Types of equity-based compensation awards

Equity-based compensation has become an important, and often sizeable, part of employee compensation packages. As companies focus more on “pay-for-performance,” equity-based compensation offers employers the ability to tie employee performance directly to company performance, and represents a growing portion of employee take home pay.

Both private and public companies (and corporations and partnerships) can offer equity-based compensation, which can come in various forms. The differing names given to these awards and the complexity with how they operate can cause confusion for employees and have important implications for employers.

It’s important for employers and employees to understand the different kinds of commonly granted equity-based compensation, as not all types receive the same tax treatment. Whether (or when) equity-based compensation results in taxable compensation to the recipient and whether the company gets a tax deduction are all dependent on the type of equity-based compensation that has been awarded.

The table below provides a general overview of common equity-based compensation arrangements provided by corporations, and partnerships to employees. The descriptions in the table include basic information on when income is recognized, when deductions are allowed, and how the awards operate differently. Keep in mind, however, that these are general descriptions and certain facts can change the timing of income recognition or the tax deduction. Employers and employees should always analyze each equity-based compensation transaction individually to determine the appropriate tax treatment.

This table uses the term “employee,” but the information, unless otherwise noted, applies to a broad range of service providers, including external directors, consultants, and contractors. The summaries reflect accrual method employers; alternative deduction timing may apply to cash method taxpayers. While share reward programs can exist outside the context of compensation, such as warrants granted to an investor, this table focuses on equity-based compensation granted for the performance of services.

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Type of compensation	Employee compensation income recognition	Employer tax deduction
Nonqualified stock options (NQSO): The right to purchase shares of stock at a set exercise price during an exercise period.	In the taxable year the NQSO is exercised, provided that the stock received upon exercise is vested.	In the taxable year the employee exercises the NQSO.
Incentive stock options (ISO): Similar to NQSOs, but the ISO receives favorable tax treatment if the employee holds the shares after exercising until the later of two years after the grant date or one year after the exercise date (i.e., a qualifying disposition).	Upon a qualifying disposition of the stock, no compensation income is recognized, only capital gain. Upon a disqualifying disposition, compensation income is recognized in the year the stock is disposed of.	No tax deduction unless there is a disqualifying disposition. Upon a disqualifying disposition, the deduction is allowed in the year the stock is disposed of.
Stock appreciation rights (SARs): The right to be paid compensation (cash or stock) equal to the excess of the fair market value of the stock on the exercise date over the exercise price.	In the taxable year the SAR is exercised and the stock or cash is paid to the employee.	In the taxable year the SAR is exercised and the stock or cash is paid to the employee. Special rules may apply to non-calendar taxable years.
Restricted stock (RS): Also referred to as a Restricted Stock Award (“RSA”), the employer transfers a share of stock to the employee on the grant date, subject to vesting conditions. If the vesting conditions are not met, the shares are forfeited back to the employer.	Recognized on the grant date if a Section 83(b) election is made, or recognized on the vesting date if no Section 83(b) election is made.	If a Section 83(b) election is made, the deduction is triggered on the grant date. If no Section 83(b) election is made, the deduction is triggered on the vesting date.
Restricted stock units (RSU): Represents a promise by the employer to transfer stock (or cash equivalent) to the employee after the RSU has vested.	Recognized on the date the stock or cash is transferred to the employee to settle the RSU.	Varies depending on whether settled in cash or stock and whether the RSU is considered to be “deferred compensation.” Generally in the tax year of settlement.
Performance share unit (PSU): The same as an RSU, but the vesting conditions are based on meeting stated performance goals other than remaining employed for a specified period of time.	Recognized on the date the stock or cash is transferred to the employee to settle the PSU.	Varies depending on whether settled in cash or stock and whether the PSU is considered to be “deferred compensation.” Generally in the tax year of settlement.
Phantom stock or equity: Granted by either a corporation or partnership, represents a promise by the employer to pay cash to the employee after vesting conditions are met. The cash payment is typically equal to the value of a specified number of shares, the value appreciation of the shares after the grant date, or the value of a percentage of outstanding equity.	Recognized on the grant date if a Section 83(b) election is made, or recognized on the vesting date if no Section 83(b) election is made.	Varies depending on whether the phantom equity is considered to be “deferred compensation.” Generally in the tax year of payment.
Profits interest (PI) in a partnership: Granted only by partnerships (and LLCs treated as a partnerships). Represents ownership equity that has a $0 liquidation value on the grant date.	No compensation is recognized if the requirements of Rev. Proc. 93-27 and 2001-43 are met.	Generally, no tax deduction if the employee recognizes no compensation income.
Capital interest in a partnership: Similar to a PI, but it has a liquidation value greater than $0 on the grant date.	Similar to restricted stock in a corporation.	If a Section 83(b) election is made, the deduction is triggered on the grant date. If no Section 83(b) election is made, the deduction is triggered on the vesting date.

Contact:

Kristen Smith

Director, Washington National Tax Office

Atlanta, Georgia

+1 404 475 0116

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Understanding the various types of equity-based compensation awards

Contact:

Kristen Smith

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