Contributed by: Kali Hassinger, CFP®
Some of you may be familiar with the blanket term "stock options." In the past, this term was most likely referring to Employee Stock Options (or ESOs). ESOs were frequently offered as an employee benefit and form of compensation, but, over time, employers have adapted stock options to better benefit both the employee and themselves.
ESOs provided the employee the right to buy a certain number of company shares at a predetermined price for a specific period of time. These options, however, would lose their value if the stock price dropped below the predetermined price, thus becoming essentially worthless to the employee. As an alternative to this format, a large number of employers are now utilizing another type of stock option known as Restricted Stock Units (or RSUs). This option is referred to as a "full value stock grant" because, unlike ESOs, RSUs are worth the "full value" of the stock shares when the grant vests. This means that the RSU will always have value to the employee upon vesting (assuming the stock price doesn't reach $0). In this sense, the RSU is more advantageous to the employee than the ESO.
As opposed to some other types of stock options, the employer is not transferring stock ownership or allocating any outstanding stock to the employee until the predetermined RSU vesting date. The shares granted with RSUs are essentially a promise between the employer and employee, but no shares are received by the employee until vesting. Since there is no "constructive receipt" (IRS term!) of the shares, there is also no taxation until vesting.
For example, if an employer grants 5,000 shares of company stock to an employee as an RSU, the employee won't be sure of how much the grant is worth until vesting. If this stock is valued at $25 upon vesting, the employee would have $125,000 of compensation income (reported on the W-2) that year.
As you can imagine, vesting can cause a large jump in taxable income for the year, so the employee may have to select how to withhold for taxes. Some usual options include paying cash, selling or holding back shares within the grant to cover taxes, or selling all shares and withholding cash from the proceeds. In some RSU plan structures, the employee is allowed to defer receipt of the shares after vesting in order to avoid income taxes during high earning years. In most cases, however, the employee will still have to pay Social Security and Medicare taxes the year the grant vests.
Although there are a few differences between the old school stock option and the newer Restricted Stock Unit hybrid, these options can provide the same incentive for employees. If you have any questions about your own stock options, please reach out to us!
Kali Hassinger, CFP® is an Associate Financial Planner at Center for Financial Planning, Inc.®
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