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Stock Compensation: A Primer

There are several types of stock-based compensation offered by companies to attract and retain employees. But the three most common types of stock compensations that I run into are restricted stock units (RSUs), incentive stock options (ISOs), and non-qualified stock options (NQSOs). The objective of this article is to help you gain foundational knowledge of how each option works and a few tax strategies to go along with each option.

The Basics

Employees who receive non-cash payouts called stock compensation essentially hold partial ownership of the company and its performance. The more successful the company becomes, the higher the value of the stock and the more money you will gain when you sell your equity compensation.

When you receive stock options, the company does not hand you shares of stock right away. Instead, you receive a contract: the right to purchase shares in company stock at a certain price, in most instances below market value, at a future date. If all goes according to plan, the price of the stock will rise over time, enabling you to sell them at a higher price than when you exercised the options.

When you exercise your options, you are purchasing shares of your employer’s common stock at the price indicated in your option grant. The “spread” is the difference in value between the strike price and the shares’ current value when you exercise your options. Keep in mind, you are not obligated to exercise your options.

Before you can exercise the options, the employee must follow a vesting schedule. In other words, you must work for the company for a specified period to obtain those shares. In some instances, you may be able to exercise your options early (e.g., before the vesting deadline). That move can have tax advantages, but there are downsides as well. You may be prohibited from selling shares of your stock to purchase the vested shares, so may have buy out of pocket.

Restricted Stock Units

Restricted stock units (RSUs) are the most common type of equity compensation. RSUs do follow a vesting schedule, so you don’t leave the company after receiving the compensation the next day. However, you don’t have to purchase and no need to exercise. The moment the vesting requirements are met (i.e., not restricted any longer) you are now the official owner of these RSUs. As long as the FMV isn’t negative, you have yourself a bonus in the form of a stock.

Upon vesting, you may notice that ordinary income taxes are due. Typically, your payroll department will withhold federal, state, social security, and medicare taxes before the final set of stocks are released to you. At this point, you can sell the stock immediately and use take the proceeds or hold the shares for a later date and hopefully sell for a higher profit (of course not guaranteed).

A word of caution for pre-IPO RSUs, there may be what’s called a “double-trigger” which requires that not only the RSUs vest, but there needs to be a liquidity event. The liquidity event can either be (1) the company goes public (2) is acquired or merged (3) can be sold in a private equity market. The rationale for this is if the shares are taxed as income when received but they can be sold to pay the tax, this could create challenges. Therefore, most companies will not have an employee taxed on the RSUs until both events happen: vesting and a liquidity event. 

Incentive Stock Options

Compared with other forms of compensation, incentive stock options (ISOs) can provide executives and other employees with substantial tax breaks. If held for 12 months + 1 day, shares purchased as ISOs secure long-term gains rate of 15%. But as many “paper millionaires” discovered during the most recent stock market downturn, exercising ISOs can be very risky, especially if the employee fails to weigh all the potential tax consequences before cashing in.

There is a limit on the total value of ISOs that can vest and be exercised in any calendar year ($100,000). Taxation can be more advantageous if a strict schedule is adhered to. You’ll need to hold onto the shares for a minimum of two years from the grant date and one year from the exercise date to qualify for preferential tax treatment. If your company is pre-IPO, this can take some careful planning to keep lock-up periods in mind.

ISOs can also trigger alternative minimum taxes (AMT), which is higher than your normal taxes.  When calculating your tax liability, you must add in the spread between the grant price and the market value as a “preference item” on the Alternative Minimum Tax (AMT) worksheet. If the amount you pay under the AMT is higher than your regular income tax, you will be have to pay the AMT instead.

The AMT is adjusted based on the price you pay for the shares (the strike price) and the fair market value when you exercise. We call the difference the bargain element. Because you can choose when to exercise, you do have some flexibility in avoiding or minimizing AMT, but it requires careful planning of your income. A financial advisor or tax professional can usually help you model out various scenarios to select the right one for your situation.

Fortunately, there are ways to reduce the chances of falling into this trap. Depending upon your circumstances, you may want to consider the following strategies when exercising your incentive stock options:

  • Sell your shares in the same year you exercise
  • Exercise just enough to avoid AMTs (break even)
  • Exercise incrementally to minimize the AMT liability
  • Exercise your ISOs when the spread between the strike price and FMV is low
  • Exercise your ISOs before April 15th so that you can sell the following year before April 15th to lock in long term capital gains and have the proceeds ready to pay for AMT

If you can’t avoid AMT, you can turn the AMT liability into AMT credits to offset future tax liabilities.

Non-Qualified Stock Options

NQSOs are the second most common type of stock options. Most companies typically choose to hand out non-qualified stock options to employees for tax reasons: they can deduct the costs of NQSOs as an operating expense sooner than with other options. In addition, the IRS does not limit the total number or value of NQSOs that a company can grant to an employee.

When you exercise your shares (i.e., assuming your strike price is lower than current market price), the difference between your strike and fair market value is considered ordinary income and will be reported on your W-2 for the year you exercised the options. In other words, your payroll department will have to withhold your taxes immediately upon exercise and you don’t get to wait until next April to pay it.

Once you receive the shares, you have the choice of either selling them or holding on to them. At this point, they are like any other stock investment and will subject to either short or long term capital gains tax.

Be mindful

  1. Understand the basics of equity compensation before you negotiate your salary
    • How long is the vesting period before you are eligible for the compensation?
  2. For pre-IPOs, do you know the multiple triggers that completes vesting requirements?
    • Do you know where you can go to sell these private shares?
  3. Read your stock plan document
    • Will your employer allow you to file 83b?
  4. Find out how you can exercise your stock options
    • Do you have enough liquidity to exercise?
    • Can you sell to cover?
  5. Plan for taxes
    • For ISOs, will you have to pay Alternative Minimum Taxes?


When accepting a job offer, it’s crucial to understand the different stock benefits available to you and the best way to take advantage of the rewards while mitigating taxes as much as possible.