Merits of RSUs vs Stock Options and Other Forms of Executive Equity Compensation

By Robert A. Adelson

Senior executives often receive equity as a significant part of their compensation. Companies use this as a way to incentivize them and give them a stake in the growth of the business. That equity comes in many forms, of which stock options (ISOs or NSOs) and restricted stock are the most common.  This article discusses the less well known form called restricted stock units (RSUs), its differences from other forms, and situations where RSUs can be a preferred alternative. 

What are Restricted Stock Units?

When a company issues an RSU to an executive, it promises to pay you one share of its stock or the cash value of that share, at a future date, if you satisfied certain requirements such as being employed at the company for a given period and meeting performance goals. These requirements are also called “vesting.”  Once you are vested on the date set in your RSU grant, the number of RSUs you are granted is the number of shares or cash equivalent you will receive when they are “settled.”

How Options and Restricted Stock Differ from RSUs

Stock options allow employees to buy shares of company stock at a set price (strike price) within a timeframe after vesting occurs.  Options designated “incentive stock options” or ISOs meet the qualifications of the tax code, the most prominent being:  strike price at least equal to fair market value; not more than $100,000 ISOs granted can vest in one year; and if you leave the company under most circumstances, you must exercise vested ISOs within 90 days or they are cancelled. 

Stock options not intended to meet the tax code requirements are “non-quals” or “NSOs”.  Non-quals are often issued in larger amounts.  Though not required, they tend to follow ISO terms on strike price and cancellation.

Like options, you don’t need to pay for RSUs when they are granted, but unlike options, when vesting has occurred, you will own the stock or its cash equivalent.  

Restricted stock involves the actual issuance of shares to you, either without charge or at a fair market value purchase price.  These shares are subject to vesting. If employment ends, unvested shares are sold back at the original price you paid or if no price was paid, are cancelled. Additionally, you cannot sell them until vested. 

Like restricted stock, RSUs provide greater chance you end up with something (unlike underwater options), but unlike restricted stock where taxes are payable on grant, you only pay taxes when vesting has occurred. 

How the Different Forms Are Taxed Differently 

We tax lawyers have a saying:  Form is substance.  Any form can provide the executive an equity stake.  But each form can have a very different financial result under Federal tax law.  This is certainly true for the planning and structuring of executive equity.

When NSOs are exercised, all appreciation (whether or not the stock is liquid at the time of exercise) is taxable at ordinary income and payroll tax rates. For ISOs, no tax is imposed on option exercise, but rather only on sale of the stock itself, at lower long term capital gains rates.  However, if ISO stock is sold within a year after option exercise, that sale disqualifies the ISO, so like an NSO, ordinary income tax is due on the appreciation at the time of original exercise.  If there is no disqualifying disposition, the appreciation is a preference item for the Alternative Minimum Tax.

Restricted stock is taxed at ordinary and payroll tax rates on the bargain element at the time vesting occurs.  If the stock is granted with no charge, the total value would be the bargain element.  If a purchase price is paid, the value at time of vesting over the original price paid is the bargain element.  You may file a Section 83(b) election within 30 days of stock issuance to accelerate taxation prior to vesting.  This is advantageous for early-stage companies with a low stock price. You purchase shares at the low initial value, make the election which results in no tax because fair market value was paid, and when you later sell the shares, the tax will be at low capital gains rates. A downside is if the restricted stock never vests, the taxes already paid on it are non-refundable.

For RSUs, only ordinary income taxes apply. There is no capital gains tax because no property has changed hands and no holding period to allow lower long term capital gains treatment.  You are not taxed until at least vesting occurs, and then only if the stock is transferred or the cash equivalent is paid.  

When Are RSUs the Best Form of Executive Equity? 

In cases like startup companies where the stock price is low, restricted stock with the 83b election is a good choice.  In more mature companies where the stock price is much higher, but the company is pre-IPO and you see a chance for considerable appreciation, stock options can be good choices.  

What if the company has far less certainty of appreciation?  You don’t want to commit funds to acquire restricted stock if the stock already has considerable value.  Also, stock options could leave you with nothing if you worked a few years and the stock price has gone under water. 

In such cases, RSUs could be a useful alternative.  Even if the stock goes down in value, you still own some stake in the company.  Also, you did not have to pay taxes in advance.  If the value is down, that is the value for taxation.  If your company is public, you would sell a portion of the RSUs to pay the tax.  If it is not, your RSU contract can include a liquidity feature.

Structuring your equity compensation properly can produce significant financial gains for you. In these matters, it is wise to consult an experienced executive compensation attorney.