⭐ How big players navigate equity compensation

☕Good morning, and welcome to another week of actionable tax-saving intel on Making Sense of Your Money with Dan Pascone. 

Today, we’re talking equity compensation—specifically, why you might have a preference for ISOs or RSUs over the other. 

Tech companies frequently use lucrative equity comp packages to attract the world’s best and brightest talent, such as yourself.

It’s their way of saying, “We value you! Please don’t leave us!”

Incentive Stock Options (ISOs) allow you to purchase company stock at a predetermined price.

ISOs tend to offer favorable tax treatment under the U.S. tax code but come with specific conditions, such as a qualifying disposition period which influences the length of time you must hold the stock upon exercising.

They typically come with a vesting period to make sure you don’t run off with a bunch of company stock given to you at a discount. 

The pros:

✅ No immediate income tax is due upon exercising ISOs (although you may owe AMT, which we get into below).

✅ Gains are taxed as long-term capital gains if the shares are held for at least one year after exercise and two years after the option was granted (the qualifying disposition period). 

✅ It’s a discounted rate on stock that may be worth considerably more at the time of exercise.

✅ You have the option, not the requirement, to purchase the shares– although the comp system is usually deliberately designed to benefit you.

The cons:

🚧 They’re more complicated, often bringing Alternative Minimum Tax (AMT) into the mix.

🚧 Must be timed with specific criteria to receive the tax-favorable benefits. If you sell before meeting specific criteria (disqualifying disposition), the bargain element is taxed as ordinary income, and any additional gain is taxed as capital gains.

🚧 Employees pay to exercise these options out of pocket, albeit at a presumably discounted rate, but still introducing some personal risk exposure.

Restricted Stock Units (RSUs) are company shares given to employees as compensation.

RSUs also usually come with vesting requirements, and they’re taxed as ordinary income upon receipt.

The pros:

✅ No out-of-pocket risk: Unlike ISOs, you get the stock upon vesting without paying anything out of pocket. You can hold or sell it at will. 

✅ They’re more straightforward and easier to deal with for both the company and the employee.

✅ They’re more predictable, absent volatile swings in company stock price.

The cons:

🚧You get taxed twice– upon receipt and upon sale. RSUs are considered taxable ordinary income (taxed at your marginal tax rate) the moment they vest and are subject to federal, state, and payroll taxes. Any gain or loss from their sale is considered a capital gain or loss. Holding the stock for over a year after vesting qualifies for long-term capital gains tax rates.

🚧 Theoretically, they have a limited upside compared to ISOs. When they vest, you receive the RSUs at market value, but generally not a predetermined lower value like ISOs.

Okay, Dan. I understand, but I’m still confused—is one better than the other?

🔎 Let’s zoom out for a second. 

📈 From the company's view, it's all about balancing growth, simplicity, and tax savvy. 

From my experience, the more established and stable companies– think Google (Alphabet Inc.), Apple, Microsoft, Amazon, and Facebook (Meta Platforms Inc.)– offer RSUs to incentivize employees with a more predictable and stable equity comp structure. 

Newer, faster-growing tech companies tend to use ISOs to attract younger and scrappier talent willing to have some skin in the game and reap the rewards as the company grows. For example, Tesla, Twitter, LinkedIn, Uber, and Square likely used ISOs in their early growth stages. 

In other words… 

🔍 ISOs are like a golden ticket to buy your company's stock at a price from yesteryear. It’s like saying, “Join us now, and if (when) things work out how we think they will, your stock options are going to be worth a fortune!”

Keep in mind they’re an option and not an obligation to exercise.

🤞 RSUs are like a promise from a company in its latter growth stages: Stick with us, and you'll get shares or cash when the time is right. There are no guessing games or out-of-pocket costs—just a straightforward path to owning a piece of the pie on top of your paycheck.

🕵️‍♂️You can get a sneak peek of executive comp with SEC Filings 

Public companies in the U.S. spill the beans on their compensation strategies through mandatory filings with the Securities and Exchange Commission (SEC). 

The 10-K and DEF 14A forms, which can be found on the SEC's EDGAR database, are your go-to resources here.

These filings spotlight executive pay and offer a glimpse into the company's overall compensation philosophy– you'll typically get the lowdown on the types of stock options or units dished out, granting practices, and more. 

Though it might not always detail ISOs and RSUs separately, it’s a peek into the playbook.

🏁 The decision between ISOs and RSUs isn't purely black and white. 

When it comes to equity compensation, knowledge isn’t just power—it's profit.

You may be weighing your options between various tech company compensation packages, some of which offer ISOs and others RSUs.

Or maybe you’ve already agreed to a comp package featuring one or the other. 

It’s unlikely you can request RSUs instead of ISOs (or vice versa), and ultimately, a company decides what form of equity compensation best aligns its growth trajectory with the mutual goals of the talent it wants to acquire and retain. Either way, it’s paramount to understand how each impacts your broader financial situation and your tax liability.

For example, ISOs can be lucrative and tax-friendly but become pretty complex with the AMT mentioned above.

RSUs, while less risky, are taxed on two different occasions. 

Arm yourself with the best possible information before meeting with a financial planner who understands the rhyme and rhythm of the dance high earners in tech must play, where minor considerations could have a profound influence down the line.

If you’re wondering which one is best for you, check out our guide on how ISOs or RSUs compare with specific examples and more case-specific information in our AMT and Equity Compensation guide. 

Until next week,

Dan from Tailored Cents