Table of contents
Introduction
Companies are often on the lookout for new ways to incentivise their employees, and one of these ways is through stock compensation. These shares are often earned by employees after they have been in the company for a certain number of years.
Stock compensation has had a long history before it became a norm. For instance, did you know that in the 1950s and 1960s, stock option compensation was restricted to the top executives of a company?
Stock based compensation can be a great mode of wealth accumulation, and if your company performs well, the value of your stocks will rise in the future and fetch you lucrative returns.
In this blog, we will explore various aspects of stock compensation and find out how they will benefit you!
What is stock-based compensation?
Stock-based or equity compensation is a non-cash-based pay offered to you by your company and acts as a reward. Before being offered these stock option compensation, you are subjected to a vesting period.
While a few decades ago, equity compensation only represented a minute fraction of the total compensation that an employee received; the dynamics have altered today with equity compensation representing a large fraction.
This compensation is also a way to participate in the company’s ownership and benefit from its growth by gaining a share of its profits. This increases the chances of retention of an employee in the company while ensuring that both employees and the company are invested in the company’s growth.
Types of stock compensation
We have compiled the list in the following section for your convenience!
- Restricted stock grants
These stocks give the right to employees to acquire certain shares provided they meet the predetermined terms and conditions. These include working with the company for several years or meeting the set targets.
The most important thing to note is that you can only acquire these stocks after the vesting period. So, if you leave before that period, you will not receive any stocks!
- Performance shares
These stock compensation options are primarily given as an incentive to the directors and executives of an organisation when they meet the company’s targets. These shares are often only given to managers and senior position management employees.
Performance shares are an excellent motivator for the top-tier management team to work harder and meet the company goals, creating a win-win situation for employees and the company!
- Incentive stock options (ISOs)
ISOs are employee benefits that allow you to purchase stocks at a discounted price. When you exercise ISOs, you can avail yourself of a stock based compensation tax benefit.
This means that any profit or capital gains you obtain from ISOs will be taxed based on the capital gains tax rate and not at the higher rate at which your income is taxed.
- Phantom stocks
Phantom shares do involve any physical transfer of shares. Instead, a future cash bonus whose value is equal to a defined number of shares is transferred to the employee.
The compensation price is determined based on the value of the shares when the cash bonus is granted, and a legal agreement binds this deal.
- Non-qualified stock options (NSOs)
Unlike ISOs, you will have to pay income tax on the difference between the grant price and the price you avail yourself of the shares. This stock compensation does not qualify for any tax benefits.
How does stock compensation work?
As we mentioned earlier, stock compensation is subjected to a vesting period. For example, if you receive 1000 shares, which vest annually for over 5 years, you can avail yourself of 200 shares yearly.
If you leave the company after, let’s say, the third year, you will not be able to exercise the remaining 400 shares.
Now that you know everything about stock compensation and its types, let us look at things from the taxation angle. Different types of stock compensation have different taxation policies, which we have listed below.
- Capital gains taxes – If you sell the shares that you have acquired from your company and gain from it, you will have to pay capital gains tax on them.
- NSOs – Your income statement will reflect the difference between the grant price and the selling price of taxes. Your total taxable income will be calculated based on the stock based compensation income statement.
- ISOs – When you exercise ISOs, you will only have to pay capital gains tax on them, and these gains will not be subject to income taxes.
You might be wondering how to calculate stock based compensation expenses. We have your answer right here: Equity compensation impacts the business’s capital structure because the number of outstanding shares in the company increases.
Therefore, there are two ways in which you can approach this expense:
- Treat the expenses as cash items, but do not add them back.
- Add it back and increase the number of outstanding shares by the number of shares awarded to the employees.
Benefits of stock compensation
Stock-based compensation gives employees an active stake in the company, which means if the company grows, the employees’ wealth will also appreciate, unlike cash bonuses and salaries, which are fixed in value.
In addition, apart from wealth or capital appreciation, employees will also be entitled to receive a part of the company profits based on their percentage of ownership.
From a company’s standpoint, stock based compensation helps increase employee performance and also increase their retention rate in the company!
Conclusion
Stock compensation is a program that provides employees with various stock options instead of rewarding them with cash bonuses. This compensation is an investment because your capital value will appreciate with the company’s growth, and you will also become eligible to receive dividends and other rewards. To know more, subscribe to StockGro,
FAQs
Stock compensation is typically a non-cash compensation that is provided to employees by companies to reward them for their performance.
Stock based compensation represents an expense to the company in compensating its employees and executives. The only difference is that this compensation comes in the form of stocks and not cash (except for phantom shares); therefore, this compensation is reconciled back to your net income.
The difference between the stocks and the exercise price is first calculated and accounted for. After this amount is determined, you will have to pay capital gains or income tax on these gains, depending on the type of stock compensation you exercise.
The answer can be a yes or no, depending on the company’s terms, conditions, and policies. Some companies may allow you to encash these stocks by selling them in the stock market immediately. In contrast, other companies might have a rule preventing you from exercising these stocks as long as you are an employee there.
If you leave the company before the end of the vesting period, you will not be eligible to receive the stock compensation. This means that the eligibility criteria for stock based compensation is to be an employee of that company!