Stock options and restricted stocks are forms of employee equity compensation given by employers. With these compensations, employees gain a stake in their companies and get the opportunity to hold partial ownership of the business and its profits. Stock options as well as the two types of restricted stocks (RSA and RSU) are generally the most common forms of equity compensation. Despite their use as equity compensation, there are differences between stock options vs RSA and RSU; in terms of vesting, way of grant, and taxation.
In this article, we will discuss stock options vs RSA differences and similarities. But first, let’s have an understanding of how stock options and RSA work.
Stock options are likely the most well-known form of equity compensation usually granted by startup companies to motivate their employees to help get the company off the ground. They do not involve a transfer of ownership and the holder may profit from the difference between the strike price and the actual market price of the stock.
The holder has the right to purchase a certain number of the company’s shares at the strike price for a fixed period of time. And the act of an option holder or employee buying the company’s shares at the strike price and time specified by the stock option is known as exercising the stock options. This can be done before the options mature (early exercise) or on the maturity date.
There are two kinds of stock options, which are the standard exchange-traded stock option and employee stock options (ESO). Employee stock options are usually compared with RSU and RSA because they are all issued to employees as compensation. Generally, the stock option involves a specific transaction date, a strike (or exercise) price, and the number of underlying shares involved. One stock option contract usually represents 100 shares of stock and its value depends on the difference between the strike price and the market price of the underlying stock.
Employees are usually offered two kinds of employee stock options, incentive stock options (ISOs) and non-qualified stock options (NQSO or NSO). One of the major advantages of getting issued stock options is that you get to buy the shares of the company stock at the strike price that may even be much lesser than the actual price of the stock in the market when the option eventually vests.
For incentive stock options, you may even get favourable tax treatment if you wait for two years from the grant date of the option and one year from the date of exercise to sell your shares. Once you meet these requirements, any profit generated from the sale of your exercised shares will be taxed as long-term capital gains.
What is an RSA?
Restricted stock award (RSA) is a type of equity compensation that grants an employee the company stock with certain restrictions. That is, an employee gets to own the shares of the company on the date that he/she accepts the grant and satisfies any purchase price requirements. Nonetheless, the shares will still be subject to vesting conditions. Restricted stock awards are considered restricted stock because the shares issued cannot be freely traded or transferred, which allows the company to stay in compliance with securities laws.
When the fair market value (FMV) of the common stock is very low, companies grant restricted stock awards so that employees don’t need to pay a lot to have ownership of the company. Moreso, when employees receive the shares of the company as compensation in form of RSAs rather than purchasing the shares outright, they don’t get hit with a significant tax burden.
Generally, RSAs are usually issued by very early-stage companies. They allow startups to offer equity with high upside potential, thus helping these companies compete for talent against larger companies that can pay higher salaries. This form of equity compensation has some advantages over certain types of options. Unlike stock options, restricted stock awards don’t have to be exercised. Therefore, as soon as you acquire RSAs, you start the long-term capital gains holding period. Also, RSAs don’t have to satisfy the additional ISO holding periods.
Once an employee is granted an RSA, the employee must decide whether to accept or decline the grant. If the grant is accepted, the employee may be required to pay the employer a purchase price for the grant. After accepting the grant and providing payment (if applicable) the employee must wait until the grant vests before the employee can receive the shares of the company stock.
Related: Equity options
Stock options vs RSA vesting
Vesting for RSA is different from how stock options vest because when granted, the recipient gets the vested RSA shares and owns them. Whereas, for stock options, the vesting period is the waiting time that the holder has to wait to earn the right to exercise their options.
Vesting of stock options
Stock options are usually restricted by a market standoff provision, that restricts the sale of shares for a specific period of time after an initial public offering (IPO) in order to stabilize the market price of the stock. Nonetheless, if stock options are awarded as compensation by a company that is already public, then, the options will usually have a vesting schedule. This schedule prevents people from leaving a company after a short period of time with shares of the company stock that could become valuable.
Vesting in stock options is earning the right to exercise your stock options over a period of time. For stock options, the time frame that an employee or investor must wait before they can fully exercise their stock options is known as the vesting period. This waiting period may be time-based, milestone-based, or a hybrid of both.
Companies usually set timelines called vesting schedules that show the employee the dates and number of years it will take to be able to exercise the option. Vesting in stock options may occur all at once or over a period of time. When vesting is granted all at once, it is said to be cliff vesting but when it is granted gradually in specific increments or stages over a period of time, it is said to be graded vesting or retable vesting.
Vesting for RSA is different from how stock options vest because RSA shares are acquired when granted to the recipient. Because the recipient that gets RSA shares owns them, the vesting for RSAs is based on whether the company can repurchase the shares when the recipient leaves the company. The RSA vesting only impacts whether the company can repurchase the shares if the employee leaves or is terminated, and therefore does not affect the employee’s tax obligations.
Several companies tend to have a vesting schedule to prevent a situation whereby an employee joins a company, gets their RSA and then immediately leaves the company. Therefore, in order to checkmate such cases, RSAs come with time-based vesting conditions. Even though time-based vesting is the standard for RSAs, milestone-based vesting can also be used although it is rare.
The company decides the rules of the vesting plan. If before the vesting period is over, an employee leaves in between, they would lose their shares because the company will either take it back or repurchase the amount vested. For example, assume Mary has been working for a company and has become a trusted senior staff. The company then decided to offer her some RSAs in order to appreciate her work and keep her for a longer time. Say, Mary gets 2,400 RSAs that have a 4-year vesting period and a 1-year cliff.
In this instance, the restrictions placed on the shares are time-based, which means that Mary has to continue working with the company for 4 more years to get the full rewards. According to the vesting schedule, Mary gets her first cut of 25% of shares after one year due to the 1-year cliff period. After that, she will get the shares on a monthly basis for the next 3 years, which means 50 shares vest per month. This means at the end of each year, Mary would have 600 more shares. After the 4 years end, she would own the full 2,400 RSAs and can choose to sell them back to the company for cash.
See also: Call option examples and problems
Taxation of RSA vs stock options
In as much as stock options and RSA are like gifts to exceptional employees, they still attract tax implications. The taxation on RSA vs stock options differs in terms of filing an 83(b) tax election and the holding period for long-term capital gain tax rate.
Taxes on RSA
The taxation of RSA is one of the unique characteristics of this type of equity compensation. The recipient of RSAs tends to have some say in how their RSA is taxed by making the choice to either file an 83(b) tax election or take no action and proceed with the default tax method. When an employee is granted RSAs by a company, he/she has to pay a certain price per share to acquire the share. If the cash purchase price that the employee pays equals the FMV, then they do not owe ordinary income taxes on the RSAs at the time of the grant.
With RSA, the time period for determining one’s eligibility for long-term capital gains tax treatment starts on the day that the RSA vests. RSAs allow you to take advantage of the 83(b) election which permits you to report the stock award as ordinary income in the year that it is granted. Hence, allowing you to start the capital gain holding period at that time. However, it is important to note that if the company’s stock fails to appreciate, you won’t get a refund of the tax paid when you made your election.
Restricted stock units (RSUs), unlike RSAs, aren’t eligible for an 83(b) election because no stock is actually issued to the employee when the units are granted. What the employee gets is basically a promise that on a date in the future, he/ she will be issued the stock if they’ve met all the vesting requirements. It is on that date, that the employee will pay ordinary income tax on the value of the stock.
RSA with 83(b) election
If the RSA of an employee includes vesting then the employee may need to file an 83(b) election with the Internal Revenue Service (IRS). Recipients of RSA should file an 83(b) election within 30 days of the grant date. A recipient filing an 83(b) election to the IRS means that he/she can choose to pay all of their ordinary income tax upfront on an RSA, at a time when the fair market value of the stock equals the strike price. Hence, there is no taxable difference between the FMV and the strike price.
As the fair market value of the stock increases over time, the employee would owe taxes on the difference between the FMV and the purchase price if they did not file an 83(b) election within the first 30 days of receiving their shares.
RSA without 83(b) election
Without filing an 83(b) election, the employee would owe ordinary income tax at each vesting event. That is, for a standard four-year monthly vesting schedule with a one-year cliff, the employee would owe ordinary income tax at the cliff and every month thereafter. The difference between the fair market value (FMV) at the time of vesting and the initial purchase price would be taxable. This means that as the value of the company grows over time, significant tax burdens could result in the future.
Therefore, an employee would owe taxes on the difference between the FMV and the purchase prices as the fair market value of the stock increases over time if he/she did not file an 83(b) election within the first 30 days of receiving their shares.
Taxes on stock options
When it comes to stock options, the tax implication begins when you exercise your options. The tax implications differ depending on the type of stock option held. With incentive stock options (ISOs), you can receive favorable tax treatment as long as you meet certain conditions. That is if you meet the requirement of holding your shares for at least two years from the grant date and one year from the exercise date before selling them.
If these requirements are met, the spread which is the difference between the strike price and the market price of the stock on the date of exercise would be exempted from ordinary income tax. And any gain gotten from when you eventually sell the shares is subject to the favorable long-term capital gains tax rate. However, note that exercising ISOs may trigger alternative minimum tax (AMT), therefore it is advisable to check with your tax advisor before exercising.
In a situation where you sell your ISO shares without meeting the holding period requirements in the same year as exercise (disqualifying disposition), then the spread and any gain from the sale of the shares is taxed as ordinary income.
For NQSOs, the tax implication is different. The difference between the strike price and the market price on the date of exercise (the spread) is taxed as ordinary income in the year of exercise and is subject to income and payroll tax withholding.
In a case whereby you hold the NQSOs shares for more than one year after you exercise and then sell the shares for a gain, the subsequent gain is taxed at the long-term capital gains rate. But if you hold the shares after exercise for one year or less and sell for a gain, the gain is taxed at your ordinary income tax rate.
Stock options vs RSA differences
- Stock options give the holder the right to buy or sell the company’s shares at a predetermined price within a certain period of time whereas RSA grants an employee the company stock with certain restrictions.
- The shares earned from stock options must be purchased by the employee whereas the RSA shares are granted to the employee.
- The shares of stock options are granted in the future (later date from the grant date) whereas RSAs are granted immediately.
- A major difference between stock options vs RSA is that the value of stock options is the difference between the strike price and the market value of the underlying stock while the value of RSA is the market value of the underlying stock.
- Another difference between RSA and stock options is that RSA doesn’t have to be exercised before one can own the shares whereas stock options have to be exercised before one can own the shares.
- Upon vesting, the employee has to take action to exercise the stock option while no action is required for RSA.
- For stock options, the unvested shares will be returned to the company’s option pool whereas the unvested RSA will be repurchased by the company.
Other essential differences between stock options vs RSA include their way of grant, terms, vesting, risk, expiration, and taxation which are explained in the table below:
|Criteria for comparison||Stock options||RSA|
|Definition||Stock options are a type of equity compensation that gives the holder the right to buy or sell the company’s shares at a predetermined price before or on a fixed date||Restricted stock award (RSA) is a type of equity compensation that grants an employee the company stock with certain restrictions.|
|Way of grant||The shares earned from a stock option must be purchased by the employee in order to own it||The shares are granted to the employee|
|Usually issued by||Private and startup companies||Very early-stage companies|
When granted stock options, the employee is given the option to either buy or sell the underlying stock at the strike price or leave the option to expire.
|When granted an RSA, the employee must decide whether to accept or decline the grant. If accepted, the employee may be required to pay a purchase price for the grant|
|Value||The value of stock options is the difference between the strike price and market value of the underlying stock||The value of RSAs is the fair market value of the underlying stock|
|Vesting||Vesting for stock options is earning the right to exercise your stock options over a period of time.||Vesting for RSAs is based on whether the company can repurchase the shares when the recipient leaves the company|
|Action upon vesting||The employee must take action to exercise the option and decide whether to hold or sell the shares||No action is required of the employee as the shares are usually deposited into a brokerage account for the employee|
|Risk||They are considered riskier because the value may be zero if the market price of the underlying stock is equal to or less than the strike price||They are considered less risky because the employee ultimately receives stock with the current fair market value|
|Taxation||Incentive stock options may be taxed as ordinary income, long-term capital gains, or according to the alternative minimum tax, depending on the timing of sale while NSO gains are taxed as ordinary income when exercised, whether the shares are kept or sold||With RSA, filing an 83(b) election permits the employee to report the stock award as ordinary income in the year that it is granted and then start the capital gain holding period at that time. But without filing an 83(b) election, the employee would owe ordinary income tax at each vesting event|
|Time of grant||The shares of stock options are granted in the future (later date from the grant date)||The shares of RSAs are granted immediately|
|Termination||If an employee leaves the company after their shares vest, they can still exercise their option before the 90-day post-termination exercise period ( PTEP). But if the employee leaves before the option vests, all the unvested shares will be returned to the company’s option pool.||If an employee leaves, they keep the vested RSA shares while the unvested RSA shares will be repurchased by the company at a lesser price than the price the employee paid for them or the current FMV|
|Expiration||The stock option contract comes with an expiration date||No expiration date on RSAs|
- Stock options and RSAs are both types of equity compensation.
- An 83(b) election can be filed for both RSAs and early exercise of stock options.
- They can both be offered to employees.
- Stock options and RSA have vesting schedules.
- The shares of the company are the payment for the settlement of stock options and RSAs.
- There are tax implications for both stock options and restricted stock awards.
See also: Put option examples and problems
Stock options vs RSA: which is better?
The comparison of stock options vs RSA to know which is better will depend on how we view both forms of compensation. Restricted stock awards can be considered less of an effort to deal with. This is because, typically, RSAs are automatically deposited in a brokerage account once vested on the employee’s behalf by the employer. Also, they represent actual shares given to the employee, so the employee doesn’t need to buy them. Stock options, on the other hand, involve more effort. This is because the employee must exercise them and buy the underlying shares.
Apart from the effort, the recipient has to put in, there can be different tax implications, for stock options and RSAs. The recipient of RSAs tends to have some say in how their RSA is taxed by making the choice to either file an 83(b) tax election or take no action and proceed with the default tax method. But for stock options, filing an 83(b) tax election is applicable upon early exercise.