Stock Options Vs. Restricted Shares

by Eric Bank Google

    When companies want to compensate employees beyond salaries and bonuses, they often grant incentives like stock options and restricted shares. Stock options give employees the right to buy the company's stock at a preset strike price. The value of a stock option is the current price of the stock less the option strike price. Restricted shares are shares of the company stock that vest to an employee over time. They are restricted in the sense that an employee cannot sell them until the shares vest.

    Stock options provide the possibility of a big payoff if the stock price soars. For instance, a stock option with a strike price of $10 is worthless as long as the stock price is $10 or less. But should the stock price zoom up to $50, each stock option would be worth $40 a share. The number of shares represented by the option determines the employee’s ultimate gain. If management sets each option to convert into 100 shares, then in this example each option would be worth $4,000.

    Stock options granted to employees are termed “statutory” by the IRS. This means employees only owe taxes when they sell the stock received after the options are exercised. Receiving or exercising statutory options does not create a taxable event, only the subsequent stock sale triggers a liability. If an employee owned the options for at least two years or held the shares for at least 12 months following option exercise, the profit is subject to favorable long-term capital gains treatment. Shorter holding periods will result in ordinary income, taxed at the normal marginal rate. Stock options are risky -- if the underlying stock never pierces the strike price, the options remain worthless.

    Restricted shares have, when vested, the same value as normal shares trading on the stock market. Restricted shares cost employees nothing, and receiving them is not a taxable event. Employees are taxed as the shares vest. Vesting usually occurs in stages over a number of years, with specific percentages of holdings becoming the employee’s property in each year. When a share is vested, the employee must note the share value on the vesting date and pay taxes on that amount as ordinary income. Any dividends received on restricted shares are taxable at ordinary rates, whether vested or not.

    Within 30 days of receiving restricted shares, an employee can elect Section 83b tax treatment. Under this scenario, employees pay ordinary taxes on the shares when they are granted, calculated using the share price on the grant date. There are two benefits: (1) Employees do not owe any taxes when the shares vest; and (2) Employees receive long-term capital gains treatment when they eventually sell vested shares if held for at least 12 months following vesting. The downsides are that if the stock never appreciates, the employee paid earlier taxes without benefit, and if, for some reason, the shares have to be forfeited after 83b election, the tax paid cannot be recovered.

    Resources (3)

    • Getting Started In Employee Stock Options; John Olagues, John F. Summa
    • Consider Your Options: Get the Most from Your Equity Compensation; Kaye A. Thomas
    • he Compensation Handbook; Lance Berger, Dorothy Berger

    Photo Credits

    • Siri Stafford/Lifesize/Getty Images

    About the Author

    Based in Chicago, Eric Bank has been writing business-related articles since 1985, and science articles since 2010. His articles have appeared in "PC Magazine" and on numerous websites. He holds a B.S. in biology and an M.B.A. from New York University. He also holds an M.S. in finance from DePaul University.

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