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Employee Stock Options and Restricted Stock Units: How Are They Different?

  • ESOs and RSUs are two types of equity compensation available to many workers in the tech industry
  • There are crucial tax impacts regarding NQSOs and ISOs along with RSUs that you should be aware of when exercising options and/or selling shares
  • Knowing a few basic terms and any unique aspects of your company’s plan is step one
  • Working with an experienced advisor to strategize and execute the right plan is step two

Two of the most common types of equity compensation are employee stock options (ESOs) and Restricted Stock Units (RSUs). While prevalent across many industries, there’s often confusion among workers about what they represent and what strategy to take so that value is maximized. Moreover, questions frequently arise regarding how they are taxed. Let’s go through the most important facets of both ESOs and RSUs along with how they are different.

Knowing the Ropes

ESOs are financial options. In the investing world, an option gives you the right, but not the obligation, to buy shares at a pre-determined price, known as the strike price (sometimes referred to as the exercise price).

There are two kinds of ESOs: non-qualified (NQSOs) and incentive stock options (ISOs). The former has less favorable tax treatment than the latter, but we’ll leave that discussion for another blog! What’s great, though confusing and sometimes causing anxiety, is that you have the choice of when to exercise your employee stock options. When you exercise, you effectively convert options into shares. You then face the decision to continue holding the stock or to sell.

By contrast, RSUs are not options. They are shares of stock owed to you if certain conditions are met. The biggest requirement is that RSUs must go through a vesting period. You might already be familiar with vesting, such as with your 401(k) plan’s employer matching contributions. RSUs work sort of like that. Through time, RSUs vest, and you get to take part in the growth of the company (that’s the hope, at least). It’s important to know that there are tax implications when RSUs vest, so be sure you understand how your plan works. To make equity compensation matters a little more confusing, RSUs are different from so-called Restricted Stock Awards. Always know what you own!

For a little more background, while NQSOs can be issued to employees, contractors, and directors, among others, ISOs are only granted to employees, and there is a $100,000 per year limit on the amount. RSUs, like NQSOs, can be given to a variety of worker types and do not have a maximum amount that can be granted to workers.

The Initial Tax Impacts

Maybe you are new at a tech firm and were recently granted a set of ESOs and RSUs. Congratulations! More good news: you don’t face any tax impact yet. Unlike with RSUs, ESOs are not taxed when they vest. It’s when you exercise those options that you might face tax consequences. You generally owe income tax on the value of RSUs in the year they vest.

Let’s dig deeper into NQSOs. In the year you exercise these ESOs, you’ll owe ordinary income taxes on the difference between the options’ strike price and fair market value at exercise. Whether you continue to hold the stock or sell immediately, you will still face that tax hit.

With ISOs, though, you can exercise the options without incurring a tax impact so long as there is not what’s known as a disqualifying disposition. A disqualifying disposition happens when you sell stock from the exercise of ESOs too soon – you’ll then face a combination of ordinary income tax and capital gains tax on the stock sale. Proper planning can avoid this outcome. Another consideration we must weigh based on the price difference between the exercise price of the options and the fair market value when you strike is your AMT impact.

Turning Shares into Cash: Being Mindful of Tax Risk

Let’s focus on when you go about selling stock options. With NQSOs, you’ll face either a short- or long-term capital gain or loss based on the spread between the price at which shares were sold and the adjusted cost basis (what you paid for the stock or the price at which you exercised). ISOs, though, feature either qualified sales that earn you favorable long-term capital gains tax rates or disqualified sales as we described earlier. Both types are subject to different AMT tax treatments.

As for RSUs, it’s a bit more straightforward as you face either short- or long-term capital gains tax impact from selling shares you’ve earned. Short-term capital gains tax is owed when you profitably sell shares within a year of acquiring them. Long-term capital gains tax is owed on gains from the sale of shares held for longer than a year.

A common concern among folks with ESOs surrounds tax withholding. The key thing to know is that when you exercise NQSOs, there’s withholding for federal income tax (often 22%, but it could be 37% for very high-income earners). There is no tax withheld when you exercise ISOs, however. That goes for both qualifying and disqualifying dispositions. When you sell stock from either ESO type, there is no automatic tax withholding, but that’s when you want to be sure you make estimated tax payments so you don’t face an underpayment penalty or just a large, unexpected bill come tax season.

Tax withholding for RSUs is done when your RSUs vest. Many firms will automatically take withholding into account by reserving some units and paying you a netted share amount. Upon the sale of stock, no taxes are withheld.

Cash Flow Planning Strategies

What’s great about both types of stock options is that we can construct optimal cash flow situations through what is called a “cashless exercise” or sell-to-cover strategy. Here, we exercise the options and sell some shares to cover the cost of buying the stock along with withholding for taxes and (for ISOs) any AMT obligations. Don’t go at this alone, though. Experienced financial planners are needed to ensure no boxes are left unchecked.

With RSUs, the most important thing to consider from a cash flow and tax planning perspective is that you ensure you make sufficient estimated tax payments based on what you might owe above the amount withheld by your employer.

There’s another upshot with ESOs under certain conditions. You might be eligible for an 83(b) election that essentially pulls forward your tax liability. Why is that a good thing? It means possibly paying tax on a smaller amount today to avoid owing taxes on a bigger amount tomorrow. The 83(b) election is particularly lucrative for workers at early-stage firms. The risk is that the company turns out to be valued lower in the future, so all risks must be carefully weighed here. RSUs are not eligible for the 83(b) election, but restricted stock awards may be.

Upon Departure

Let’s say you’ve had a great run on a young tech firm and wish to move on to even greener pastures. You must have a strategy with your options and RSUs. For NQSOs, there could be a post-termination window within which to exercise or even an options expiration date, so be sure you know your plan documents. ISOs have a strict 90-day window after you leave the company to exercise. Unvested RSUs, like unvested funds in your 401(k), are generally forfeited when you leave a firm, but we have seen plans that allow for accelerated vesting, too.

A Nod to Diversification

Whether we are dealing with either type of ESO or RSUs, there are tax impacts along the path to turning options into shares and finally into cash. Working with a skilled advisor is critical to not missing a beat. Another topic we have not touched on is concentration risk – the notion that you should avoid holding too many shares in your employer’s stock. While taxes are a big deal, it’s also key that we manage your broader financial risks.

The Bottom Line

Employee stock options and Restricted Stock Units are two common, though tricky, forms of equity compensation in the tech industry. Understanding the basics of how they work and grasping any key details in your company’s plan documents is important. Working with a fiduciary advisor well-versed in handling and strategizing ESOs and RSUs can save you a significant amount of time and money rather than going at it alone.