RSU, ISO, NQSO, and QSBS: What Are the Differences?
RSU, ISO, NQSO, and QSBS: The alphabet soup of executive compensation. For most employees, the names themselves are difficult to navigate, let alone the tax implications involved with each type of compensation.
Equity compensation can be complex, and with the rise in popularity of equity as a form of compensation, it is more important than ever to understand the details as the equity comp can often be many times greater than base salary.
When working with equity compensation clients, the most commonly asked questions are: What are the differences between each type, and how do I minimize the tax?
Let's start with an overview of the various stock compensation categories.
RSUs: Automatic Vesting of Set Number of Units
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Taxation |
Taxed as ordinary income (through W2) at vest. Capital Gain thereafter with “new” cost basis being the price at vesting. |
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Vesting and Exercise |
Automatic vest, usually every quarter in 4-year cycles. No exercise is required. |
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Expiration |
Vesting schedule applies. |
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Risk |
No control as to when stock gains are recognized or at what price. |
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Key Characteristic |
The employee does not have to pay to acquire the RSUs – infinite leverage. |
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Key Decision |
Take all cash at vest or retain net shares after taxes. |
NQSO: Option to Buy Stock at a Set Price – The Strike Price
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Taxation |
At the time of exercise, taxed as ordinary income (through W2) on the difference between the stock’s fair market value (FMV) at the time of exercise and the exercise (“Strike”) price. Capital Gains on any appreciation thereafter if stock is held after exercise. |
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Vesting and Exercise |
Usually have a vesting period. Thereafter, there is discretion when to exercise. |
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Expiration |
Typically, must be exercised within 10 years of the Grant. |
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Risk |
Can become worthless if the stock price falls below the Strike price. |
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Key Characteristics |
The employee has to fund the Strike price. The employee has control over when to exercise and takes the gain through W2. |
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Key Decision |
Exercising early and having the financial liquidity to do so. |
Incentive Stock Options: The AMT and Capital Gains
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Taxation |
FMV at exercise—strike price = AMT Income and possibly AMT. After exercise, capital gains tax rates apply to any appreciation above the Strike price. This income is not included in W2 income. |
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Vesting and Exercise |
Usually have a vesting period. After vesting, there is discretion when to exercise. |
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Expiration |
Typically, 10 years. |
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Risk |
Can become worthless if stock price falls. AMT can be viewed as a pre-payment of tax which may not be able to be utilized if the stock price falls. |
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Key Characteristic |
Management of the AMT Liability and the AMT Credit. |
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Key Decision |
Whether to incur and ways to avoid incurring the AMT. |
Qualified Small Business Stock: The First $10M of Gain Is Exempt From Tax
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Taxation |
Up to 100% capital gains tax exclusion on first $10M of gain if shares are held for >5 years, the company is a C corp, and the shares were acquired at a time when the company had gross assets of less than $50M. |
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Vesting and Exercise |
5-year clock begins when shares are acquired – they must be shares, not options. |
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Expiration |
N/A. |
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Risk |
Usually, start-up risk and eligibility criteria. |
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Key Characteristic |
If the shares are QSBS at issue – they always remain QSBS shares . |
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Key Decision |
Whether to wait the 5 years or take an earlier exit |
Source: BakerAvenue Gerry O'Connell, Enrolled Agent Tax Planning, Partner
Understanding the nuances of each option and layering on the Alternative Minimum Tax (AMT) considerations can be extremely challenging. Many of our clients choose BakerAvenue because they know they can access a team of in-house Tax Enrolled Agents (the most elite certification awarded by the IRS) with deep experience from Big 4 accounting, law, and banking firms.
If you'd like to discuss your specific situation, click to schedule an introductory call.