Author: Oleg Ryabtsev
Managing partner, C&C
This guide to ESOP (Employee Stock Ownership Plan) covers the main forms of stock options, their features, and practical applications. Traditional options are financial instruments that provide the right, but not the obligation, to buy or sell an underlying asset at a fixed price within a certain period. However in technology companies options are widely used as a tool for motivating management, attracting investment, and structuring deals.
Main Forms of Option Plans
Several primary forms of option plans are used in modern corporate practice, each with its own features and advantages:
Standard Stock Options (ISO/NSO)
Standard stock options grant the right to purchase a certain number of company shares at a predetermined price (strike price) within a specified period. The process of exercising the right to purchase shares is called exercising the option. Standard options are usually granted with a vesting schedule that defines when the employee gains the right to exercise the option.
Standard options fall into two main categories:
Incentive Stock Options (ISO)
Options that meet the requirements of the U.S. Tax Code and provide tax benefits. ISOs can only be granted to employees and, under certain conditions (holding period of at least 1 year after exercise and 2 years from grant), are taxed at the preferential long-term capital gains rate instead of regular income tax.
Non-qualified Stock Options (NSO)
Options that do not meet ISO requirements and can be granted to any individuals, including directors, consultants, and investors.
Example: Consultant Maria receives 2,000 NSOs with an exercise price of $3 per share as compensation for strategic advisory services. Upon exercising the options, she must pay ordinary income tax on the difference between market value and the exercise price.
Option Type | ISO | NSO |
Employee Investment | $10,000 (1,000 Γ $10) | $10,000 (1,000 Γ $10) |
Sale Proceeds | $50,000 (1,000 Γ $50) | $50,000 (1,000 Γ $50) |
Profit | $40,000 | $40,000 |
Tax | $8,000 (20% of profit)* | $14,800 (37% of profit)** |
Net Profit | $32,000 | $25,200 |
Effective Return | +320% on investment | +252% on investment |
Restricted Stock Units (RSU)
RSUs represent a company's promise to grant an employee a certain number of shares upon meeting specified conditions, typically related to length of service or performance metrics. Unlike standard options, RSUs do not require the employee to pay for the shares upon receipt.
RSUs are a gratuitous right to receive shares upon completion of the vesting period, without the need to purchase them. Upon vesting, the employee automatically receives shares and is taxed on their full market value.
For U.S. Tax Residents
Taxation occurs at vesting based on full market value. Withholding tax rates typically range from 22% to 37% depending on the employeeβs income level. Companies often withhold a portion of the shares to cover tax liabilities: e.g., if an employee receives 1,000 RSUs, the company may automatically withhold 300 shares (30%) for tax, so the employee effectively receives only 700 shares. This eliminates the need to raise cash to pay taxes. Capital gains tax applies to any future sale of shares. If sold within one year after vesting, short-term capital gains tax applies (same as income tax, up to 37%). If sold after one year, long-term capital gains tax applies (0%, 15%, or 20%, depending on income level). Tax is levied on the difference between the sale price and the market value at vesting.
For Non-U.S. Tax Residents
Taxation also occurs at vesting, at a flat rate of 30% (unless otherwise provided by a tax treaty). There is a risk of double taxation in the country of residence.
Unlike ISO, RSUs do not allow tax optimization through an 83(b) election, since the taxable event occurs only upon actual receipt of shares.
83(b) election β a special provision in the U.S. Tax Code allowing taxpayers to elect taxation at the time of grant rather than vesting. This can be advantageous when share value at grant is low and expected to rise.
RSUs do not qualify for this, as the employee has no rights to the shares before vesting.
The main tax optimization strategy for RSU holders is long-term holding of shares after vesting to benefit from preferential long-term capital gains tax rates (0β20%) under Β§1(h) of the U.S. Tax Code. Upon sale of shares held for more than a year after vesting, additional gains are taxed at the long-term capital gains rate under Β§1222(3) rather than regular income tax per Β§1.
Phantom Stock Options
Phantom stock options are a form of cash compensation tied to the value of the companyβs shares, but do not involve actual transfer of equity. This tool incentivizes employees without diluting existing shareholders.
- No actual share transfer β employee does not become a shareholder
- Taxed as ordinary income β entire payout is subject to personal income tax if held personally
- Suitable for private companies without the need to determine market value
- No additional shares issued β preserves equity control
For U.S. Tax Residents
Tax is due upon payout at full value, as ordinary income. Rates range from 22% to 37%. The company typically withholds part of the payment (approx. 22β35%) to cover taxes.
For Non-U.S. Tax Residents
Tax is also due at payout at a flat 30% (unless modified by treaty). Risk of double taxation applies.
Stock Appreciation Rights (SAR)
SARs are similar to phantom options but grant the right to receive cash equal to the difference between the current share value and the strike price. Like phantom stock, SARs do not require actual share transfer.
- No strike price paid by the holder β unlike standard options
- No equity dilution β shareholder percentages remain intact
- Simple administration β no actual share transfer needed
For U.S. Tax Residents
Tax is due upon payout at ordinary income rates (22%β37%). Companies usually withhold part of the payout for tax.
For Non-U.S. Tax Residents
Also taxed upon payout at 30% unless reduced by treaty. Risk of double taxation applies.
SAR tax burden can be reduced by assigning the option to a holding company. In such cases, the holding company receives the SAR payout, allowing use of corporate tax benefits to reduce the effective rate.
Restricted Stock Awards (RSA)
RSA (Restricted Stock Awards) represent a reverse vesting mechanism whereby the employee receives all shares at the time of grant, but with restrictions on their disposal. Unlike RSUs, in the case of RSA the option holder immediately becomes a full shareholder, however the shares remain "frozen" until certain conditions are met.
- Immediate acquisition of shareholder status β including voting rights and rights to dividends
- Reverse vesting mechanism β shares are returned to the company if KPIs are not met or if the employee leaves the company
- Risk of loss of shares if vesting conditions are not fulfilled β the company may repurchase the shares
- Possible requirement to pay for shares at the time of receipt β although this is often a nominal value
For U.S. tax residents
The founder files an 83(b) election under the U.S. Internal Revenue Code within 30 days of receiving the RSA, which allows him to pay tax on the minimal value of the shares immediately, rather than on their market value at the time of vesting. This is especially beneficial when the initial share value is low, as the tax base will be minimal. Upon filing the 83(b) election, any subsequent appreciation in value will be taxed at the preferential long-term capital gains rate (0β20%) if the shares are sold after one year or more.
For non-U.S. tax residents
The 83(b) mechanism is also available, but with some nuances. Upon filing, the non-resident pays tax at a rate of 30% (unless otherwise provided for in a tax treaty) on the fair market value of the shares at the time of receipt. There may be a risk of double taxation in the country of residence.
Employee Stock Purchase Plans (ESPP)
ESPP allow employees to purchase company shares at a discount from the market price through regular payroll deductions. This is a popular instrument in public companies.
For U.S. tax residents
Tax is paid only upon sale of the shares, and if the shares are held for at least 1 year after purchase and 2 years from the start of the offering period, part of the gain may be taxed at the preferential long-term capital gains rate (0β20%).
For non-U.S. tax residents
When foreign employees participate in an ESPP, the discount is usually taxed as compensation income at the time of share purchase at a rate of 30% (unless otherwise provided for in a tax treaty). Subsequent capital gains upon sale of the shares may be taxed in the U.S. at a rate of 30% or in the country of residence, depending on tax status and treaties.
Related topics
Comparative table of option programs
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