What Is a Restricted Stock Option?

The term “restricted stock option” often appears in equity compensation discussions. This article clarifies what these arrangements entail, how they function, and their tax treatment.

Understanding the Term “Restricted Stock Option”

The phrase “restricted stock option” is not a formally defined legal or financial term like “Incentive Stock Option (ISO)” or “Restricted Stock Unit (RSU).” Instead, it commonly refers to a Non-Qualified Stock Option (NSO) that includes specific conditions before it can be fully utilized. The “restriction” in this context usually pertains to the ability to exercise the option until certain criteria are met, such as continued employment for a specified period or the achievement of performance goals.

This term is sometimes used interchangeably with, or confused for, Restricted Stock Units (RSUs), which are fundamentally different forms of equity compensation. While an RSU represents a promise to deliver actual shares of company stock upon vesting, an option grants the right, but not the obligation, to purchase shares at a predetermined price.

It is necessary to distinguish between a “restricted option” and “restricted stock.” With a restricted option, the restriction applies to the ability to buy the shares. In contrast, restricted stock involves receiving actual shares upfront, but these shares are subject to forfeiture and cannot be freely transferred or sold until vesting conditions are satisfied. For restricted stock, the tax event occurs at vesting, whereas for an option, the tax event is at exercise.

How Restricted Stock Options Typically Work

Grant

At the Grant stage, the company awards the option to an employee. This grant specifies the number of shares the employee has the right to purchase and the “grant price,” also known as the strike price or exercise price. This price is fixed at the time of the grant, meaning the employee can later buy the shares at this predetermined rate, regardless of the future market value.

Vesting

Vesting is the process by which the option gradually becomes exercisable. The “restriction” on these options is experienced during this period, as the employee must satisfy certain conditions, such as continued employment over a set timeframe or the achievement of specific performance targets. Common vesting schedules include “cliff vesting,” where a portion of the options vests all at once after an initial period, often one year, followed by gradual vesting monthly or quarterly over subsequent years. Another common type is “graded vesting,” where a percentage of options vests incrementally over several years, providing a continuous incentive for the employee to remain with the company.

Exercise

Once vested, the employee gains the right to Exercise the option, meaning they can purchase the company’s stock at the established grant price. The employee is not obligated to exercise the option; they can choose to do so only if the market price of the stock is higher than the exercise price, making the option “in the money.” If the market price falls below the exercise price, the options are considered “underwater” and hold no financial value.

Holding Period

After exercising, the employee enters a Holding Period for the newly acquired shares. The employee can then choose to sell these shares at a later date, subject to any company-imposed trading restrictions or blackout periods.

Expiration

Finally, every stock option has an Expiration date, which is the last day the option can be exercised before it becomes worthless. This period is set for up to 10 years from the grant date, though if an employee leaves the company, there is often a shorter post-termination exercise period, around 90 days, to exercise vested options before they are forfeited.

Tax Implications

There is no taxable event for the employee at the time the option is initially granted. Similarly, vesting itself does not trigger a taxable event for NSOs, because the employee has not yet acquired the shares. The right to purchase shares has simply become exercisable.

The primary taxable event for NSOs occurs at exercise. When the employee exercises the option, the difference between the fair market value (FMV) of the stock on the exercise date and the lower exercise price paid is considered a “bargain element.” This bargain element is taxed as ordinary income to the employee. This amount is subject to federal income tax, as well as Social Security and Medicare taxes, and is reported on the employee’s Form W-2 as wages. The employer is responsible for withholding these taxes at the time of exercise.

When the employee later sells the shares acquired through exercising the option, a capital gain or loss may be realized. The cost basis for calculating this gain or loss includes the exercise price paid plus the amount of ordinary income recognized at exercise. If the shares are sold within one year of the exercise date, any profit is considered a short-term capital gain and is taxed at the employee’s ordinary income tax rates. If the shares are held for more than one year after exercise before being sold, any profit is treated as a long-term capital gain, which is taxed at more favorable, lower capital gains rates.

Key Differences from Other Equity Compensation

Incentive Stock Options (ISOs)

Incentive Stock Options (ISOs) differ significantly from NSOs, particularly in their tax treatment, as there is no regular income tax due at the time of exercise. However, the bargain element at exercise for ISOs is considered a preference item for the Alternative Minimum Tax (AMT), which can result in a tax liability for higher-income earners. To qualify for favorable long-term capital gains treatment, ISO shares must be held for specific periods: at least two years from the grant date and one year from the exercise date. If these holding periods are not met, a “disqualifying disposition” occurs, and the bargain element is then taxed as ordinary income, similar to an NSO. ISOs are only available to employees, while NSOs can be granted to employees, consultants, and directors.

Non-Qualified Stock Options (NSOs)

The characteristic of NSOs is that the bargain element at exercise is immediately taxed as ordinary income, subject to regular income tax and payroll taxes (Social Security and Medicare). Unlike ISOs, NSOs do not have the same preferential tax treatment and are not subject to AMT at exercise.

Restricted Stock Units (RSUs)

Restricted Stock Units (RSUs) are fundamentally different from stock options because they represent a promise to deliver actual shares of company stock (or their cash equivalent) once vesting conditions are met, rather than an option to purchase shares. Employees do not pay to acquire RSU shares. The tax event for RSUs occurs at vesting, when the fair market value of the vested shares is taxed as ordinary income and reported on the employee’s W-2. This differs from options, where the tax event is at exercise. RSUs always have some value as long as the company stock has value, making them less risky than stock options, which can become worthless if the stock price falls below the exercise price.