Stock Options vs. RSUs – Which is Better for Taxation, Cost Basis & Vesting

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Stock options are a benefit that is given to employees or certain stakeholders as part of their affiliation with a corporation. It gives the individual an option to purchase stock in the company at a stated fixed price. Some stock options may choose to offer a discount over the current price of the stock rather than offer a specific fixed rate.

RSUs are restricted stock units. It is compensation that is offered to an employee in the form of company stock. They are typically issued through vesting plans, then distributed according to a schedule when certain performance milestones are reached. A qualifying milestone may include the amount of time an employee has spent with the corporation.

There are certain advantages and disadvantages to consider with each benefit option. The key areas to consider are for taxation, cost basis, and vesting.

Because each financial situation is unique, this is a generalized guide which looks at the overview of each key section.

Which Is Better for Taxation?

Stock options are a contract issued by the employer to purchase a set of shares at a specific rate for a limited time period. They may be incentive stock options or non-qualified stock options, depending upon who receives them. Non-qualified stock options are offered to outside directors, consultants, and non-executive employees.

Incentive stock options are usually reserved for the C-Suite.

The granting of a stock option is not a taxable event. If the stock options are never exercised, then there is no taxation responsibility.

For most stock options, the first taxable event occurs when they are sold. If they are sold immediately after being exercised, then the difference between the stock option price and the sale price is treated as ordinary income.

The bargain element of an incentive tax option may trigger an alternative minimum tax (AMT) issue for some executives.

If stock options are exercised 1 year after they have been granted, then they must be held for a year to be treated as a long-term capital gain.

RSUs are released on a vesting schedule. Until that schedule is complete, the RSU holds no actual value. When the employee interest does completely vest, then the restricted stock unit will be assigned a fair market value. At that stage, there are considered taxable income. In a standard RSU scenario, a portion of the shares issued with the RSU will be withheld to pay for the income taxes.

Once the withholding occurs, the employee can choose to hold their remaining shares or sell them at their discretion.

Let’s say that an employee works for XYZ Enterprises and receives an RSU benefit of 100 shares. Until those shares are fully vested, there is no tax liability.

Next year, when those shares are fully vested, the fair market value of them is $50. That means there is an income liability of $5,000 for this benefit. Income tax will be withheld at the standard rate, reducing the number of actual shares owned. Then the shares can be sold without further tax implications – unless they are held, and their value goes up.

Stock options and RSUs are treated as ordinary income under most circumstances. One requires the employee to pay the taxes, while the other withholds the taxes. Only long-term holding is advantageous under stock options. Otherwise, the tax implications of either benefit are relatively equal.

Which is Better for Cost Basis?

Cost basis is the original value of an asset for taxation purposes. In most circumstances, it is a reference to the purchase price of a stock, adjusted for splits, capital distributions, and dividends. It is a value that is used to determine the capital gain which has been achieved.

The difference between the current market value of the stock to the cost basis of it creates the capital gain figure that is reported for taxation.

For stock options, the cost basis is the actual price you paid for your shares, times the number of shares. If you received a stock option of 100 shares at $25, then you’d have $2,500. You would then take the compensation element from the difference in the sale at $50 per share, which comes to $5,000.

The price difference is listed on your W-2 as income. In this situation, you’d have a difference of $2,500, just like you’d been paid a cash bonus.

Even if you don’t sell your shares, the difference in market price when you exercise your stock option will appear as income on your W-2.

For RSUs cost basis, what happens during tax season depends upon the tax withholding method you chose for this benefit. You can choose a same-day sale, to sell for cover, or a cash transfer.

Once the RSUs have created value, the employer will report the value of the restricted stock unit as income on your W-2 form. You will also have the amount withheld in taxes placed on your W-2.

How you decide to account for taxes depends upon the withholding choice.

For a net issuance, you report the numbers from your W-2 because you have nothing to report for a vesting event. Your tax liabilities have already been withheld and reported, which means you’re ready to file.

For a same-day sale, you’ll receive a 1099-B form from the broker who sold your RSUs, listing the total value of the proceeds. If the sale of the RSU is less than what the employer reports on your W-2, then you’ll show a cost basis short-term loss.

When you sell to cover, you’re going to be selling a portion of your RSU to cover the tax responsibilities you have. The cost basis is still the amount of value that the employer lists on your W-2 less the sales price. Any shares you keep would then have their own cost basis figures based on their sale, so you may have 2+ calculations to make.

With a cash transfer, you’ll take care of the entire sale of the RSU on your own. You will then give the necessary portion for tax withholding to your employer. Under this method, you can keep your shares for as long as you like. When you do sell, you’ll show a short-term or long-term gain or loss, with the withholding numbers listed as-is from your W-2.

Because of the complicated nature of RSU cost basis, most people will see advantages in this category with stock options. For those who plan to hold their stock options after exercising, however, the RSU holds a benefit because of the tax withholding scenario built into it.

If you hold a stock option after exercising it, you will be reporting the net difference in market price as actual income, even though you did not receive any currency in the transaction.

Which Is Better for Vesting?

Stock options and RSUs both include vesting requirements before they are allowed to be exercised. Vesting options may be anywhere from 3 months to 5 years (or longer), depending upon the structure of the benefit.

Neither stock options nor RSUs offer a tax issue to consider when they are in the vesting process. You simply hold onto the benefit until you’re ready to exercise it.

With a stock option, you’re given an opportunity to purchase shares of common stock in the company at an assigned rate. Most companies grant a stock option for a specific price which will expire after a specific time period.

You might be given the opportunity to purchase stock at $10 per share once the benefit vests in 6 months. You may also have the option to purchase the stock at a 10% discount off the fair market price of shares at the time of vesting.

In this example, let’s say that XYZ Enterprises is trading at $25 per share. The stock options are issued with a 6-month vesting period and we’ll use the two options described above.

Now fast-forward 6 months. The shares now have a fair market value of $8. With a fixed purchase price of $10, the stock option is worthless. The employee can purchase the stock through their own broker at a price that is $2 per share better than their stock option.

If there is a 10% discount offered instead, then the employee could purchase stock at $7.20 instead of $8.

Now let’s say the stock options expire 1 year after vesting. The employee can choose to exercise their options at any time within that 12-month period.

Fast-forward 10 months. Now the shares of XYZ Enterprises have a fair market value of $15. The fixed-priced stock option of $10 is exercised, which means the employee can earn a net gain of $5 per share.

If the 10% discount is applied instead, they would purchase stock at $13.50.

In comparison, RSUs are assigned their fair market value at the moment they vest. There is no purchase of the stock required when a restricted stock unit is offered as a benefit. The employee is awarded those shares as if they were a financial bonus.

When the shares vest, a portion of them will be withheld, either by the employer or the employee, for taxation purposes. Whatever remains after the withholding goes into the employee’s investment portfolio. They can choose to hold onto the shares or they can choose to sell them immediate.

RSUs don’t have voting rights until the shares are vesting according to their schedule and the IRS doesn’t consider them to be tangible property. In addition, an employee which leaves the company before the vesting schedule is complete will forfeit their remaining shares.

From a vesting standpoint, RSUs are the clear favorite. You receive the full, immediate market value of the shares as soon as they are vested. With stock options, you receive the right to purchase shares at a set or discounted rate within a specific time period. Depending upon how the company is performing, the stock options may be completely worthless, even if they are held to their expiration date.

Stock Options vs RSUs: Which Is Better?

Stock options can be a powerful incentive to employees when there is value available in the purchase. If a stock option is available at $10 and the fair market value of shares is $50, then that’s a $40-per-share potential windfall.

At the same time, stock options can also be a powerful disincentive. Offering an employee the chance to purchase shares at $10, when the fair market value ends up being $5, will at-best create ill feelings within the workplace about the company’s reputation.

RSUs offer a few more guarantees. The fair market value is immediately assigned, which means there is a guaranteed income benefit. Even if the value of the shares is just $5, that’s $500 in value with a 100-share RSU. Once the income is withheld, the shares can be sold for cash or held to see if the long-term value will accumulate.

Stock options offer the benefit of an immediately large cash windfall, but with the risk of offering nothing at all. RSUs may offer a more conservative bonus, but it is one that has guaranteed value.

Each offers strengths and weaknesses that must be considered for taxation, cost basis, and vesting. Although employees may not have a choice in which benefit they receive, employers can look at their current worth to choose the benefit which will hold the best possible value.