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Take the Options!

Simplest isn’t always best, unfortunately.

Rick Segal writes about his preference for restricted shares over stock options, based on the fact that restricted stock is easier to explain than an option. That’s true.  No need to worry about strike prices, exercise dates, and all that stuff.

The tax consequences of restricted shares, though, are substantially different.

If you’re an American, restricted shares are either taxable when they vest, or taxable at the time they grant. Here’s a nice web page from Fidelity explaining this.  Stock options are taxable when they’re exercised.  You get the picture?  When you work for a startup who gives you a grant of restricted stock, the first thing you do is get your check book out and write a check to the IRS. You can either elect to pay all the tax at the time that the restricted stock is granted, or you can elect to pay tax on the fair market value as the stock grant vests.  Which is worse?  It’s tough to say.  If your company tanks, and you’ve paid the tax to Uncle Sam, then you have a capital loss on paper.  If your company soars, and you elect to pay tax as the stock vests, your grant becomes more and more expensive — your tax bill becomes higher and higher, even though you may not want to sell the stock right away. Stock options, by comparison, are only taxable at the time they’re exercised. No tax is owing until you decide to take your gain.

There is an upside to restricted stock.  If you own restricted stock for long enough, the gains will be taxed at the long term capital gains rate, which is half the rate that stock options are taxed. Restricted stock can be a good thing for you in the long run.  But be ready to write your check to Uncle Sam to get that benefit.

In Canada, restricted stock is taxed as ordinary income at the time of the grant.  Get $50,000 of stock, pay Revenue Canada it’s share.  The catch is this – if the vesting conditions aren’t satisfied, you don’t get to claim the tax back.  There is one potential upside.  Unlike a stock option, if your company pays a dividend (an unlikely event for a startup) you get to participate if you own restricted stock.

By comparison, if you are a Canadian resident and own stock options in a Canadian company, the tax treatment is very favourable.  The option is taxed, not at the time it is exercised, but rather at the time when the underlying stock is sold.  And, it’s always taxed at the capital gain rate, which is half the rate of ordinary income.  In Canada, a stock option has all the tax benefits of restricted stock in the US, but without any of the negatives.

As Rick points out, restricted stock granted at a penny a share, or stock options granted with a penny exercise price are basically the same.  And, in the case of a very early stage startup, it’s likely easier to give out restricted stock.  But as soon as the valuation moves up, new grants of restricted stock become a tax liability for the employee.

There you have it.  Restricted stock is easy to understand, but I’d always take options if they were offered.

My lawyer made me say this:

Not intended as legal advice.  Please consult a tax specialist before making any important decision with tax consequences.

{ 5 comments… add one }

  • Frank Miller October 5, 2006, 6:39 am

    There are actually two kinds of options: 1) non-qualified options and 2) incentive options. From the employees point of view, ISOs are generally considered better. Let me describe an example that will hopefully illustrate this.

    Let's say you are an employee of a startup that provides you X options at Y strike price. Lets further say that the company is acquired and the stock price at the time of acquisition is Z (which is presumably >> Y). Finally, lets say that you exercise the stock on the day the acquisition closes.

    If the options are NQ, the gain (i.e. X * (Z – Y)) is taxable immediately as ordinary income. Hopefully, this shoots you into a much higher tax bracket and you pay tons of taxes. If the options are ISO, you do not owe taxes as ordindary income. You instead apply the gain to whats called the Alternative Minimum Tax (AMT) calculation (which happens under the covers in things like TurboTax). In most cases, your AMT will skyrocket compared to your ordinary income tax and you'll endup paying that. The difference is that AMT is calclated essentially at a long term capital gains rate so the overall amount you pay to the govt is less.

    Its really much more complicated than this, and there are lots of options that need to be considered about when you exercise and when you actually sell. I'm mainly bringing up the fact that there are more than one type of option and employees would generally consider ISO's to be better than NQs.


  • Alec October 5, 2006, 12:37 pm

    You're entirely right Frank. My only experience with options in the US has been NQSO's. ISO's are a different beast altogether.

  • Espen Robak December 26, 2006, 8:49 am

    Frank, another great thing about Non-Qual's is that they are transferrable to your kids or other relatives. AND you get to pay taxes on them at exercise yourself, instead of that hit coming out of your kids' trusts. The estate planning tax benefits are very great from gifting options. Not so with ISOs (non-transferrable) or restricted stock (not transferrable during the restriction period, unless it's Rule 144 restricted stock, which is another animal altogether).

  • Ken March 23, 2008, 12:34 pm

    my question of the day is this: are restricted stock options NQSOs or ISOs?

    put another way: do I have to factor in restricted stock options that I have exercised but not yet sold into Alternative Minimum Tax calculations for IRS filing purposes? Or am I all set because I have already been taxed (federal withholding) at the time of vesting?

  • Alec March 23, 2008, 1:38 pm

    Ken, my understanding is that they can be either. But I would be talk with an account to be sure. Never having owned ISOs I don't have direct experience with them.

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