Executive Compensation – A Deeper Dive into Definitions
With the continued competitive labor market, companies are beginning to rely more heavily on creative strategies to award their top performers. As an added benefit to most executive compensation packages, a company may award, grant, or allow for purchase a vehicle known as a stock option. If you are a top performer, you may be concerned about the potential tax consequences that may arise due to the award of or eventual vesting and execution of the stock option. You may also find this award becomes a large part of your overall asset holding and needs to be evaluated in relation to the other risk factors associated with your financial plan, or you may be evaluating your own exit strategy and need to understand the vesting limitations.
While all these scenarios can be worked through, a strategy and baseline understanding of your options are vital to the long-term success of your plan. Here’s a summary of the types of option awards and the terminology associated with each.
- A nonqualified stock option (NSO) is transferable, has no limit on the grant size, has the exercise serve as the triggering event, and is taxed as ordinary income to the grantee.
- An incentive stock option (ISO) is nontransferable except at death, is subject to $100,000 rule to grant, has the triggering event at the sale of the stock, and is taxed as long-term capital gain to the grantee provided certain holding period requirements are met.
- Restricted stock is an additional class of compensation, is nontransferable, often has a term associated with a vesting component, has the triggering event at vesting, and is taxable as ordinary income to the grantee. This class may also have an 83(b) election option.
- A restricted stock unit (RSU) is nontransferable, is taxable as ordinary income, and is not eligible for early exercise.
- Vesting is the time frame for which the stock is subject to ownership. The vesting may have a time component, such as years, or also a performance-based component.
As with any option or unit, the event at which the stock may be redeemed or forfeited is generally defined in the grant agreement. As a participant/grantee of such compensation, be aware of such terms as “termination,” “normal retirement,” “normal resignation,” or “in the event of early retirement.” The awards and/or grants may be subject to additional vesting acceleration or eliminated from the compensation structure altogether if certain exit components are not adhered to.
As with any strategy and evaluation, your award agreement may have a variation of definitions that are likely unique to your organization. The benefits of evaluating your options earlier rather than at a forced triggering event include:
- Tax reduction
- Wealth accumulation
- Long-term gifting transfer options
- Better liquidity of asset structure
- Risk reduction
Contact your BKD Trusted Advisor™ or submit the Contact Us form today to connect with our BKD Private Client team and start working on your stock option strategy.