Executive Stock Options, Restricted Shares and Restricted Stock Units – What’s Best for You

By Robert A. Adelson, Esq.

For most CEOs,  C-suite and senior executives, and even for many directors and mid-level executives, a major part of executive compensation negotiations concerns the level, tax structuring and terms of equity compensation.

This article discusses key things to look for in your equity package, among the four main choices for equity structure and the different consequences of each.

Where Equity Has Its Greatest Value

Executive equity compensation offers its greatest potential value in companies with high growth potential, or in turn-around situations where in each case the equity starts with a low base price and there is considerable opportunity for value appreciation.

Another very important consideration is that your salary is taxed at ordinary income tax rates and is subject to payroll taxes.  If equity appreciation is achieved, that appreciation has the potential to escape ordinary income and payroll taxes and be taxable at much lower capital gains rates. Furthermore, if your shares are QSBS – qualified small business stock, there is the potential to, in the future, sell shares with up to $10 million or 10x growth shielded from even capital gains taxes.  So, the after-tax income generated by the sale of the equity has the potential to far exceed the after-tax income of salary and bonus.

Key Ways to Assure Value in Your Equity Compensation

In considering which is best for you, here are several other takeaways.

• What will be the strike price? Is there opportunity for considerable appreciation within the given time horizon.
• Did you receive enough equity to make this worth it? If you started with equity whose aggregate exercise price was $2 million, 3x appreciation would translate to an appreciation of $4 million.  Had the aggregate exercise price been $200,000, then even with 3x growth, the potential gain for 4 years would only have been $400,000.
• Type of equity and its tax treatment is important. There are many choices in how to structure equity.  The executive in a high potential growth or turnaround situation should seek the structure for his or her equity that offers the best prospect for capital gains on the appreciation.

Main Equity Structures in Executive Compensation

There are four main choices for equity structure:

1. ISOs – Incentive stock options, qualified under the tax code
2. Non-quals – Non-qualified stock options
3. Restricted Stock
4. RSUs – Restricted Stock Units

Stock Options:  Most popular & Differences ISOs vs Non-Quals

The most popular choice of equity structure are stock options, either ISOs or non-quals. The advantage of stock options is that they cost nothing when they are issued.  At the same time, they are also worth nothing on issuance. The recipient must pay the strike price on exercise. The stock options disappear on or shortly after employment termination, and the opportunity for a favorable tax outcome on appreciation is limited.

For non-quals, when the options are exercised, all appreciation at the point of exercise (whether or not the stock is liquid at the time of exercise) is taxable and payable at ordinary income tax rates and subject to payroll taxes.

ISOs have an advantage that no tax is imposed on option exercise, but rather on sale of the stock itself. If the stock is held after exercise for less than a year, the appreciation at the time of exercise is taxed at ordinary income tax rates and subject to payroll taxes. If the stock is held longer than a year, the appreciation is a preference item for the Alternative Minimum Tax, potentially triggering AMT taxation, with later sale at capital gains rates.

Restricted Stock:  Best Choice in High Growth and Turnaround Situations

In the high growth and turnaround situations where the executive wants appreciation taxed at lower rates, restricted stock is a good choice with the following advantages:

• Avoiding the strike price. CEO and executive restrictive stock grants often grant the stock at zero cost so there is no payment of the strike price.
• Retention of value on termination. ISOs must expire within 90 days of employment termination, and that’s also often true for non-quals, typically written the same way. With restricted stock, once you vest, you own and retain it, with no company cancellation of your equity on employment termination.
• Capital gains tax treatment. Typically, an IRC Section 83(b) election is made within 30 days of the grant of restricted stock.  This is accompanied by payment of the value of the stock issued (For true startups, the stock may be worth little at founding and a nominal payment is made which is fair market value at the time). After that, if the stock is held more than a year, all appreciation will be taxed at capital gains rates and that tax will fall only on sale of the shares.

If the company is established and the stock already has considerable value, you may not wish to receive restricted stock and make an 83(b) election because it will result in immediate tax for shares that might be forfeited in the future.  Hence RSUs described next might be a better choice.

RSUs:  Hybrid Equity That Also Delivers Value

RSUs are a hybrid. The RSU arises from a contract of the company to issue stock in the future.  Thus, like restricted stock, you are receiving something of value with no strike price and where vested, not terminable on employment termination.  On the other hand, like options, ordinary income taxes will be due as it vests.  The RSUs structure is desirable where focus is not on appreciation but assurance the equity will have at least some value (even if stock value declines), and the company is willing to grant RSUs in lieu of more cash compensation.

Other important issues arise in the terms of stock, option and RSU grant agreements, and their interplay with company equity plans.  Thus, it is wise to have an experienced executive compensation lawyer review and advise you on those contract terms.