

Only about a third of employees with equity compensation feel confident in knowing how taxes may affect their particular stock plan advantages. So, here are a few tax-efficient equity compensation strategies so you can make informed decisions.

• Planning ahead for tax liabilities- You may receive the right, but not the responsibility, to acquire shares at a predefined price within a certain amount of time when your employer grants stock options. You may have to wait a certain amount of time after receiving stock options before you can buy the shares with the money you’ll get from selling them. One of the most crucial tax-efficient equity compensation strategies for reducing one’s net taxable earnings and tax liability is to time financial transactions for years when one qualifies for a lower tax band due to reduced income.
• Timing the exercise of options or vesting of shares- It might be beneficial to exercise a stock option if the stock’s FMV at the time of exercise is higher than the option’s exercise price. The premium or discount between the fair market value and the value of the exercise price of a stock option is treated as ordinary income for tax purposes. 
• Utilizing tax-deferred accounts (401(k), IRA, etc.)- If you’re unsure of the tax band you’ll be in, it is vital to diversify by tax treatment. One strategy for optimizing retirement savings involves allocating contributions between an account with a taxable brokerage, a tax-deferred IRA or 401(k), and a Roth after-tax account. Using such tax-efficient equity compensation strategies can provide greater flexibility for income management during retirement, irrespective of one’s tax bracket.
• Tax-loss harvesting- Using tax-efficient equity compensation strategies necessitates a reduction in share value. It may seem paradoxical to keep a loss to reduce current tax responsibilities, but “harvesting” unrealized losses on investments will help you do that. You should check with your accounting and financial consultants to be sure the sale you’re planning will qualify for this tax management technique.
• Charitable giving with equity compensation-  Donating shares to charity and lowers your taxed income at the same time. Contributions of appreciated securities to a tax-exempt organization are exempt from capital gains tax. Further, the stock’s FMV may qualify as a tax deduction for you.
• Estate planning with equity compensation- Estate planning issues and philanthropic intent  play a substantial role in your portfolio planning. If you’re thinking about leaving stocks to your heirs, stocks in taxable accounts are generally preferable. That’s because the cost is calculated based on the market value at the time of death (rather than at the time they were originally acquired, when they may have been worth substantially less).

Examples of Tax-Efficient Equity Compensation Planning Strategies in action;

Let’s imagine an investor who works the ranks of a big retail chain and amasses a substantial stake in the firm. At age 60, when the share price reaches $30, she plans to retire. Some years later, the share price fell to $10 due to the company’s inability to react to the rise of online shopping and the unexpected exit of a long-time CEO. She stands to lose a portion of her fortune as a result of the abrupt shift. 

Concentrated stock investments can have hazards, and they are not confined to financial loss even though this hypothetical situation seems excessive. When selling a stock that has performed well, the investor may be subject to significant income tax obligations because of the gain or loss in value from the purchase price to the selling price.

Fortunately, you may easily move out of a tight holding while minimizing the tax impact by using tax-efficient equity compensation strategies. 

• Scenario I (Tax- Loss Harvesting) – To minimize the federal income tax owed on profits from a consolidated stock or securities the investor uses tax-loss harvesting using independently managed accounts. The investor may “harvest” unrealized losses on investments from the net capital gains on the exchange of consolidated shares or securities from a different account, possibly lowering the investor’s federal income tax burden. 
• Scenario II (Donating funds to charity) – By donating to a pooled income fund, you will invest your funds alongside other donors’ funds. When you set up a charitable remainder trust, you or the person you name will get an income for life from the money you donate. The cash value of the leftover interest may be deducted from federal income taxes right away.

Benefits of Tax-Efficient Strategies for Equity Compensation

Having tax-efficient equity compensation strategies in place is an important requirement to establish your financial planning. There are several benefits associated with doing so as the following.

• Minimizing Taxes-
• Maximizing Wealth Accumulation
• Reducing Risk
• Flexibility and Control

Considerations for Implementing Tax-Efficient Strategies

To maximize the value of your stock, you need to consider a number of factors including taxes, and this may be difficult for even the most competent investors. The goal is to include equity pay into a comprehensive budget. Here are a few considerations you must have before implementing tax-efficient equity compensation strategies.

• Risks and Limitations- Any holdings in a single stock are fraught with unwarranted danger. The majority of businesses fail to meet or exceed market performance. 40% of equities experience a 70% or more from their peak value. Your tax-efficient equity compensation strategies should consider this because so much of your wealth depends on one single enterprise, and the potential for loss is magnified.
• Impact on Financial Planning- Consider how your stock compensation will affect your portfolio. You may build a substantial stake in your company’s shares if you were awarded a large number of options or RSUs, or if you participated in an ESPP for a lengthy period of time. 
• Need for Professional Advice- The majority of professionals who get equity remuneration are high-achieving experts in their fields. However, it doesn’t guarantee you’re interested in or have the time to manage the grants in view of your broader financial strategy. A financial planner who has a thorough understanding of your income, assets, and objectives can help you maximize the wealth-creating potential of equity pay. 

Comply With Equity Compensation Taxation With Eqvista!

Equity may be used in a variety of ways by corporations to sweeten pay packages, and when done so strategically, it can be highly beneficial for the employee. Every circumstance is unique, but you may learn something useful by always being prepared, keeping track of your tax obligations, and knowing the consequences of your choices. You don’t have to handle the procedure’s potential complexity alone.

Eqvista can assist with managing your cap table and the costs incurred when option grants. We offer scalable services and packages, such as cap table management and limitless 409A valuations, to businesses of all sizes, from startups to multinationals. Need more answers? Call us right away!