What Are Restricted Stock Options & How Are They Taxed?

Restricted stock options are a form of equity compensation that companies offer to employees. They provide the employee with the opportunity to purchase company stock at a pre-determined price after specific conditions are fulfilled.

Understanding Restricted Stock Options

A restricted stock option (RSO) grants an employee the right, but not the obligation, to purchase a specified number of company shares at a fixed price, known as the strike price or exercise price. The “restricted” aspect refers to conditions, typically related to continued employment or performance targets, that must be met before the options can be exercised.

The process begins on the grant date, when the company issues the options to the employee, along with the set strike price. This price is commonly established at the fair market value (FMV) of the company’s stock on the grant date, though sometimes it might be set at a discount. The options are not immediately available for purchase; they must first vest.

Vesting schedules dictate when the options become exercisable. Common vesting structures include time-based schedules, such as a four-year period with 25% vesting annually, or performance-based vesting tied to achieving specific company or individual goals. Once options vest, the employee gains the right to exercise them, meaning they can now buy the shares at the pre-determined strike price.

Restricted stock options also come with an expiration date, typically ranging from seven to ten years from the grant date, by which time they must be exercised or they will be forfeited. RSOs are merely a promise to sell stock, not actual stock ownership, until the employee chooses to exercise them.

Taxation of Restricted Stock Options

When restricted stock options are initially granted to an employee, there is generally no taxable event. The employee does not incur any income tax liability at this stage, as they have only received the right to purchase shares, not the shares themselves.

The primary taxable event for restricted stock options occurs at the time of exercise. When an employee exercises their options, the difference between the fair market value (FMV) of the stock on the exercise date and the lower strike price is considered a “bargain element.” This bargain element is immediately taxed as ordinary income to the employee. For example, if shares are exercised at a strike price of $10 when the FMV is $50, the $40 difference per share is treated as ordinary income.

This ordinary income is subject to federal income tax, Social Security taxes, and Medicare taxes. Employers are typically required to withhold these taxes at the time of exercise, treating the bargain element similarly to regular wages. The cost basis for the shares acquired through exercise is the sum of the exercise price paid plus the amount of the bargain element that was recognized as ordinary income.

A second taxable event occurs when the shares acquired from exercising the options are subsequently sold. At this point, the employee will realize a capital gain or loss. This is calculated as the difference between the sale price of the stock and its adjusted cost basis. If the shares are held for one year or less after the exercise date before being sold, any gain is considered a short-term capital gain and is taxed at the employee’s ordinary income tax rate. If the shares are held for more than one year after the exercise date, any gain is considered a long-term capital gain, which typically qualifies for more favorable tax rates depending on the taxpayer’s income level.

Comparing Restricted Stock Options with Other Equity Awards

Restricted stock options are a specific type of non-qualified stock option (NSO), sharing similar tax treatment where the bargain element is taxed as ordinary income at exercise. Their fundamental tax mechanics largely align with general NSO rules.

Incentive stock options (ISOs) offer a different tax treatment compared to restricted stock options. With ISOs, there is generally no regular income tax due at exercise, which can be a significant advantage. Instead, the gain at exercise (the difference between the FMV and the strike price) may be subject to the Alternative Minimum Tax (AMT). For ISOs to receive favorable long-term capital gains tax treatment upon sale, specific holding periods must be met: the shares must be held for at least two years from the grant date and one year from the exercise date. If these holding periods are not satisfied, the gain at sale may be reclassified as ordinary income, similar to an RSO.

Restricted stock units (RSUs) represent a promise from the company to deliver actual shares or their cash equivalent upon vesting, without the need for the employee to pay an exercise price. The key difference from restricted stock options is that RSUs are taxed as ordinary income at the time of vesting, based on the fair market value of the shares received. There is no exercise step for RSUs. In contrast, restricted stock options provide the right to purchase shares, and taxation occurs at the point of exercise, not vesting.

The fundamental distinction among these equity awards lies in when the taxable event occurs and the nature of the income recognized. Restricted stock options involve a purchase decision and ordinary income at exercise, with subsequent capital gains or losses upon sale. ISOs offer potential tax deferral and capital gains treatment if holding periods are met, while RSUs result in ordinary income recognition at vesting without an employee purchase.

Exercising and Selling Restricted Stock Options

Once restricted stock options have vested, an employee can choose to exercise them, which means purchasing the underlying company stock at the pre-determined strike price. The process typically involves notifying the company or plan administrator of the intent to exercise and arranging for payment of both the exercise price and the associated taxes due on the bargain element. Tax withholding, including federal income tax, Social Security, and Medicare, is generally required at the time of exercise.

There are several common methods for exercising options. A cash exercise involves the employee paying the exercise price and taxes directly from their personal funds. Another popular method is a cashless exercise, also known as “sell to cover,” where a portion of the newly acquired shares are immediately sold in the market to cover the exercise price and the required tax withholdings. The remaining shares are then delivered to the employee.

A stock swap is another exercise method, where an employee uses existing shares of company stock they already own to pay the exercise price for the new options. This method can be tax-efficient for the exercise portion, though tax implications still arise from the deemed sale of the existing shares. After the exercise process is complete and payment is made, the employee receives the actual shares of company stock.

Once the shares are received, they can be held or sold in the open market, subject to any company-specific trading policies, such as blackout periods, or insider trading regulations. Selling these shares will trigger a capital gain or loss, calculated based on the difference between the sale price and the adjusted cost basis established at the time of exercise. Employees should consult their company’s guidelines and any applicable securities laws before selling their shares.