From Options To Phantom Stock: An Equity Compensation Rewind

Justin Timberlake, Madonna, and U2 are on tour.

Denim jackets and butterfly clips are cool again.

And Neve Campbell is prepping to play Sidney Prescott in Wes Craven's Scream.

Is it the 1990s—or, squinting to read the calendar—2024?

It's not just pop culture giving some folks deja vu—it's also the economy.

The unemployment rate has been below 4% for two years running, the best record since the 1960s. The first time it fell below 4% in the stretch after 1969? The 1990s.

Wages are edging up. In February, average hourly earnings increased by five cents to $34.57—but it's happening at a slower pace. Just one month earlier, the increase was 18 cents. According to the EPI, wages also grew in the late 1990s, with high-wage workers seeing the most growth.

That's good news for employees at the top—but is it sustainable? Employers are thinking about long-term strategies for attracting and retaining workers without dipping into their cash, and they're reaching back into their late 1990s/(very) early 2000s bag of compensation tricks. That means, in some sectors, equity compensation awards are all the rage again.

Equity compensation can take many forms. Here's a quick look at some of the most popular.

But first: What is equity compensation? At its most basic, it's a chance to be paid with a stake in the company as opposed to cash—although the stake isn't always stock (keep reading). No matter how it’s doled out, the compensation is typically tied to periods of time or employee performance—the goal of the company is to keep you employed and literally vested in the health and growth of the company.

Stock Options

Stock options are some of the most common types of equity compensation. They generally come in two flavors: incentive stock options (ISOs) and non-qualified stock options (NSOs).

ISOs are generally considered the most tax-favored of the two. With an ISO, a company gives an employee the right, at a specified time, to buy shares of company stock—often, but not always, it’s a small private company with big ambitions. This right is usually subject to a vesting period of at least a few years. After you hit that date, you can buy the stock at a discount—the price is generally referred to as the exercise price. Normally, there are no tax implications when the ISOs are granted. And, when you exercise the ISOs, there's also typically no tax hit, depending on how long you hold onto the shares. If you hold the shares for the required time (at least two years from the grant date and one year from the exercise date), the profit is treated as capital gains. If, however, you sell before that time, the difference between the exercise price and the fair market value is treated as ordinary income, while any profits after exercise are taxed as capital gains. It’s also worth noting that ISOs may carry some Alternative Minimum Tax (AMT) baggage—the difference between the fair market value and the exercise price could trigger the tax.

NSOs are generally less tax-favored than ISOs, but also less risky since you don’t have to hold onto them as long. When you exercise an NSO after the vesting date, the difference between the exercise price and the fair market is taxed as compensation (ordinary income). The best part? There's typically no restriction on your right to sell your shares immediately—however, the length of time you keep the shares before you sell them will impact the tax due since the normal capital gains rules apply.

Restricted Stock Units

ISOs and NSOs typically require you to put up cash to exercise the options—or to conduct a cashless purchase where you agree to surrender some stock shares as payment. To avoid having employees scrambling for money or forcing a sale, some companies may opt to award restricted stock units (RSUs). RSUs are typically are issued to employees of public companies (or private companies that can easily be valued) as compensation after hitting certain time or performance milestones. They're typically tied to a vesting schedule—until then, they have no real value. Once the RSUs vest, they are treated as compensation, and the entire value is considered ordinary income. On the plus side, once they're vested, the shares belong to you outright, and any subsequent sales are subject to capital gains treatment.

Phantom Stock & Stock Appreciation Rights

Companies may also issue phantom stock. While they sound dramatic and kind of spooky, it's an arrangement where employees aren't issued the right to shares but instead earn rewards tied to the company's stock performance. The phantom stock throws off the same kinds of benefits as the actual shares (like a shadow or ghost of the real thing), but you don't actually own shares of company stock. If you wait out the vesting period, there's typically a cash reward. However, since no ownership interest is attached to the phantom shares, the tax treatment of any related compensation is treated as ordinary income.

Stock appreciation rights (SARs) operate in a similar manner. As with phantom stock, there are no actual shares that change hands. The company promises to pay employees compensation at specific times tied to the health of the company and stock performance. As with phantom stock, if you wait out the vesting period for SARs, you generally earn additional funds taxed as ordinary income.

Employee Stock Purchase Plans

Companies may also allow you to participate in Employee Stock Purchase Plans (ESPP). Because of the moving parts, it's more common to see these at large public companies (my first ESPP was at Gap Inc.—shout out to my fellow tee shirt folders). With an ESPP, you set aside after-tax payroll deductions that you can use to buy stock, usually at a discount. If the plan is a qualified 423 plan, there's no compensation attributed to the discount (unlike a stock option plan). However, if it's a non-qualified ESPP, it’s not treated as tax-favored, which means that you'll pay tax on the value of the discount. Either way, once you own the shares, they're yours—and they'll get capital gains treatment when you sell them.

If all of this sounds tricky, it can be. The vesting or exercise of these equity compensation awards can result in terrific opportunities for executives and employees. But it can also result in large—and often complex—tax liabilities. And if you think it’s complicated now, as companies and lawyers become more creative, plans may have nuances that take them outside the norm. Before you pull the trigger on yours, check with your financial and tax advisors to ensure you understand the practical consequences.