Many corporations seek to incentivize their valued employees to remain with the company (unless the firm is downsizing) to limit the damage of turnover. Of course, pay and benefits are significant components of an attractive compensation package, but many companies like to encourage tenure by offering deferred rewards that depend on the employee remaining with the company. Often, these rewards are tied to the company's stock price. The theory is that you will earn a greater return if you help the company succeed.
While startups may offer equity positions, many publicly traded companies provide stock grants or options. Stock options were the go-to distribution method in the past but have been overtaken in the last 20 years by Restricted Stock Units. In fact, a recent survey from the National Association of Stock Plan Professionals shows that the percentage of US public companies granting RSUs has increased from three percent in 2000 to 86 percent in 2021. In contrast, the number of public firms giving stock options has decreased from 100% to less than half.1
A stock option gives an employee the right to buy a stock at a specific price (strike price or exercise price) on or after a set date. Unlike RSUs, the stock is not a gift to the worker. However, it can be lucrative, nonetheless. For example, if you work for XYZ corporation and receive a grant of 1000 stock options that vest over five years, you can exercise 200 options each year on the vesting date.
Suppose the price when the option is granted is $10 per share. If the price rises, you can profit by buying the shares, which you can then hold or sell. You are not obligated to purchase the shares if the price drops before your vesting date. You don’t pay taxes on the value of unexercised options. However, you pay either short- or long-term capital gains taxes on the difference between the strike price and the sales price if you sell. There are differences between the tax implications for non-qualified and incentive stock options.
On the other hand, an RSU is a stock grant that vests over a specified period. The employee doesn’t buy the stock. For that reason, the stock’s value at the time of vesting is taxable income. If you have an RSU grant of 100 shares that vest at $100 per share, that is $10,000 in ordinary income. In many cases, the issuing company will sell enough shares to cover the taxes they need to withhold for you.
Yes. You pay income taxes when the stock vests (because that is when it belongs to you, at the current value) and capital gains taxes when you sell. Whether you pay short or long-term capital gains rates depends on how long you hold the stock before selling. Keep in mind that your ownership begins when the shares vest, not when you receive the grant. Therefore, to qualify for long-term capital gains rates, you must hold the stock for one year after the vesting date, not the grant date.
1 Barrons, Tom Tauli, “Restricted Stock Grants Are Increasingly Popular. What Advisors Need to Know”, barrons.com/advisor, retrieved January 2023.