I met with a client recently who was given the choice of receiving the equity portion of his compensation as a percentage of stock options or restricted stock unit (RSUs). An RSU is a grant valued in terms of company stock, but company stock is not issued at the time of the grant. After the recipient of a unit satisfies the vesting requirement, the company distributes shares or the cash equivalent of the number of shares used to value the unit. Depending on plan rules, the employee or employer may be allowed to choose whether to settle in stock or cash.
The most important variable is how the equivalent number of options is set to RSUs. RSUs are preferred if the same number of options are offered. However, most companies typically offer a third to a fifth of the number of RSU shares than they would have granted in options. This is because the options are worthless if the share price never gets above the grant price during the vesting period. RSUs have greater downside protection but they also limit your upside if you have more options than RSUs.
RSUs are taxed in much the same manner as actual restricted shares. There is no capital gains treatment available at exercise. Employees are taxed at ordinary income rates on the amount received on the vesting date, based on the market value of the stock. The employees may have to make payments of unnecessary taxes under Section 83(b) election if the stock price declines. Taxation of options depends on whether they are incentive stock options (ISO) or non-qualified stock options (NQSO). The rules regarding the taxation of ISOs are complex, especially on the alternative minimum tax. The tax treatment for NQSOs is relatively straightforward.
There are several other equity incentive instruments used by employers today.
Stock Appreciation Rights
Stock appreciation rights (SARS) are cash or stock bonuses tied to the performance of a company’s stock over a certain period. SARS are similar to employee stock options in that the holder can benefit from the appreciation of the stock. The holder is taxed when the right to the benefit is exercised.
Phantom stock is a cash or stock bonus that replicates owning a company’s stock over a certain period. But phantom stock is not technically stock, it is simply a promise to pay a bonus in the form of the equivalent of either the value of company shares or the increase in that value. The taxation is the same as SARs, employees are taxed on the phantom stock when the right to the benefit is exercised.
Profits interests are a claim to the increase in value of a Limited Liability Company (LLC) over a period of time. The ownership is evidenced by membership interests rather than shares of stock. LLCs who want to reward employees with an equity stake in the company cannot give out stocks options or provide restricted stock. A profits interest is very similar to a stock appreciation right including the ability to attach a vesting requirement.
There are other considerations affecting the decision – the vesting schedule, options expiration, outlook on company’s future, whether this is a public company or private. Complexity abounds with respect to a RSU or option decision. Employees facing this decision should seek a competent financial adviser knowledgeable about these issues.