Tax Implications of Equity Compensation in Tech: Navigating ISOs and RSUs

Dan Pascone |

Equity compensation is the cherry on top tech companies offer to attract brilliant minds like yours and encourage them to stay for at least a few years.

It's like getting a slice of the company pie; if its value skyrockets, your slice gets sweeter, too. 

Today, roughly one-third of private and 40% of public companies offer stock options to a wide range of employees, not just executive levels. 

Navigating the various stock compensation plans– ISOs, RSUs, RSAs, NSOs, ESPPs, and more– for the first time can be a dizzying experience. 

Each type has its own set of rules and tax implications, making it tricky to precisely determine what you're getting into when weighing your options between companies. 

Fear not– we’ll decode the alphabet soup for you in less time than it takes to wait for your coffee order. 

In this guide, we’ll examine the tax implications of ISOs and RSUs, the two most common forms of equity compensation in tech companies. 

Incentive Stock Options (ISOs) allow employees to purchase company stock at a predetermined price, usually after a vesting period.

Companies might have different vesting schedules for stock options: some use a graded approach (for example, 25% of the options vest every year for four years), while others have a cliff setup (for example, 100% of the options vest after four years). 

While there's no rush to exercise them as soon as they vest, keep an eye on the expiration date so you don’t miss out on your opportunity. 

ISOs receive favorable tax treatment under the U.S. tax code, but come with specific conditions and complexities– such as the Alternative Minimum Tax (AMT). 

You don’t pay income tax upfront when you exercise ISOs (i.e., you use your option to buy company stock), but the “bargain element” (the difference between the exercise price and the market value at the time of exercise) may be subject to the Alternative Minimum Tax (AMT), which could affect your tax liability.

The (AMT) is a parallel tax system in the United States designed to ensure that individuals who benefit from certain tax advantages pay at least a minimum amount of tax; it recalculates income tax after adding back specific tax preferences and deductions.

The AMT uses two tax rates– 26% up to $206,100 in 2023 and 28% above that), and the bargain element may be subject to it. 

When you sell, it also impacts your taxation:

  1. When you sell your ISO shares at least one year after exercising them and at least two years after they were granted, you have a qualifying disposition– profits are taxed at long-term capital gains rates. 
  2. Suppose you sell your ISO shares before meeting these time requirements. In that case, it's called a disqualifying disposition– the bargain element (the difference between the stock's market value at the time of exercise and the exercise price) is taxed as ordinary income. Any additional gains beyond the bargain element are taxed as capital gains.

Let’s put a pin in AMTs for now and spare you the intricacies– but just know you need to consider the entire context of your overall income and deductions to calculate the specific AMT for the bargain element. 

Restricted Stock Units (RSUs) are shares given to you that become entirely yours after vesting.

RSUs are way more straightforward than the ISOs above but don’t receive as favorable tax treatment. 

Uncle Sam taxes Restricted Stock Units (RSUs) twice.

First, their value is taxed as ordinary income when they vest, so brace for federal, payroll (Social Security and Medicare taxes), state, and local taxes. Companies will sometimes withhold 20% for taxes, but that might not cover the total bill, so plan for any additional tax due– you’ll be receiving shares but paying taxes on them in dollars out of pocket. 

Remember that RSUs are taxed as ordinary income—the same as your salary and other ordinary income. 

So, let’s say you receive $50,000 worth of RSUs, and your marginal tax rate is 25%– you’d theoretically owe about $12,500 in tax (or more if it bumps you up to a higher tax bracket). 

Secondly, you get taxed again when you sell the shares:

  1. Selling after holding them for a year post-vesting qualifies you for the lower long-term capital gains rate;
  2. Selling earlier means paying tax at your ordinary income rate.

Let’s zoom out briefly and see things from the company’s perspective. 

The Company and Employee POV: ISO vs RSU

When companies decide between granting Incentive Stock Options (ISOs) and Restricted Stock Units (RSUs), they're thinking about a few critical things in addition to employee motivation:

  1. Their growth stage
  2. the simplicity of the plan,
  3. and its tax implications.

ISOs are like giving employees a future ticket to buy company shares at today's price. They're complex but can be very rewarding tax-wise for employees if they play their cards right. 

Companies often use ISOs to give their employees a sense of ownership and a direct stake in their success—“the harder you work to make the company grow, the more valuable these options can become!” 

However, ISOs can be a gamble for employees because they sometimes have to put up their own money to buy the shares and hope the shares increase in value.

That’s where salary becomes a significant consideration— a company wants to pay its employees enough to make exercising those options realistic. 

On the other hand, RSUs are more like a promise that employees will get shares in the future, not at today's price, but at the price when the shares actually "vest" or become theirs. 

RSUs are more straightforward to deal with from a tax perspective and don't require employees to spend money. 

However, RSUs are taxed as ordinary income when they vest and don’t get the potential tax benefits that ISOs do. 

When a company is new, and its shares aren't worth much, Restricted Stock Awards 

(RSAs– a cousin of RSUs) can be attractive because they give employees ownership right away with minimal tax impact. 

As the company and the value of its shares grow, RSUs might be more appealing because they're straightforward and still offer significant value without the complexities and risks of stock options.

A company considers a balance between company goals, current growth trajectory, and employee incentives when deciding between things like ISOs and RSUs. 

Both are attractive for employee retention since employees must stay with the company until the options vest. 

ISOs aren’t recognized as an expense for the company until they're exercised and can be complex to administer and understand. Their tax benefits are mainly for the employees, not the company.

A company might choose RSUs over ISOs if it wants a simpler compensation tool that employees can understand and value. RSUs are simpler and don't involve any out-of-pocket expenses for employees. They're recognized as an expense for the company when they vest, which can be a more immediate financial consideration for the company than ISOs. 

RSUs are also taxed as income, so there's less favorable tax treatment for employees compared to ISOs, but this simplicity can make them more straightforward to manage and explain.

A more established and stable company may favor RSUs because they offer a predictable and guaranteed benefit. RSUs provide guaranteed value (assuming the stock has value) at the time of vesting. In contrast, ISOs carry a risk if the stock's value decreases since employees pay for them out of pocket. 

Leading tech giants like Google (Alphabet Inc.), Apple, Microsoft, Amazon, and Facebook (Meta Platforms Inc.) offer highly competitive compensation packages that include RSUs.

However, ISOs can be very appealing for rapidly growing tech companies where the stock price is anticipated to increase over time. ISOs help this type of company cater to talent willing to get some “skin in the game” and reap the rewards as the company grows. 

For example, Tesla, Twitter, LinkedIn, Uber, and Square all likely used ISOs in their early growth stages. 

If you’re ever curious about a publicly traded company's stock compensation strategy, including the use of ISOs or RSUs, you can check out the company's filings with the Securities and Exchange Commission (SEC), particularly the 10-K and DEF 14A forms. 

You can search the SEC's EDGAR database for the most recent 10-K (annual report) and DEF 14A (proxy statement) filings, which will contain sections on executive compensation. Keep in mind the focus is usually solely on executive compensation, and non-executive employee information is typically not as readily available in public filings as companies aren’t required to disclose it in the same level of detail as its executive officers. 

However, these forms can provide insight into the company’s broader compensation philosophy, detailing the types of stock options or units offered, granting practices, and other relevant equity comp info. It might not always break down the information into ISOs and RSUs specifically, but it’s still helpful. 

Anyway, a company’s leadership may choose to bob rather than weave with either ISOs or RSUs depending on their growth stage and goals– but how about you, the employee?

Every scenario and risk tolerance is different, so discussing the nuances with a professional financial planner is best. The insights shared in this guide should help prepare you for that conversation.

 Making Cents– What’s Better: ISOs or RSUs?

As we make cents of the tax implications of equity compensation in tech, it's clear that ISOs and RSUs offer unique advantages and considerations for high-earners in tech. 

ISOs are like a bet on the company's future success, offering significant upside with some risk, whereas RSUs provide a more stable, predictable compensation. 

With their favorable tax treatment, ISOs provide a compelling opportunity for substantial long-term gains, especially if you believe in the company's growth and are prepared to navigate the complexities of AMTs. 

We’ve harped on the complexity of ISOs plenty, but the heart of the complications lies in the disposition time periods and the AMT, and most importantly, a comprehensive view of your entire financial situation. 

On the other hand, RSUs offer a straightforward, less risky path to owning a piece of your company, with immediate value upon vesting but taxed as ordinary income.

RSUs are simpler and provide immediate value upon vesting but are taxed as ordinary income. They’re like a company's promise to grant employees stock or the cash equivalent after they meet certain conditions—typically a vesting period. 

There's no need to spend money out of pocket to "purchase" RSUs as you would ISOs; employees just receive them as compensation. However, you will likely owe taxes on both the receipt and sale of the shares. 

Deciding between ISOs and RSUs requires aligning your compensation with your financial goals, risk tolerance, and belief in your company's future, as much as it is about timing and strategic planning to maximize the potential upside and minimize the tax implications. 

Whether you’re new to equity compensation or this isn’t your first rodeo, it's crucial to get tailored and updated guidance from a financial planner who can effectively help you navigate those significant decisions.