Stock Options and Restricted Stock Units (RSUs)

By Glenn J. Downing, MBA, CFP®

What might an employer do to incentivize the workforce?  Make his employees owners.  Gives them an entirely new perspective on the job.  What employee-owned businesses do you know?  Does Southwest Airlines come to mind?  The flight attendant pouring your coffee may very well be a millionaire in SW stock if employed there long enough.  A little closer to home, how about Publix, where shopping is a pleasure?  Publix is a privately-owned company, but with a strong employee-ownership policy – and it shows.  People who work in Publix are actually helpful, and actually greet shoppers!

Employee-Owners

In our practice the main two ways we see employers accomplishing the goal of employee ownership is through  stock options and restricted stock units (RSUs).  The first involves the employee making a purchase of employer stock; the second is a direct stock grant to the employee.

In the stock option, the numbers to know are the grant price, the number of options, and the expiration date of the option. 

How Stock Options Work

For example, say I’m granted an option to purchase 100 shares of ABC corporation for $40/share.  The option expires in two years.  If the stock is trading on the market for $35/share at the time of the grant, the options are worthless.  Why would I ever exercise at $40 if I can purchase in the open market for $35? But the option is good for another two years – so maybe they’ll become valuable during that time. 

Continue the example.  The stock rises to $45, so I exercise.  This means that I must come up with $35 (option price) * 100 shares or $3500 to exercise.  There is an immediate tax hit at the time of exercise.  The difference between the market price and the option price at the time of exercise, $10/share * 100 shares, or $1000, is taxable at ordinary income rates. 

Cashless Exercise

Often companies offer their employees a cashless exercise option.  The brokerage firm handling the options would, in effect, offer the employee a momentary loan of the purchase price, here $3500, and then turn around and sell the shares.  There may be a nominal amount of margin interest on the trade, which would be netted out of the proceeds.  The proceeds would then be roughly $1000, or the difference between selling price and option price.  Employees who actually want to be owners would not choose the cashless exercise but would rather purchase the shares and hold them for future appreciation. 

Your holding period for capital gains tax begins with the exercise date – the date you actually made the purchase.  If you hold the stock for more than a year from exercise date before selling, then you have favorable long-term gains treatment.  If you sell your position within one year, then you have short-term capital gains (or loss) treatment.  This gain or loss is netted with gains and losses of other capital assets on Schedule D of your tax return.

The RSU

The restricted stock unit is another animal entirely, and one we commonly see with employees who work for tech firms.  There is no exercise price here, as there is no option to be exercised.  This is a direct grant of stock.  There is a vesting period, typically a year or two.  Vesting itself is a taxable event to the employee – the amount of stock vested is taxable as payroll, meaning with deductions for FICA and Federal tax.  Typically, the employee can choose at the time of vesting how many shares to immediately sell – all or just a portion sufficient to pay the associated taxes.  A large block of RSUs can easily run an employee into higher tax brackets.  This is sort of a high-class problem in that the employee is not out of pocket any money and ends up with another asset on his personal balance sheet – be it in cash from the sale of the RSUs or in the form of the RSUs themselves. 

Golden Handcuffs

The intention of the employer in offering employees RSUs is that of golden handcuffs.  The employer may offer new RSU shares with an associated vesting period each year – thus the employee has every motivation to remain with the company until the vesting period is met.  The goalposts are constantly moving forward, in other words. 

Either way – stock options or restricted stock units – the employer is binding the employee to the company and giving the employee serious reasons to remain and be productive and see the company prosper. 

Questions?  Thoughts?

Feel free to get in touch at [email protected].  Also follow me on LinkedInFacebook, and YouTube for more personal financial information relevant to you! 

 

 

 

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