Many companies issue their employees equity, or stock, as part of an overall compensation package. Two of the most popular forms of equity granted to employees are stock options (the right to purchase the stock at a set price) and restricted stock units, or RSUs (stock that is owned by the employee outright after working with the company for a set amount of time). While there are many considerations when choosing between options and RSUs, one of the most important things to keep in mind is how, and when, each is taxed.

While stock options were king in the 1990s, not all companies use them today, and for a good reason. Stock options require the employee to actually purchase the stock. Many employees will not do so, especially if the strike price is unusually high. On the other hand, from a tax perspective, stock options are attractive because the grant of an option is not taxable, which means that the employee does not have to pay taxes when the stock option is granted. This is assuming that the stock option does not have a marketable value, which would usually be the case with startup stock options. The employee will have to pay taxes when the stock option is exercised and sold, but these two events are within the control of the employee. (Certain types of stock options — called Incentive Stock Options, or ISOs — are not subject to income tax even at the point when they are exercised. However, they may be subject to an alternative minimum tax, or AMT.)

RSUs, in contrast, are immediately subject to tax when given to the employee. Since an employee who is granted RSUs is essentially receiving stock with a set monetary value, the RSUs are treated as income for tax purposes as soon as they have vested. This can create a significant cashflow burden for the employee since the granted stock, in many cases, cannot be sold immediately. Unlike with stock options, the receipt date of the stock represented by the RSUs is beyond the control of the employee.

To illustrate the concepts above, let’s consider the following comparison.

Example 1: Stock Options

In 2009, a company issues stock options to Sharon, a software engineer. The options allow Sharon to purchase 100 shares of stock at a strike price of $5/share, but the stock options come with a vesting period of 3 years. As no tax liability arises on the granting of stock options, Sharon owes no tax in 2009 with respect to these stock options. (If the strike price of the stock options is set at a price less than market value at the time of issuance, an additional tax penalty may arise. For the sake of simplicity, we’ll assume that this is not the case here.)

In 2012, the stock options have vested, so Sharon owns 100 options which can be exercised at any point. She chooses not to exercise the stock. As no stock options have been exercised, Sharon owes no tax in 2012 with respect to these stock options.

In 2014, the company is acquired for $50/share. Sharon exercises all the options, paying $500 for 100 shares of the new company. The amount of taxable income represented by Sharon’s exercised stock options is calculated as the difference between the price per share at the time the options are exercised — also referred to as the exercise price — and the strike price, multiplied by the total number of shares. In this case, that means ($50 – $5) x 100 shares, or $4,500, will be subject to income tax in 2014 (assuming the options are not ISOs; if they are ISOs, this amount will be subject to capital gains tax). As Sharon has not sold these shares, the payment of tax will have to come from an alternative cash source – that is, the “income” received for tax purposes is not in the form of immediately usable cash, but rather the paper value of the stock.

In 2016, the shares in the new company are worth $60/share. Sharon sells all 100 shares, making $1,000 from the sale. This $1,000 is subject to capital gains tax in 2016.

Example 2: RSUs

In 2009, a company issues RSUs to Rhonda, a sales and marketing manager. The RSUs granted to Rhonda stipulate that she will receive 100 shares of stock after a vesting period of 3 years. Rhonda owes no tax on the RSUs in 2009, as she does not own any stock at this point.

In 2012, the RSUs vest and Rhonda now owns 100 shares of the company’s stock. Let’s assume that the ascertained market value of the company’s stock is $20/share (in practice the market value of an unlisted business is very difficult to ascertain, but this is a topic for another post). The vested RSUs are valued at $20/share x 100 shares = $2,000. Since Rhonda now owns the stock, she is subject to income tax on this $2,000 in 2012. If there are no purchasers for the stock of the company, Rhonda will not be able sell the shares at this point and must therefore find money from other sources to pay this tax liability.

In 2014, the company is acquired, but Rhonda decides not to sell any stock. She owes no taxes on her RSUs in 2014.

In 2016, the market value of the stock is $60/share, and Rhonda sells all the stock for $6,000. Rhonda has just made $6,000 in income. Remember, however, that she has already been taxed for the $2,000 in income that she “earned” once the RSUs vested. For this reason, she only owes capital gains tax on $4,000 in 2016, the amount of the increase in the stock from the date at which the stocks vested.

From a purely tax perspective, an employee who is granted stock options will only have to pay income tax when the stock options are exercised, and capital gains tax when the shares are sold. The timing of both events is within the control of the employee. An employee who is given RSUs will be subject to income tax when RSUs vest — according to a schedule which is outside the control of the employee — and capital gains tax when the shares are sold. The uncontrollable nature of the tax liability that arises when RSUs vest may make RSUs appear less attractive than stock options for employees.

However, it is important to remember that the employee does not need to pay for RSUs, whereas stock options need to be bought. Furthermore, stock options become effectively worthless if the market value of the shares is lower than the strike price. Any company should take these factors into consideration when deciding whether to issue options or RSUs — and make sure their employees are aware of the tax implications.