RSUs and stock options are the most popular equity compensation forms by both early-stage start-ups and established companies. If you receive equity compensation from your employer, there is a good chance that you own a combination of different equity grants. RSUs and stock options have some similarities as wells as many differences in tax treatment and potential upside. Sometimes your new employer may offer you the opportunity to choose between having RSUs or stock options. Or you already own a mix of them. The purpose of this article is to describe how each compensation works. You will learn how they affect your taxes and how to plan for future upside.
What are RSUs?
RSUs (Restricted Stock Units) are a type of equity compensation in the form of company stock. Typically, your employer will grant you a specific number of shares that will vest over a particular period. The classic vesting schedule is four years with a first-anniversary cliff equal to 25%. The remaining shares will vest gradually on either a monthly, quarterly, or annual basis.
Taxes on RSUs
RSUs are taxable as ordinary income. Every time your RSUs vest, the fair market value of your shares will be added to your W2 earnings. The employer must withhold Federal and State income tax. In most cases, public companies will sell a portion of your shares to cover all taxes. In the end, you will own a smaller number of shares than your original grant.
Example. You have 1,000 RSUs of company XYZ, which get vested tomorrow. The fair market value is $10. Therefore $10,000 [1,000 x 10) will be added to your payroll. To cover all Federal income, FICA, and state taxes, the company will sell 300 shares from the total. The proceeds of $3,000 will be used to cover your tax obligations. You can keep 700 shares which you can either sell immediately or keep long term.
If you hold and sell your RSUs before the 1st anniversary of their vesting, all potential gains will be taxable as short-term capital gains.
If you hold and sell your RSUs for longer than one year after vesting, all potential gain will be taxable as long-term capital gains
Double Trigger RSUs
Many private Pre-IPO companies would offer double-trigger RSUs. These types of RSUs are taxable under two conditions:
- Your RSUs are vested
- You experience a liquidity event such as an IPO, tender offer, or acquisition.
You will not owe taxes on any double-trigger RSUs at your vesting date. However, you will pay taxes on ALL your vested shares on the day of your liquidity event.
What are stock options?
Employee stock options are another type of equity compensation that gives you the right but not obligation to purchase a specific number of company’s shares at a pre-determined price.
Incentive stock options (ISOs)
ISOs are a type of employee stock option with preferential tax treatment. They can only be granted to current employees. You can receive up to $100,000 of ISOs every year. If your total grant exceeds $100,000, you will receive the difference as Non-qualified stock options (NSOs). Most ISOs and NSOs grants will have a 4-year vesting schedule with a one-year cliff. For more information about ISOs, check out this article.
Taxes on ISOs
The vesting and exercise of ISOs do not trigger income taxes.
If you hold your ISOs for two years from the grant date and one year from the exercise date, you will owe long-term capital gains of the difference between the sale and exercise price.
The exercise of ISOs may cause paying Alternative Minimum Tax (AMT). The AMT is an alternative tax system that is calculated in parallel with your regular taxes. The bargain element or economic benefit of your exercise equals the difference between the Fair Market Value (FMV) and the exercise price of your shares. The AMT formula adds the bargain element to your regular income and calculates a minimum tax rate. If the AMT value is higher than your regular income, you will have to pay the difference to the IRS.
The probability of paying AMT increases as the gap between your shares’ Fair Market Value (FMV) and exercise price widens.
It is crucial to remember that the AMT is a future tax credit. You can potentially recoup all of it. Every year when your AMT dues are lower than your regular taxes, you will receive a tax rebate until you deplete the entire credit.
Non-qualified stock options (NSOs)
NSOs are another type of employee stock option. However, they lack the preferential tax treatment of ISOs. Furthermore, NSOs can be granted to a broader group of stakeholders. For more information about NSOs check out this article.
Taxes on NSOs
The exercise of ISOs triggers Federal and state income taxes. The difference between your shares’ Fair Market Value (FMV) and the exercise cost is taxable as compensation income. Whether your employer is a public company or a startup, you will be responsible for paying the taxes due from the option exercise.
How to choose between RSUs and stock options in your job offer
There is a rule of thumb that 1 RSU is equal to 3 or 4 stock options. Most companies that give you a choice between RSUs and stock options will likely offer you a similar ratio. Let’s discuss some of the key factors that can help you choose between the different grant types.
Public versus private company
Private companies and startups tend to gravitate towards offering ISOs and double-trigger RSUs. These two equity compensation types require the lowest financial commitment from the employees before any liquidity event or an IPO.
Public companies tend to offer traditional RSUs and employee stock purchase plans (ESPPs). You can read more about ESPPs here. Many recent public companies will maintain legacy stock options from their startup stage but will not issue new grants.
Early-stage vs. established startups
Early-stage startups with fewer employees usually give generous ISO grants at below a dollar per shares valuations. The shares are often worth a few cents. These grants offer the biggest upside if the venture becomes successful down the road. Exercising your shares early will allow you to avoid or minimize AMT and pay long-term capital gains when selling your shares in the future. The biggest downside of an early startup is that your first liquidity event might be years away. You may not see a windfall for a long time.
More mature or pre-IPO startups might offer a wider range of equity compensation types. If you join those companies, you may end up owning a mix of ISOs, NSOs, and RSUs. Working for a more established startup, you will be closer to a liquidity event. But the cost of your stock options will be a lot higher. You may have a chance to sell your share through a tender offer or a pending IPO.
Sometimes your company may get acquired by a larger firm. When that happens, your stock options and RSUs will be converted to the acquiring company’s stock.
Liquidity and cash
Owning RSUs generally requires spending less upfront cash. Your company will pay your taxes by selling a portion of your shares on the open market. You don’t have to dip in your checking account.
Both ISOs and NSOs require paying your exercise cost out of pocket. You also may owe taxes or AMT on the transaction.
In some cases, employers offer a cashless exercise either through a tender offer or post-IPO. If you are opt-in for a cashless exercise of your ISOs, they will lose their preferential tax treatment and automatically turn into NSOs.
With a cashless exercise, you exercise your shares and immediately sell them to the buyer. If your firm is private, the buyer can be the company itself or an external investor. If your company is public, you will sell your shares on the stock market.
The exercise cost of your shares will be subtracted from the total value of the proceeds after the sale. Sometimes your payroll department will withhold taxes automatically. Otherwise, you will be responsible for paying taxes on your gains.
The upside potential of RSUs and stock options
From a risk-reward perspective, traditional RSUs offer a lower risk relative to stock options. You can get more predictable payouts if you choose to receive RSUs or NSOs from a public company.
In contrast, owning stock options of an early-stage startup offer a higher risk/reward upside potential. At the same time, your financial outcome is a lot more uncertain. Your windfall will depend on your company’s success in addition to your strategy to exercise your shares early, well in advance of any liquidity events.
Waiting to exercise your ISOs after receiving a tender offer or going public can create issues with paying extremely high AMT and reducing your financial upside by paying higher taxes.
In closing, the benefits of owning RSUs and stock options will depend on the odds of your company running a successful business model, getting acquired, or going public. There is a massive range of financial outcomes depending on when you exercise your shares, your investment horizon, risk tolerance, cash savings, tax situation, and a little bit of luck. If you want to get the most out of your ISOs, NSOs and RSUs, you need to plan proactively. The decisions that you take today will impact what you keep in your pocket years down the road.
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