There are a few different types of stock-based compensation packages your employer may offer to you. We’ve already discussed two of those types in our blog post here on ISOs and NSOs. To quickly refresh, stock options (either ISOs or NSOs) are the most common offered stock-based compensation and give the employee the right, but not the obligation, to purchase common stock in a company at a pre-defined “exercise price.”
In this article we’re going to discuss a third type of stock-based compensation: RSUs, or restricted stock units. While RSUs are a form of stock-based compensation (and resemble stock options in concept), there are key differences between RSUs and stock options (i.e. ISOs and NSOs) that you’ll want to know. Once you’ve read this article, you’ll understand exactly what RSUs are and how they differ from stock options in regard to exercising, vesting, and taxes.
First Things First: What are RSUs?
RSUs, or restricted stock units, are a way for your employer to essentially grant you with stock in the company. They are called, “restricted,” because they cannot be transferred to the employee who has earned them until certain outlined restrictions are met.
Like standard stock options, RSUs are assigned through a vesting plan and distribution schedule and are earned through fulfilling performance milestones or remaining with the employer for a certain amount of time.
Unlike standard options, RSUs are issued in the form of units – not stock – and entitle holders to a specific number of shares in employer stock.
Note: Pre-vested RSUs do not have voting rights and are not entitled to dividends because they are not yet actual shares. Once RSUs vest, they become common stock.
RSUs v. Options – how is exercising different?
Here lies the core difference between RSUs and stock options. Unlike stock options, RSUs do not have an “exercise price.” This means that employees with RSUs, upon vesting, will automatically receive normal shares of company stock at a defined fair market value (FMV) without paying a dime to exercise.
Pros: On one hand, the lack of an exercise price means that RSUs always have some value. The RSU holder does not have to worry about paying an exercise price (which has the potential to end up upside down in value, meaning that the cost to exercise is higher than the price of the underlying stock). RSU holders also do not have to come up with or risk large sums of cash to exercise – it is instead considered more of a grant – a gifted number of shares.
Cons: On the other hand, RSUs offer limited flexibility when compared to stock options. With ISOs and NSOs, holders have some discretion in choosing when to exercise and when to pay taxes. This is not the case with RSUs, as we’ll explore later in this article.
RSUs v. Options – how is vesting different?
Both RSUs and stock options almost always have some sort of vesting schedule (they often follow similar schedules). However, vesting details and specifics depend on the company and employee in question.
If you haven’t yet, we advise you check out our blog post on vesting here. It will help you understand the different types of vesting schedules and how they might affect your exercise. To quickly review, there are three common vesting schedules: time-based, milestone-based, and mixed. These schedule types will apply to almost all stock-based compensation packages including RSUs.
A time-based vesting schedule may include a one-year cliff after which a significant portion (1/4 of the total is common) of the RSUs vest, and the remaining RSUs vest in small equal amounts every month for a set number of years.
In a milestone-based vesting schedule, the RSUs will vest when the company achieves a pre-defined “milestone”. This may be organization-level goals such as reaching a certain valuation, or job-specific goals like an executive reaching a certain stage in a product roadmap.
Mixed vesting schedules incorporate a combination of time-based and milestone-based vesting schedules. It’s worth noting that termination of employment (no matter who initiates it) usually stops vesting and forfeits any non-vested shares.
RSUs v. Options – how is taxation different?
We’ve already covered how ISOs and NSOs are taxed in our blog post here [INSERT LINK], so we suggest you check that out to get up to speed on option taxation.
In the case of RSUs, the entire amount of vested stock is counted as ordinary income in the year it vests. In other words, vested RSUs are considered supplementary income by the IRS, and will appear in your W2 along with your compensation income. Your taxable income will be the fair market value of the stock at the time of vesting x the number of shares you own. Income from RSUs is also subject to applicable state and local taxes.
Since RSUs are considered supplemental income, withholding taxes may also be different than with stock options; if your supplemental income is <$1MM, 22% of your income is withheld. If it’s >$1MM, withholding tax will be 37%. This means that, unfortunately, high income earners in high-income tax states/cities can be subject to a tax rate upwards of 50% on their RSUs.
Once RSUs are vested, they become normal shares. As a result, when you decide to sell your RSUs, if your sale price is higher than the fair market value was at the date of vesting, you are subject to capital gains taxes on the difference.
Note: If you hold your shares for more than one year, you will be taxed at the long-term capital gains rate (a smaller, more favorable rate), while if you hold your shares less than a year, you will be taxed at the short-term capital gains rate (the same as the ordinary income tax rate). Your tax rates may differ depending on your income bracket, so we always advise you consult with your CPA for tax advice.
Some (but not all) companies will allow RSU holders to tender (or sell) a certain number of shares to cover associated taxes, allowing holders not to tap into personal funds.
If you hold RSUs, you can also choose to file a Section 83(b) election. To briefly explain, this means that you are allowed to report the FMV of shares at the time of they are granted to you, rather than the FMV once your RSUs vest. You will still pay capital gains taxes once you sell, but this amount could be much lower because the FMV of the shares at the time of grant is typically lower than the FMV at the time of vesting. You may opt to file a Section 83(b) election if your RSUs have a 5+ year vesting schedule.
Your tax basis depends on a multitude of factors, so we always advise you consult with your CPA for tax advice.
- RSUs are a form of equity compensation that differ from stock options in a couple of important ways.
- RSUs do not have an “exercise price.” This means that employees that have RSUs, upon vesting, will receive normal shares of company stock at a defined fair market value.
- Vested RSUs are considered supplemental income in the year they vest and are subject to ordinary income taxes. At the time of a stock sale, holders will pay either the long-term or short-term capital gains rate.
We know this was a lot of new acronyms and in-depth information. We also realize that every situation is different. If you have any questions, we’re just a quick email or phone call away. Ready to talk? Here’s the number: (917) 905-0031