Oct 01, 2023 · 2 min read · AICPA & CIMA Insights Blog
During the hiring process, offering extra incentives and benefits can make an employer a more enticing and competitive option. One such perk could be equity compensation — non-cash benefits such as restricted stock or performance shares.
While these benefits are great to show appreciation and to boost employee retention, from a finance perspective, equity awards do have high-level tax and accounting ramifications. Equity awards can be complex and it’s important to fully understand the pros and cons before implementation.
The basics
Combined with salaries and other bonuses, distribution of equity compensation can attract high-quality talent —common at startup companies and other fledgling firms as they may not be able to pay employees market or above-market salaries. These equity benefits could yield a big payout for the employee over time.
Stock options — including non-qualified stock options and incentive stock options — performance shares and restricted stocks are all examples of equity awards. (Even crypto currencies fall under the umbrella of equity compensation.)
However, there are risks for the employee. Unlike a salary where they know exactly what they’re getting and when, equity awards can fluctuate, and employees never truly know if they will fully pay off. There are many variables that can impact total compensation — and accountant and finance professionals need to be sure they are implementing these correctly to avoid any consequences.
Awards explained
Here are a few of the equity awards that might be offered in your firm. Because of certain advanced technical aspects — such as the implications of section 409A ¬valuation — it’s very important to have a comprehensive understanding of the awards available.
Stock options are a very common employee reward, and often will offer the right to purchase company shares at a predetermined price. After being employed for a certain duration, the right may vest with time, granting employees control of the option and the right to sell or transfer. With this option, however, employees are not considered stockholders and do not have the same rights as shareholders.
Non-qualified stock options (NSO) and incentive stock options (ISO) provide certain tax advantages, including how they are reported. While NSOs are taxed as regular income, ISOs enable employees the ability to buy shares of the company stock at a discounted price with the added benefit of potential tax breaks on the profit.
Most commonly awarded in established companies, restricted stocks are nontransferable shares that require a specified vesting period that could last several years.
After certain metrics or benchmarks are met, performance shares are often granted to employees in the form of bonuses or stock options. This kind of equity award helps align the goals of managers and employees to those of shareholders.
Mistakes happen
Equity awards are regulated by state and federal laws and mistakes can happen when setting up these incentive plans.
When offering or selling stock options, they must be registered with the Securities and Exchange Commission and state securities agencies. Mistakes often happen with who gets the incentives, as they’re unavailable for former employees and additional reporting is required for consultants.
If an award has a certain time-based constraint, the employer must clearly communicate what those milestones are and how they need to be achieved — something often overlooked.
A third common mistake is the potential tax consequences if employees and companies accidentally overlook certain details. As the awards are still considered income, the recipient is responsible for any tax obligations. Because there may be withholding obligations from the employers, it’s important that these awards are taxed and reported correctly.
Get the full scope
To gain a more complete understanding of equity benefits, their payroll implications and more, the AICPA & CIMA Employee Benefit Plan Conference, at the Gaylord Opryland Resort in Nashville, will be offering two unique sessions on this complex topic. Additional conference topics include data privacy, the intersection of virtual burnout and remote work, guidance and updates from the Department of Labor and much more. The conference is open to in-person and virtual attendees and there is still time to register before the May 10 kickoff.
FAQs
Combined with salaries and other bonuses, distribution of equity compensation can attract high-quality talent —common at startup companies and other fledgling firms as they may not be able to pay employees market or above-market salaries. These equity benefits could yield a big payout for the employee over time.
What does equity compensation mean? ›
What Is Equity Compensation? Equity compensation is non-cash pay that is offered to employees. Equity compensation may include options, restricted stock, and performance shares; all of these investment vehicles represent ownership in the firm for a company's employees.
What is an example of equity based compensation? ›
Equity compensation, also known as share-based compensation, is a type of non-cash pay that a company offers to employees to partake in ownership of the firm. Some examples are stock options, restricted stock, stock appreciation rights (SARs) and ESPPs.
What is internal equity compensation? ›
What Is Internal Equity? Internal equity means equal pay within an organization. Employees with similar positions, skill sets, and experience within a company are paid similarly. This includes salary, benefits, and other forms of pay.
What is the most common form of equity compensation? ›
A stock option is the most commonly used form of equity compensation. It's a contract that gives the holder the right, but not the obligation, to buy or sell shares of a particular stock at a predetermined price, also known as exercise price, within a specific time frame.
What is the risk of equity compensation? ›
There's another risk with all forms of equity compensation: Concentration risk. Your financial future already depends on your employer to pay a salary and benefits. Equity compensation makes you even more invested in the financial stability of your employer, which can make you vulnerable if the employer falters.
Does equity compensation count as income? ›
Your award pays out Ordinary income and FICA* • Your employer withholds these taxes for you. On your W-2, your employer reports the value of your shares as income, along with the amount of taxes withheld. Use the information on your W-2 to complete your tax return.
What is the standard equity compensation? ›
The most common type of equity compensation, restricted stock units (RSUs), are offered when a company has a stable valuation or goes public. Similar to stock options, they vest over time, but you don't have to buy them. Therefore, RSUs have less risk while enticing employees to stick around for their assets to vest.
What is a good equity package? ›
As a rule of thumb, a non-founder CEO joining an early-stage startup (that has been running less than a year) would receive 7-10% equity. Other C-level execs would receive 1-5% equity that vests over time (usually 4 years).
What is the difference between internal and external equity compensation? ›
Internal vs external equity
External pay equity refers to the pay levels of an organization's employees in comparison to those of its competitors in the same industry or market. In contrast, internal pay equity refers to the fairness and equity of pay among employees within an organization.
It provides a structured approach to quantify the compensation shareholders expect for their investment risk. You can calculate it using the capital asset pricing model (CAPM), where the equity cost equals the risk-free rate, the product of the company's beta, and the equity risk premium.
What are the cons of internal equity? ›
Cons Of Internal Equity: The main issue with the internal equity pay is that the employees may feel like their job and responsibilities are the same as the others. Therefore, they shall be paid the same as the other employees. Everyone is a victim in their own eyes.
What is the difference between cash and equity compensation? ›
Cash has a guaranteed value (setting aside changes like inflation), while equity can end up being worth a lot more or less than anyone's best guess. Cash is a commodity; equity in a company is not. A candidate's response to equity vs. cash may stem from their risk preference.
How much equity should a VP get? ›
For early-stage startups, equity tends to be higher, around 1.5% to 3%, to compensate for higher risk. On the other hand, for more established companies, the range is usually 0.5% to 1.5%. This allocation ensures the VP of Sales is motivated and aligned with the company's long-term goals.
Is equity compensation the same as profit sharing? ›
Equity compensation provides company shares in lieu of or in addition to a salary, giving recipient employees an actual ownership stake in the company. Profit sharing, on the other hand, distributes a portion of company profits to qualified employees using a company-determined formula.
Is equity the same as salary? ›
Equity supplements your salary package with deferred, but potentially significant compensation, even more so if you join a company that is just starting up and that takes off later down the line. The younger the company, the more money its equity could end up representing.
