- Aw, are you setting up a lemonade stand?
- Yep.
I've done market research, set my prices accordingly,
and hired my first employee.
She's only four, and her resume was written in crayon
but she shows some serious potential.
- Oh, really?
Well, she's not exactly known for follow through,
so how do you plan on keeping her around
when it gets really hot outside?
- I already thought about that.
I'm gonna give her equity
alongside her 10 cents an hour pay.
So the harder she works, the higher the value of the company
and the more she'll ultimately make.
- I sort of feel like lollipops would be more effective.
- But the competition is stiff out there.
Places like Starbucks and Whole Foods
are offering this stuff now and I gotta keep up.
- Okay, hon.
Well, when she starts crying
about how complicated her taxes are,
don't say I didn't warn you.
(bright music)
- When an employee is granted ownership in the company
alongside a normal salary,
it's known as equity compensation.
In the olden days,
this sort of thing was reserved
for highfalutin C-suite executives,
but due to changes in tax laws over time
they've enjoyed phases of popularity since the 1950s.
During the dot-com boom,
tech companies left and right
used it as a way to attract and retain talent.
And even now, Silicon Valley is seemingly crawling
with overnight millionaires,
all thanks to equity.
Now it seems like everyone from fast food joints
to grocery stores are offering employees a way into the game.
- Equity compensation is great for the employer
for many reasons.
It requires less cash flow on their part
and it encourages employees
to feel some investment in the company,
which can improve productivity
and keep employees around longer.
They don't call 'em golden handcuffs for nothing.
- Of course, it's not just good for the employers,
depending on when it's granted to you
and how much you profit,
it's possible you can pay less tax on this form of income.
If you join a company early on,
the shares you're granted could also skyrocket in value.
But this type of compensation
can come in a bunch of different forms,
which can be hard to understand,
and may end up feeling more like a burden than a boon.
So let's see if we can shed a bit of light on these things.
- Let's start with the most well-known form: stock options.
We've highlighted what these are in a previous episode
but as refresher, a stock option is the right to buy a stock
at a certain price.
Why would this be valuable?
Well, if the stock goes up in value, you can buy it,
also known as exercising at the strike price,
the amount you have the right to buy it for,
and then sell it at a profit.
Usually there's a limited amount of time
in which you can take advantage of this,
generally around 10 years.
- There are a few different kinds of options,
but the most widely used are known
as non-qualified stock options.
They can be granted to anyone, management, employees,
even contractors and consultants,
but if you manage to sell them for a profit,
it's going to be be taxed as ordinary income.
The profits are not qualified
for beneficial tax treatment by the IRS.
- Employee Stock Options or ESOs work similarly
except they can only be offered to employees
and there is usually a vesting schedule attached.
So for example, you might be granted a thousand options,
but you only get access to 25% of them
after your first year,
then another 25% after your second year and so on.
Again, the purpose of this structure
is to keep you around for longer.
Employee turnover is vastly expensive
so companies do everything they can to avoid it.
- ISOs or incentive stock options
are usually granted by companies
that are already publicly traded
or intent on becoming so shortly.
They're offered to key employees in top management.
But why would someone that's able to command a high salary
be interested in this form of compensation?
It basically comes down to tax savings.
- Take Roberta, she's a highly qualified software engineer
and has two different job offers.
One from an established company at a 200 grand base salary
and the other one, from a startup
offering her 160 grand with a grant of ISOs upon signing
that are currently worth about 40K.
If she takes option one,
that would put her in the 32% tax bracket.
Now, that doesn't mean she's paying 32%
of every dollar she's making,
for more on that,
check out our video on how progressive taxation works,
but it's significant.
If she takes the second option,
she stays in the 24% bracket
and she'll only pay 15% capital gains on the options.
Sounds good, right?
- If only it were so straightforward.
Something you have to watch out for is the bargain element.
This is the difference
between the market price and the strike price.
Essentially, the discount you get on the option.
If Roberta's company stock is worth $100 per share
and she can buy it for as little as $10,
the bargain element is $90
and that's taxed as ordinary income.
If she held the stock for a little bit longer
after she exercised it and it goes up to $120 a share,
then the $20 is subject
to the more favorable capital gains tax rate.
- Her shares must also be held for more than one year
from the date she sells them
and two years from the time they were granted
for her to get that benefit.
This could possibly keep her stuck
in a job she doesn't end up liking.
And if the stock price goes down instead,
she could be underwater on her options.
Executing a large amount of ISOs
could also potentially flip her
into an alternate tax universe
called the alternative minimum tax.
So proceed with caution.
- Another way that employers offer access to equity
is through an employee stock purchase plan or ESPP.
It's similar to a 401k, in that it involves setting up
a deduction from your paycheck,
which is used to purchase company stock
at a discounted price, sometimes as much as 15%.
Pretty sweet, right?
Of course, there are some catches.
The IRS puts limits on how much you can shovel
into such a thing,
and timing the sale can leave you in the position
of having to choose between diversifying your portfolio
or possibly getting a tax break
if you hold onto them an extra year.
A tough call for many.
- Of course, a company could just give you stock outright.
Employees are generally granted stock in the form of RSUs
or restricted stock units.
When they're initially granted, they're yours only on paper.
You can't sell them off until they've vest,
which they do in chunks over time.
Once vested, they are considered taxable income
for that year, even if you don't sell them immediately.
Thankfully, unlike options,
RSU's always have some value to you
even if they go down in value from the time of the grant.
But remember, if you leave the company,
the unvested shares finish into the air.
- If you're offered a significant amount
of equity compensation,
hiring a professional planner who is a fiduciary
will enable you to make the best calls
for your overall financial health.
But here are three main things to look out for
when trying to make a decision.
- Number one, figure out your tax liability.
The form that this compensation
takes in the dates at which you decide to sell things
can make a massive difference on how much you pocket.
So reach out to a CPA if you have questions.
Sometimes, even your HR department
will be able to provide you with some guidance.
- Number two, watch out for diversification.
When you're relying on a single company's performance,
not only for your income but also your net worth,
it can get really risky.
Hopefully you're working for a company that you believe in
but don't let that blind you to the possibility
that things can take a downturn at any time.
- Number three, remember,
this company is not granting you this stuff
out of the kindness of their corporate hearts.
They want to keep you from jumping ship
when the going gets tough.
- But money is a renewable resource, time is not.
Don't let things like possible future payouts
keep you from seeking out a healthier
or more rewarding workplace.
- [Both] And that's our two cents.
- Thanks to our patrons for keeping "Two Cents"
financially healthy.
Click the link in the description
to become a "Two Cents" patron.
- For more advice on evaluating employment compensation,
check out our video, "How to Weigh Job Benefits."
(bright music)