Equity compensation

• Equity compensation
  • Vesting Schedules
  • Tax withholding of equity compensation
    • Covering taxes
    • Fair market value and cost basis
    • Capital gains/losses
    • Tax considerations

Vesting Schedules

A vesting schedule is a pre-defined schedule that dictates when equity becomes yours to do with as you please. In the case of RSUs, those shares are transferred from company holdings to your account to either hold or sell. Options become yours to either exercise or hold, as well.

These schedules are determined by the company and are outlined in offer letters. A common vesting schedule is 4 years, vesting quarterly. Generally there can be a form of cliff which can refer to a period of time where shares are not vesting (such as 1 year), it can also refer to the end of a grant. In the latter case, it is a cliff because that grant is ending, and thus a new grant is necessary to offset that equity per quarter.

Tax withholding of equity compensation

Equity compensation is still income, but in a different form. It is considered supplemental income, so has a different withholding treatment than regular salary income.

Supplemental income is withheld at 22% and any applicable FICA or state taxes. I emphasize "withheld" because it is still taxed at income rates, but withheld at supplemental rates. If your top marginal tax rate is higher than 22%, you will likely have to account for under-withholding throughout the year.

The income taxable amount of your options is the difference between the exercise price and the grant price. So if you sold an option with a $10 grant price and was exercised at $50, your income for that option would be $40. This is subject to all applicable income taxes.

Covering taxes

Most brokerages allow you to opt for "sell to cover" or "pay cash" for the tax withholdings. You are liable for paying the above taxes at the time of vesting (RSUs) or exercising (options), but you can either use the equity itself, or put cash in your account to cover the taxes.

If you opt to sell to cover, your brokerage will sell the appropriate number of shares (by way of RSUs or of the shares you would have received when exercising options) at market value to be able to cover the full balance of your tax liability.

In my opinion sell to cover is a stronger choice because "pay cash" is equivalent to taking cash from elsewhere in your accounts to effectively buy your RSUs/Options that would've otherwise been sold.

Fair market value and cost basis

When your equity is granted, it has a fair market value assigned to it. This is generally the price of the equity at market close the day it was vested. The reason this may differ from your cost basis, is that not every share across the company can be sold for the closing price due to open buy orders likely not meeting the demand at that price. This amounts to a difference between the cost basis and the reported value on your W-2. However, it is documented on your 1099-B issued from the brokerage that the cost basis is the FMV but the sale occurred at whatever amount you were able to sell for.

Given the capital loss/gain is taxed at income rates, this is effectively the same thing as your company knowing exactly what it was sold for.

Capital gains/losses

In addition to income taxes, there is almost always applicable capital gains taxes on your vesting (unless you have an immediate sale that occurs all at the same price and $0 net gains/losses). These gains/losses occur in the time between when you vest & when you sell.

Your cost basis is established at the time of vesting/exercising. The cost basis is the fair market value of the RSUs as they were granted, or the exercise price of options. As with all stock sales, capital gains are in two categories: short term and long term. Short term gains are taxed at income tax rates and long term gains are taxed at a preferential tax rate. In order to cross the threshold from short to long term gains, you'd have to hold the share for 1 year.

The emphasis on the "hold the share" is that it is how long the share itself is in your account. It doesn't matter when it was granted, or that the option to buy the share is more than a year past vesting. You have to have the actual share for over a year.

From my perspective, the inherent risk of holding your company stock for a year or more is not worth the tax difference (I prefer to diversify) given the gains/losses are for a very short period of time from vesting to sale (as soon as I can).

Tax considerations

As any employee who has been compensated in an unpredictable way knows, withholding your taxes can be challenging. The key thing to understand is that your salary is generally very predictable and withheld according to the tax tables by your employer. For the most part, entering your dependent count on your W-4 (tax withholding document submitted to tell your employer how to withhold taxes based on dependents, other income, etc).

However, with unpredictable income in the form of bonuses or equity based compensation with a volatile stock, is very difficult to predict at the beginning of the year. My perspective is that you should check your withholdings a few times a year. I typically do so in February, August, and re-check in October. My reasoning: in February you will know your general compensation picture in terms of salary increases for the year. August, you will have 3/4ths of your stock compensation determined (and those who make above FICA limits will start seeing that drop off). In October, you have a few months to make up the difference if you need to do extra withholdings.

The way I determine if extra withholdings need to be done is to use the IRS withholding calculator. It’s a bit of a process, but is generally a pretty good tool, in my experience.