Tax Impact of Employee Stock Options

Employee stock options are a common way for companies to compensate their employees in addition to, or sometimes in lieu of, a salary. Understanding the tax impacts is critical to ensuring that the maximum benefit is received.

Restricted Stock Units

Restricted Stock Units (RSUs) are shares of company stock that are granted to an employee and “restricted” until a vesting schedule is satisfied. The vesting schedule can vary with different employers and is typically based on length of employment or performance metrics. Although the shares have been granted to the employee, separation of employment will generally stop the shares from vesting (most plans allow for exceptions such as disability, retirement, displacement, death, etc.)

Since there is the possibility of RSUs being forfeited, they are not taxable until they are delivered to the employee on the vesting date. Once vesting occurs the shares become taxable as compensation and are subject to employment tax withholding (Federal, FICA, State, & Local). The amount of taxable compensation is reported on the employee's W-2, and is determined by taking the per share market value on the vesting date, and multiplying by the number of shares vested. Most commonly companies will pay the employment taxes by holding back a number of shares equal to the taxes.

After the shares have vested and employment taxes are paid, the net shares are now owned by the employee and can be sold at any time. The cost of the shares for determining capital gain or loss is the market value on the vesting date. If held for 1 year or longer past the vesting date, any gain on sale will be considered long-term and subject to a maximum tax rate of 20%. If the value decreases and a loss is incurred, the loss can be used entirely to offset capital gains and up to $3,000 of ordinary income per year.

To bring it all together with an example, let’s say you are granted 1,200 RSUs with a market value of $10 per share on the grant date. The vesting schedule provides that 1/3 of the shares will vest on each 1 year anniversary from the grant date.

Grant Date – The total value of the RSUs are $12,000 on the grant date (1,200 shares x $10/share). Nothing happens at this time because the shares have not yet vested.

1st Year Anniversary – One year after the grant date 400 shares will vest. If the market value of the shares has decreased to $8 your taxable compensation will be $3,200(400 shares x $8/share). Assuming employment taxes on that amount are $1000 you would then receive a net of 275 shares ($2,200 MV / $8).

2nd Year Anniversary- Two years after the grant date another 400 shares will vest. If the market value of the shares has increased to $12 your taxable compensation will be $4,800(400 shares x $12/share). Assuming employment taxes on that amount are $1,500 you would then receive a net of 275 shares ($3,300 MV / $12).

3rd Year Anniversary – Three years after the grant date the final 400 shares will vest. If the market value of the shares has increased to $16 your taxable compensation will be $6,400(400 shares x $16/share). Assuming employment taxes on that amount are $2,000 you would then receive a net of 275 shares (4,400 MV / $16). Your total basis in the remaining 825 shares is $9,900(2,200 + 3,300 + 4,400).

4th Year Anniversary – Unless you have received additional RSUs there are no more shares to vest. If you decide to sell all 825 of the previously vested shares when the market value is $20 you will receive $16,500(825 x $20). Of that amount $6,600 will be taxable as a long-term capital gain ($16,500 – $9,900).