Taxation of RSUs, ISOs & NSOs
Non-Qualified Stock Options (NSO)
When you exercise the option, the difference between the option’s strike price and the current fair market value (FMV) is considered ordinary income and will show up on your W-2 and require withholding for income and payroll (FICA) taxes. If you are no longer an employee you will be required to provide the withholding amount to the employer. Any further appreciate or depreciation in the stock from that point forward is treated normally (i.e., as if you had bought the stock at the market price when you excised the option).
Warning – It is highly recommended that, at a minimum, you immediately sell enough stock to pay for the incurred tax liability of exercising your option. Otherwise, you risk having the stock plummet in value leaving you with a large tax liability with no way to pay for it (this happened to many people during the dot com bust).
Incentive Stock Options (ISO)
Unlike the NSO, an ISO does not get taxed as ordinary income when the option is exercised. Instead, when the ISO is exercised the gain (FMV – strike price) is added to the federal AMT income. If this amount is large enough to make the AMT tax larger than your regular income tax then additional taxes will be owed (you get a credit for this payment when you sell). If the shares are then sold more than a year after they were bought and more than two years after the ISO was issued, then the gain (i.e., the sale price minus the option strike price) will be treated as long term capital gains and is NOT added to your W-2.
Warning – If those criteria are not met (i.e., sell too soon), then it will be taxed like an NSO, except that the ordinary income is recognized at stock sale rather than option exercise which means it is not subject withholding of income and payroll taxes.
One last note on ISOs. Since the fair market value of the common stock normally takes a very large jump at IPO, you can significantly lower the AMT tax exposure by exercising the options before the IPO. Of course this requires you have to the money to do so and are willing to take the risk the IPO may not happen.
Restricted Stock Units (RSUs)
When you receive restricted stock units (i.e., stock which you are not allowed to sell until you are vested), you have two tax choices.
- Special Tax 83(b) election – report the restricted stock as ordinary income in the year the restricted stock is issued to you at the market value at issuance. It will be subject to withholding of income and payroll taxes. This has the advantage that all subsequent stock appreciation will only get taxed when you sell and will be taxed at capital gain rates. Warning – If you never become vested in the stock or the stock price drops in value before vesting you will not get back the extra taxes you paid.
- No election – report the restricted stock as ordinary income in the year you become vested in the stock at its market value at vesting. It will be subject to withholding of income and payroll taxes. Warning – like with the NSO, it is highly recommended that, at a minimum, you immediately sell enough stock to pay for the incurred tax liability.
Income Tax Implications Summary Table
|RSU – 83(b) election
As an executive for a large company or a founder of a start-up, you have invested a lot of yourself in the company. And it is natural to feel the stock is undervalued in the marketplace and that its future prospects are quite good. However, if a significant part of your net worth is tied up in a single company, you owe it to yourself to consider hedging enough of that exposure to ensure your personal fortunes don’t drop below an acceptable level no matter what happens to the company. And while diversification is much easier to achieve once you have vested in your stock, it is still possible to provide some hedging even before you are fully vested so don’t put it off.