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’s a good chance you own a combination of different equity grants. RSUs and stock options have some similarities as well as differences in tax treatment and potential upsides. Sometimes your new employer may offer you the opportunity to choose between holding an RSU or stock options. Or you already own a mix of them. The purpose of this article is to describe how each compensation works. You’ll learn how they affect your taxes and how to plan for future upside.
What are RSUs?
RSU (Restricted Stock Units) is a type of equity compensation in the form of company stock. Generally, your employer will assign you a specific number of vested shares over a specific period of time. The classic vesting schedule is four years, with the first anniversary cliff equaling 25%. The remaining shares will vest gradually on a monthly, quarterly or annual basis.
tax on RSU
RSUs are taxable as ordinary income. Each time your RSU is vested, the fair market value of your shares will be added to your W2 earnings. Employers must withhold federal and state income taxes. In most cases, public companies will sell a portion of your shares to cover all taxes. In the end, you’ll have a smaller number of shares than your original grant.
Example. You have 1,000 RSUs of Company XYZ, which become vested tomorrow. Fair market value is $10. Therefore $10,000[1000×10)willbeaddedtoyourpayroll[1000×10)willbeaddedtoyourpayrollTocoverallFederalincomeFICAandstatetaxesthecompanywillsell300sharesfromthetotalTheproceedsof000willbeusedtocoveryourtaxobligationsYoucankeep700shareswhichyoucaneithersellimmediatelyorkeeplongterm[1000×10)आपकेपेरोलमेंजोड़दिएजाएंगे।सभीसंघीयआयFICAऔरराज्यकरोंकोकवरकरनेकेलिएकंपनीकुलमेंसे300शेयरबेचेगी।00कीआयकाउपयोगआपकेकरदायित्वोंकोपूराकरनेकेलिएकियाजाएगा।आप700शेयररखसकतेहैंजिन्हेंआपयातोतुरंतबेचसकतेहैंयालंबीअवधिकेलिएरखसकतेहैं।[1000×10)willbeaddedtoyourpayrollTocoverallFederalincomeFICAandstatetaxesthecompanywillsell300sharesfromthetotalTheproceedsof000willbeusedtocoveryourtaxobligationsYoucankeep700shareswhichyoucaneithersellimmediatelyorkeeplongterm
If you set your RSU as 1 . before keep and sellscheduled tribe The anniversary of their vesting, all potential gains will be taxable as short-term capital gains.
If you hold and sell your RSU for more than a year after vesting, all potential gains will be taxable as long-term capital gains.
Dual Trigger RSUs
Many private pre-IPO companies will offer double-triggered RSUs. This type of RSU is taxable under two conditions:
- your RSUs are rooted
- You experience a liquidity event such as an IPO, tender offer, or acquisition.
You will not have to pay tax on any double-triggered RSUs on 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 the obligation to buy a specific number of company shares at a pre-determined price.
Incentive Stock Options (ISO)
An ISO is a type of employee stock option that has preferential tax treatment. They can be given only to current employees. You can get an ISO for up to $100,000 per year. If your total grant exceeds $100,000, you will receive the difference in the form of non-qualified stock options (NSOs). Most ISO and NSO grants will have a 4-year vesting program with a one-year cliff. Check out this article for more information about ISO.
tax on iso
Implicit and use of ISO does not trigger income taxes.
If you hold your ISO for two years from the grant date and one year from the exercise date, you must pay the long-term capital gains of the difference between the sale and exercise price.
The practice of ISO can lead to payment of alternative minimum tax (AMT). AMT is an alternative tax system that is calculated in parallel with your regular taxes. The deal element or economic profit of your exercise is equal to the difference between the fair market value (FMV) and the exercise price of your shares. The AMT formula adds a bargaining element to your regular income and calculates the minimum tax rate. If the AMT value exceeds your regular income, you must pay the difference to the IRS.
Your chances of paying AMT increase as the difference between the fair market value (FMV) and exercise price of your shares increases.
It is important to remember that the AMT is a future tax credit. You can potentially recover it all. Every year when your AMT due is less than your regular taxes, you will receive a tax exemption until you exhaust the entire credit.
non-qualified stock options (NSOs)
NSOs are another type of employee stock option. However, they lack the preferential tax treatment of ISO. In addition, NSOs can be provided to a wider set of stakeholders. Check out this article for more information about NSO.
tax on NSO
The practice of ISO triggers federal and state income taxes. The difference between the fair market value (FMV) of your shares 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 RSU and Stock Options in Your Job Offering
A rule of thumb is that 1 RSU is equal to 3 or 4 stock options. Most companies that give you a choice between RSU and stock options can offer you a similar ratio. Let us discuss some of the key factors that can help you choose between the different grant types.
public vs private company
Private companies and startups gravitate towards offering ISOs and double-triggered RSUs. These two equity compensation types require a minimum financial commitment from employees prior to any liquidity event or IPO.
Public companies offer traditional RSUs and employee stock purchase plans (ESPPs). You can read more about ESPP here. Many recently public companies will retain legacy stock options from their startup phase but will not issue new grants.
Early Stage Vs. established startup
Early-stage startups with fewer employees typically offer generous ISO grants at less than a dollar per share valuation. Shares are often worth a few cents. These grants provide the biggest upside if the venture becomes successful down the road. Exercising your shares early will allow you to avoid or reduce the AMT and pay long-term capital gains when you sell your shares in the future. The biggest downside of an early startup is that your first liquidity event could be years away. You can’t see the gust of wind for a long time.
More mature or pre-IPO startups can offer a wider range of equity compensation types. If you join those companies, you can own a mix of ISO, NSO and RSU. Working for more established startups, you will be closer to a liquidity event. But the cost of your stock options will be very high. You may have a chance to sell your shares through tender offer or pending IPO.
Sometimes your company may be acquired by a larger firm. When this happens, your stock options and RSU will be converted into stock of the acquiring company.
liquidity and cash
Owning an RSU generally requires spending less cash upfront. Your company will pay your taxes by selling a portion of your shares on the open market. You don’t need to dip into your checking account.
Both ISO and NSO require you to pay the cost of your exercise out of pocket. You may also have to pay taxes or AMT on the transaction.
In some cases, employers offer either a tender offer or a cashless exercise post IPO. If you opt-in for the cashless practice of your ISOs, they will lose their preferential tax treatment and automatically convert to NSOs.
With cashless practice, you exercise your shares and sell them to the buyer immediately. If your firm is private, the buyer can be the company itself or an outside investor. If your company is public, you will sell your shares on the stock market.
The exercise cost of your shares will be deducted from the total value of the proceeds after the sale. Sometimes your payroll department will automatically withhold taxes. Otherwise, you will be responsible for paying taxes on your winnings.
Upward Potential of RSUs and Stock Options
From a risk-reward perspective, traditional RSUs offer less risk relative to stock options. If you choose to get an RSU or NSO from a public company, you can get a higher estimated payout.
Conversely, owning stock options from early-stage startups offers higher risk/reward upside potential. Also, your financial outcome is very uncertain. Your windfall will depend on the success of your company, as well as your strategy for using your shares quickly, before any liquidity event.
Waiting to exercise your ISO after receiving a tender offer or going public can lead to problems with paying extremely high AMT and reducing your financial leverage by paying high taxes.
Ultimately, the benefits of owning RSUs and stock options will depend on your company’s odds of running a successful business model, acquiring or going public. When you exercise your stocks, there is a wide range of financial results depending on 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 ISO, NSO and RSU, you should plan actively, The decision you take today will have an impact on what you have in your pocket for years.
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