Stock Compensations
Learn how different stock compensations can impact you—so you don’t get burned like I did!
When you're joining a company that offers stock-based compensation, understanding the tax implications is just as important as knowing what the options are. Terms like ISOs, NSOs, RSUs, and RSAs might sound similar, but they work very differently when it comes to vesting and taxes. Below is a breakdown of how each of these work and the key tax points you should keep in mind. But before we dive in, here are some key terms explained in plain English to help you make sense of everything below
Key Terms to Know:
Vesting: Vesting is when you earn the right to your stock or options over time. For example, if you’re granted stock options, you might only own them after working for the company for a few years. You’ll typically "vest" a portion each year.
Exercise: Exercising is when you decide to buy the company stock at a set price (the strike price) as part of your stock options. You can only exercise once your options have vested.
Strike Price (Exercise Price): This is the fixed price at which you can buy the stock. If the company’s stock goes up in value, you get to buy it at the lower strike price.
Capital Gains: If you sell a stock for more than you paid, the profit you make is called a capital gain. The tax on this profit depends on how long you’ve held the stock.
Ordinary Income: This is the regular income you earn, like your salary, which gets taxed at your normal income tax rate.
83(b) Election: A special tax option you can choose for certain types of stock compensation, allowing you to pay taxes on the stock’s value at the time you get it, rather than when it vests. This can help if the stock's value goes up in the future.
1. Incentive Stock Options (ISOs)
ISOs are great because they come with favorable tax treatment if you play it right.
How They Work:
ISOs give you the option to buy company stock at a set price (the strike price) after you hit certain vesting milestones.
After vesting, you can exercise your options to buy stock at the strike price, which might be a deal if the stock has appreciated.
Vesting and Taxes:
No taxes are due when ISOs are granted or when they vest.
The key tax advantage comes if you hold the stock for more than two years after the grant and more than one year after exercising. When you meet these holding periods, your gains are taxed at the lower long-term capital gains rate instead of as ordinary income.
However, if you sell the stock before meeting the holding period, you’ll pay ordinary income tax on the difference between the strike price and the stock’s market price at exercise.
Important note: Exercising ISOs might trigger the Alternative Minimum Tax (AMT), depending on your income. AMT is a parallel tax system that kicks in when your income exceeds certain limits. Essentially, the “bargain element” (the difference between the strike price and fair market value) can be counted as income under AMT, which could mean a hefty tax bill when you exercise ISOs, even if you don’t sell the stock.
Pros:
Big tax savings if you hold long enough for capital gains treatment.
No ordinary tax at exercise (except for AMT, if applicable).
Cons:
AMT risk if you exercise a lot of options at once.
If you don’t meet the holding period, it’s taxed as ordinary income.
2. Non-Qualified Stock Options (NSOs)
NSOs are a little more straightforward but come with a bigger immediate tax hit.
How They Work:
NSOs let you buy stock at a set price after they vest, just like ISOs.
The big difference is how taxes are handled.
Vesting and Taxes:
When you exercise NSOs, the difference between the strike price and the fair market value of the stock is taxed as ordinary income.
The company will often withhold some taxes at the time of exercise, but you might still owe more depending on your tax bracket.
Any additional gains from the time you exercise to when you sell the stock are taxed at capital gains rates.
There’s no AMT to worry about with NSOs, which simplifies the tax process.
Pros:
No risk of AMT complications.
Works for both employees and non-employees (contractors, board members).
Cons:
You’re taxed as ordinary income on the difference at the time of exercise, which can lead to a big bill if the stock has appreciated significantly.
3. Restricted Stock Units (RSUs)
RSUs are easier to understand and don’t require you to buy stock—you’re just granted shares when they vest.
How They Work:
RSUs represent actual shares of stock that are granted to you, but you don’t own them until they vest.
Once they vest, you receive the shares, and you don’t have to exercise an option or pay anything.
Vesting and Taxes:
RSUs are taxed as ordinary income when they vest, based on the market value of the shares at that time.
Some companies will automatically withhold a portion of the shares to cover your tax bill, but it’s important to check your tax rate to ensure you're covered.
If you hold the shares after they vest and the stock appreciates, any additional gains are taxed at the capital gains rate (long-term or short-term depending on how long you hold).
Pros:
Simple—no exercise price or complicated tax timing.
You get the shares outright once they vest.
Cons:
You’re taxed as ordinary income at vesting, even if you hold the shares and don’t sell them.
4. Restricted Stock Awards (RSAs)
RSAs are similar to RSUs but come with an added tax flexibility that can make a big difference: the 83(b) election.
How They Work:
With RSAs, you’re granted stock upfront, but they remain “restricted” until they vest. If you leave the company before they vest, the company can take them back.
Here’s where the 83(b) election comes into play: You have the option to file this election within 30 days of receiving the RSA, which lets you pay taxes based on the stock’s value at the time of the grant rather than when the stock vests.
Vesting and Taxes:
If you don’t file an 83(b) election, RSAs are taxed as ordinary income when they vest.
If you file an 83(b) election, you pay taxes upfront, which could be beneficial if the stock’s value increases significantly by the time it vests. You’re essentially locking in a lower tax bill if you believe the stock will rise.
After vesting, any further appreciation is taxed as capital gains, rather than ordinary income.
Pros:
Filing an 83(b) election can save you on taxes if the stock’s value appreciates significantly.
You own the shares from day one, giving you more control (even though they’re restricted).
Cons:
Filing the 83(b) is a gamble—you’ll pay taxes upfront, even if the stock drops in value or doesn’t vest.
Key Differences and What to Consider
Vesting: All of these types of compensation come with vesting schedules, meaning you earn your stock or options over time. You don’t benefit from them unless you stay with the company long enough for them to vest.
Taxation: This is the biggest factor that differentiates these options:
ISOs: Capital gains tax if you hold the stock long enough; potential AMT at exercise.
NSOs: Ordinary income tax at exercise, then capital gains tax on future gains.
RSUs: Ordinary income tax at vesting.
RSAs: Taxed at vesting unless you file an 83(b) election to pay taxes upfront.
Immediate Tax vs. Capital Gains:
RSUs and NSOs trigger immediate ordinary income tax at vesting or exercise.
ISOs and RSAs (with 83(b) elections) give you a chance to lock in capital gains treatment if you plan carefully and meet the holding period requirements.
Which is Right for You?
Each of these stock options has its pros and cons, and the right choice depends on your financial goals, your company’s future, and your risk tolerance. From my experience, I’ve learned the hard way. I was granted NSOs in a previous role, but I didn’t exercise them as soon as they vested. As a result, I ended up paying ordinary income tax on the gains instead of benefiting from the lower long-term capital gains rate. On top of that, another company didn’t allow me to file for an 83(b) election, which led to a much larger tax bill than I anticipated when the stock eventually vested.
These experiences taught me how important it is to understand the full picture of your stock compensation, including the tax implications. I hope the information I’ve shared here helps you avoid the same mistakes I made and guides you to make more informed decisions when considering your total compensation package. And as always, working with a tax advisor can make all the difference in ensuring you’re making the right choices for your situation.
"Dream big, deliver bigger"
Sujaiy Shivakumar
Sujaiy Shivakumar is a 3x tech startup founder, with his latest successful venture, Cloud303, growing into an AWS Premier Partner with over 60 employees. All views and opinions expressed in this blog are entirely his own.
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