RSU vs. ISO: Key Differences in Stock Compensation

Employee stock compensation is a common method companies use to attract and retain talent. Two prevalent forms of these equity awards are Restricted Stock Units (RSUs) and Incentive Stock Options (ISOs). While both offer employees a stake in the company’s success, they are different in their structure, value, and how they are taxed. Understanding these distinctions is important for managing personal finances, as they can impact financial planning and tax liability.

How Restricted Stock Units (RSUs) Work and Are Taxed

Restricted Stock Units represent a company’s promise to grant an employee a specific number of shares at a future date, provided certain conditions are met. The grant outlines the number of RSUs awarded and the corresponding vesting schedule. Vesting is the period an employee must work for the company to earn the right to the shares. A common schedule might involve a one-year “cliff,” where no shares vest, followed by quarterly vesting over the subsequent three to four years.

The vesting date is the primary event for tax purposes. The moment RSUs vest, their fair market value is considered ordinary income. This amount is subject to federal, state, and local income taxes, as well as Social Security and Medicare (FICA) taxes. The value is reported on the employee’s Form W-2 and can push an individual into a higher tax bracket for that year.

To manage the immediate tax liability, companies commonly use a method called “sell-to-cover.” With this approach, the company automatically withholds and sells a portion of the vested shares to pay the estimated taxes. The employee receives the net number of shares remaining, and this process simplifies tax compliance by addressing the obligation at the source.

After receiving the net shares, the employee owns them outright. If the employee holds these shares and sells them later, any subsequent change in value is treated as a capital gain or loss. The cost basis for this calculation is the fair market value of the stock on the vesting date. If held for more than one year after vesting, any appreciation is taxed at long-term capital gains rates.

How Incentive Stock Options (ISOs) Work and Are Taxed

Incentive Stock Options grant an employee the right, but not the obligation, to purchase a set number of company shares at a fixed price. This predetermined purchase price is known as the strike price and is set at the stock’s fair market value on the date the options are granted. Like RSUs, ISOs are subject to a vesting schedule, which dictates when the employee earns the right to exercise their options and buy the shares.

The taxation of ISOs is more complex than that of RSUs and depends entirely on when the employee sells the shares after exercising the options. There are two possible tax treatments: a qualifying disposition and a disqualifying disposition. Each path has different consequences for the employee’s tax liability.

A qualifying disposition offers the most favorable tax outcome. To achieve this, two holding period requirements must be met: the shares must be sold at least two years after the initial grant date, and at least one year after the exercise date. If both conditions are satisfied, the entire economic gain—the difference between the final sale price and the original strike price—is taxed as a long-term capital gain.

Conversely, a disqualifying disposition occurs if either of the holding period rules is not met. In this scenario, the “bargain element,” which is the difference between the stock’s fair market value on the day of exercise and the strike price, is taxed as ordinary income. Any additional appreciation from the exercise date to the sale date is then treated as a capital gain, either short-term or long-term, depending on how long the shares were held after being exercised.

The Alternative Minimum Tax (AMT) Complication with ISOs

The tax benefits of Incentive Stock Options are accompanied by the Alternative Minimum Tax (AMT). The AMT is a parallel tax system established by the Internal Revenue Service to ensure certain taxpayers pay a minimum amount of tax. When an employee exercises ISOs and holds the shares—the strategy required for a qualifying disposition—it can trigger an AMT liability.

The issue lies in how the AMT system treats the “bargain element” from an ISO exercise. For regular income tax purposes, this bargain element is not recognized as income in the year of exercise. For AMT calculations, however, this amount is considered an “AMT preference item” and must be added to the taxpayer’s income, increasing one’s alternative minimum taxable income (AMTI).

This creates a situation where an employee might owe a large tax bill for the year they exercise their ISOs, even if they haven’t sold any shares and have generated no cash from the transaction. The tax is due for the year of exercise, meaning an employee must have sufficient cash on hand to both purchase the shares at the strike price and pay the associated AMT.

A mechanism that can provide relief in subsequent years is the AMT credit. The amount of AMT paid due to exercising ISOs can be carried forward as a credit against future regular tax liabilities. This credit can be used in years when the taxpayer’s regular tax is higher than their AMT, effectively allowing them to recoup the previously paid AMT over time. The rules governing the use of the AMT credit can be complex.

Key Distinctions for Employees

When comparing RSUs and ISOs, employees should consider several practical differences that relate to upfront value, financial risk, and cash flow requirements.

A primary distinction is the inherent value and associated risk. RSUs have value as long as the company’s stock price is greater than zero, providing a tangible benefit regardless of stock price fluctuations. ISOs, on the other hand, only have value if the stock’s market price is above the strike price. If the stock price falls below the strike price, the options are “underwater” and effectively worthless.

The cash flow requirements for each award type are also different. RSUs require no upfront investment from the employee, as taxes are handled through an automatic sale of a portion of those shares. In contrast, ISOs demand capital to pay the strike price to purchase the shares and may need additional funds to cover the potential Alternative Minimum Tax liability.

Tax complexity and predictability also diverge. The tax treatment of RSUs is straightforward: the value at vest is taxed as ordinary income, and the process is largely automated by the employer. ISO taxation is more complex, as it is contingent on the employee’s decision of when to sell the shares and carries the risk of triggering the AMT.

The potential for tax upside differs. With RSUs, the value of the shares at the vesting date is always taxed at ordinary income rates, and only subsequent appreciation is eligible for capital gains treatment. ISOs, if managed correctly for a qualifying disposition, offer the potential for the entire gain to be taxed at lower long-term capital gains rates.