Overview of Equity Compensation
Jeff Storch | 10.26.21
“Equity compensation” broadly encompasses all compensation that consists of direct or indirect ownership in the employer or a related company. It can be actual ownership or notational, or “phantom” ownership (book-entry ownership) and be based on the value of the company or other defined formula. Common types of equity compensation include:
- Restricted Stock
- Phantom Stock
- Stock Appreciation Rights
- Stock Options
Although the above types of equity compensation refer to stock in corporations, similar programs can be developed for tax partnerships or sole proprietors (including LLCs taxed as partnerships or sole proprietors). In addition, tax partnerships may offer another type of equity, a profits interest.
Equity compensation is generally treated as taxable ordinary income because it is compensation for services performed. Ordinary income is subject to:
- US federal income tax (at the taxpayer’s marginal rate).
- Federal Insurance Contributions Act (FICA) taxes.
- Federal Unemployment Tax Act (FUTA) taxes.
Most equity compensation is subject to some form of vesting (which means employees forfeit or cannot transfer the award or receive a settlement of the award until they have worked for a specific period of time and/or specific company or employee performance criteria have been met). Vesting periods typically last two to five years (though can be longer). Awards typically vest either:
- All at once at the end of the vesting period (referred to as cliff vesting).
- In tranches (typically pro-rata) over the vesting period (referred to as graded vesting).
Vesting periods are often accelerated after an initial public offering or sale of the company, or when certain not-for-cause terminations of an employee take place before the end of the vesting period.
This overview is the first in a series of posts. Later posts will address some of the specific types of equity compensation discussed above.
DISCLAIMER: The information provided is for general informational purposes only. This post is not updated to account for changes in the law and should not be considered tax or legal advice. This article is not intended to create an attorney-client relationship. You should consult with legal and/or financial advisors for legal and tax advice tailored to your specific circumstances.