Navigating Stock Compensation: An In-Depth Analysis (RSA, RSU, ISO, & NSO/NQSO)

Stock compensation can often be complex. In this blog post, we look into the intricacies of Restricted Stock Awards (RSAs), Restricted Stock Units (RSUs), Incentive Stock Options (ISOs), and Nonqualified Stock Options (NQSOs). Below we break down these financial instruments with a focused examination, shedding light on their different characteristics.

RSAs (Restricted Stock Awards)

There is typically no payment for the employee on purchase date of the stock, but it is not prohibited.
A tax deduction is not permitted until the shares become vested, except if the employee opts for a Section 83(b) election. If such an election is made, the tax deduction for the employer company equals the fair market value of the transferred shares.
On the grant vesting date, the tax deduction equals FMV unless it was taken at the election of 83(b).
On the stock disposition date, the employer cannot claim a tax deduction since that was taken at the vesting dates.
Should dividends be disbursed to the owner of an unvested RSA, the employer company can deduct the payment as employee compensation, rather than categorizing it as a conventional dividend.
Employee compensation withholding is mandatory on the vesting date.

RSUs (Restricted Stock Units)

Generally, the employee does not pay for the shares on the purchase date of the stock, but it is not prohibited.
There is no tax deduction allowed for the employer if the grant follows Section 409A. But if the section is not followed, then the stock is tax deductible to the company and immediately taxable to the employee (plus a 20% penalty) If Section 409A is appropriately followed, the deduction for the employer will be triggered at the same time as income to the employee, at the RSU transfer date.
On the vesting date, there is no tax deduction offered for the employer.
On the stock disposition date, the employer cannot claim a tax deduction.
Should the RSU rights escalate owing to dividends disbursed prior to RSU settlement, the resulting increase becomes deductible for the employer upon payout as employee compensation, rather than being categorized as a conventional dividend.
When the stock is paid to the employee, income tax withholding is required. But when the stock is vested then the FICA tax withholding is required.
With the election of Section 83, an employer can design a stock plan to delay the employee’s income tax payment, doing so also defers the employer’s income tax deduction.

ISOs (Incentive Stock Options)

Payment for options is deferred until employee or contractor exercises their right to exercise the option at the given strike price.
The award exercise price must be equal or greater than the company stock FMV. And a minimum of 110% of the fair market value of the employer company’s stock is required when granting it to a shareholder who holds at least 10% ownership.
The employer is not allowed a tax deduction on grant date, vesting date or exercise date.
On the stock disposition date, no deduction is allowed if the employee has held the stock for at least 1 year after the exercise date and 2 years after the grant date. If these requirements are not met, the employee’s exercise is considered a ‘disqualifying disposition’, subjecting the ISO to NSO/NQSO-like limitations. The employer’s tax deduction calculated as follows: (1) the lower value between the stock’s fair market value on the exercise date or the proceeds from the disposition, minus (2) the exercise price paid. Conversely, the employee now owes ordinary income tax on the spread between the FMV of the exercise date and the original strike price (for a disqualifying disposition).
Normally, individuals holding unexercised stock options do not receive dividends. Yet, in the event dividend equivalents are disbursed on unexercised stock options, the sum will not be classified as a dividend; instead, it would be deductible for the employer as employee compensation.
Income tax withholding, but not FICA, is required on employee compensation when there is a disqualifying disposition; otherwise no tax withholding is required.

NQSOs (Nonqualified Stock Options)

Payment for options is deferred until employee or contractor exercises their right to exercise the option at the given strike price.
The Award Exercise price must be greater than or equal to the company’s stock FMV on grant date.
The employer is not allowed a tax deduction if the exercise price is more than the FMV of the stock on grant date. Otherwise, Section 409A is applicable.
On grant vesting date, the tax deduction equals the present FMV of the stock at that time, subtracted by the exercise price paid, under two conditions: (1) the employer company stock’s vesting date postdates the exercise date, and (2) no Section 83(b) election was made during the grant exercise.
On the grant exercise date, the tax deduction is equal to the current FMV on that particular date.
On the stock disposition date, the employer cannot claim a tax deduction.
Normally, individuals holding unexercised stock options do not receive dividends. Yet, in the event dividend equivalents are disbursed on unexercised stock options, the sum won’t be classified as a dividend; instead, it would be deductible for the employer as employee compensation.
Income tax and FICA tax withholding are both required on the exercise date if (1) it is the same date as the vesting date and (2) a section 83(b) election was made. Payroll tax withholding is required on vesting date if (1) the vesting date comes after the exercise date and (2) election for section 83(b) was not made.
Section 83(b) is available for NQSOs if the stock is subject to considerable risk.
With the election of Section 83, an employer can design a stock plan to delay the employee income tax payment; doing so also defers the employers income tax deduction.

Here is a more in-depth look at each stock

Restricted Stock Awards (RSA)

RSAs are shares that come from the corporation stock that the company then transfers to a specific employee. Although employees do not typically have to buy these shares, there normally is a multiple-year vesting schedule set in place and the stock is transferred over time.

When the vesting date arrives, the company stock becomes deductible to the corporation. At the same time, the stock is also reported as W2 wages for the employee. This tax deduction occurs only once the vesting date has arrived, unless a Section 83(b) election was made. In that case,the tax deduction is then equal to the fair market value of the given shares. Unlike NQSOs and ISOs, RSA’s do not require the election of Section 83(b) to be made during the early exercise period.

Section 83(b) may be a good choice for employees when offered if they think the company’s stock value will increase throughout the vesting period. However, electing into the Section 83(b) is optional as it would advantageously:

Lower the employee’s normal income during that vesting period.
Maximize the employee’s capital when the stock is eventually sold. However, the employee owes the taxes today for the full value of the RSA’s, and is exposed to two risks:

- The employee cannot receive a refund of the income taxes they have paid at the time of making the election.
- The full value of the RSA is calculated as the tax base, and the employee may be terminated prior to the full vesting of those RSA’s.

Restricted Stock Units (RSU)

RSUs are a form of compensation typically offered by companies to their employees as part of their overall remuneration package. These represent a company’s promise to grant employees a specific number of shares or their cash value on a future date. The final payout is determined by pre-defined performance metrics and stock price.

RSUs are not ruled by Section 83. This is because they are not considered property in the sense of income tax. Because of this, there are no implications for the employer when a RSU is granted to an employee.

Instead, an RSU is taxed under Section 451 because it is deferred compensation. It is important to be aware of the potential penalties that fall under Section 409A. The employer is only allowed the tax deduction once the RSU is actually paid to the employee. The deduction amount is equal to the compensation given (and income reported to the employee on their W2)

Incentive Stock Options (ISO)

Incentive Stock Options or ISOs are an award that is typically preferred by the employee because no taxable compensation is recorded when the shares are transferred to the employee and 100% of the appreciation value is taxed to them as a capital gain once they choose to sell their shares.

There are a few requirements that need to be met in order for the grant to be considered an ISO.

The option price must be equal to or more than the fair market value.
The option price must be offered in a written plan and approved by the company shareholders within 12 months pre or post the plan being adopted.
The grant can only go to employees (not contractors or vendors) and they are not allowed to be transferred.
The term of the grant cannot go past 10 years.
The maximum fair market value of the stock options that become eligible for exercise initially is capped at $100,000 within a single calendar year (any amount above this must be granted in the form of NQSO or NSO).
The employee must hold the shares for at least 2 years after the grant date and 1 year after the exercise date. Otherwise, a “disqualifying disposition” is triggered, which taxes the option as an NQSO or NSO, and ordinary income tax is owed on the spread between the FMV and strike price.

ISOs serve as a way for companies to incentivize and retain their employees by offering them the opportunity to benefit from the company’s growth through ownership of its stock.

Section 83(b) can be filed if done so in the early exercise period. A letter must be submitted to the IRS 30 days from the grant date. This letter must be followed up with a letter to the employer letting them know that there has been a filing for Section 83(b). If this is a choice they plan to make, consulting with a CPA is helpful. ISOs under stock plans without early exercise rights are not eligible for Section 83(b) election.

Nonqualified Stock Options (NQSO)

The NQSO is a stock option that typically follows the ruling of Section 83. However, in order to avoid having to use the application process from Section 409A, employers should offer equal or a greater amount than the fair market value on the grant day.

The NQSO can only qualify for Section 83(b) if it is elected during the early exercise period and is specifically permitted through the stock plan. It is helpful to contact a CPA for clarification during this process.

However, it is important to understand that if the NQSO is no longer subject to risk of forfeiture or the election of Section 83(b) is not made, the employee can postpone the taxable event beyond the expected date.

If the taxable event occurs on the date listed, the employer can claim a normal income tax deduction (but also must pay its share of FICA tax)

Does all of this sound a little overwhelming? Contact us today and we can help you!

Last Modified
August 2, 2024

FOR ANY QUESTIONS

CONTACT US

Finvisor HQ
48 2nd St, 4th Floor
San Francisco, CA 94105

(415) 416-6682

hello@finvisor.com

"*" indicates required fields

Details

Company*

Phone

Email Address*

Where did you hear about us?

Message*

Can Finvisor reach out to you via SMS?

Agree

CAPTCHA

Comments

This field is for validation purposes and should be left unchanged.

76754

Navigating Stock Compensation: An In-Depth Analysis (RSA, RSU, ISO, & NSO/NQSO)

There is typically no payment for the employee on purchase date of the stock, but it is not prohibited.

A tax deduction is not permitted until the shares become vested, except if the employee opts for a Section 83(b) election. If such an election is made, the tax deduction for the employer company equals the fair market value of the transferred shares.

On the grant vesting date, the tax deduction equals FMV unless it was taken at the election of 83(b).

On the stock disposition date, the employer cannot claim a tax deduction since that was taken at the vesting dates.

Should dividends be disbursed to the owner of an unvested RSA, the employer company can deduct the payment as employee compensation, rather than categorizing it as a conventional dividend.

Employee compensation withholding is mandatory on the vesting date.

Generally, the employee does not pay for the shares on the purchase date of the stock, but it is not prohibited.

On the vesting date, there is no tax deduction offered for the employer.

On the stock disposition date, the employer cannot claim a tax deduction.

Should the RSU rights escalate owing to dividends disbursed prior to RSU settlement, the resulting increase becomes deductible for the employer upon payout as employee compensation, rather than being categorized as a conventional dividend.

When the stock is paid to the employee, income tax withholding is required. But when the stock is vested then the FICA tax withholding is required.

With the election of Section 83, an employer can design a stock plan to delay the employee’s income tax payment, doing so also defers the employer’s income tax deduction.

Payment for options is deferred until employee or contractor exercises their right to exercise the option at the given strike price.

The award exercise price must be equal or greater than the company stock FMV. And a minimum of 110% of the fair market value of the employer company’s stock is required when granting it to a shareholder who holds at least 10% ownership.

The employer is not allowed a tax deduction on grant date, vesting date or exercise date.

Normally, individuals holding unexercised stock options do not receive dividends. Yet, in the event dividend equivalents are disbursed on unexercised stock options, the sum will not be classified as a dividend; instead, it would be deductible for the employer as employee compensation.

Income tax withholding, but not FICA, is required on employee compensation when there is a disqualifying disposition; otherwise no tax withholding is required.

Payment for options is deferred until employee or contractor exercises their right to exercise the option at the given strike price.

The Award Exercise price must be greater than or equal to the company’s stock FMV on grant date.

The employer is not allowed a tax deduction if the exercise price is more than the FMV of the stock on grant date. Otherwise, Section 409A is applicable.

On grant vesting date, the tax deduction equals the present FMV of the stock at that time, subtracted by the exercise price paid, under two conditions: (1) the employer company stock’s vesting date postdates the exercise date, and (2) no Section 83(b) election was made during the grant exercise.

On the grant exercise date, the tax deduction is equal to the current FMV on that particular date.

On the stock disposition date, the employer cannot claim a tax deduction.

Normally, individuals holding unexercised stock options do not receive dividends. Yet, in the event dividend equivalents are disbursed on unexercised stock options, the sum won’t be classified as a dividend; instead, it would be deductible for the employer as employee compensation.

Section 83(b) is available for NQSOs if the stock is subject to considerable risk.

With the election of Section 83, an employer can design a stock plan to delay the employee income tax payment; doing so also defers the employers income tax deduction.