RSU vs. ESPP | AbstractOps

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TLDR

You often want to reward employees who joined early on with a startup. One way to way to thank you to your team? Award them equity. Luckily, there are several options for granting ownership in their startups.
Two types of vehicles used to grant ownership include RSUs and ESPPs. RSUs (or restricted stock units) incentivize your employees to stay with your startup, helping it perform at its best. RSUs also permit you – as the founder – to defer issuing any startup shares until restrictions and vesting are met. This deferral helps you delay any share dilution.
RSUs, or restricted stock units, are “unsecured, unfunded promises to pay cash or stock in the future and are considered nonqualified deferred compensation,” subject to the Internal Revenue Code. Typically, one RSU represents one stock share. These stock units are generally not taxable when granted; however, they are taxed once the restricted stock units vest. Vesting is a process where the employees become entitled to the granted stock over a period of time, such as three years.
Upon vesting, RSUs are assigned a fair market value. The Internal Revenue Service considers RSUs fully taxable upon vesting. After a portion of the stock shares is withheld to pay taxes, the employee receives the balance of the shares and may sell them at their discretion.
An ESPP is an employee stock purchase plan. These plans can be qualified or non-qualified by the IRS. ESPPs are only available for publicly-traded companies, where employees can contribute part of their monthly compensation towards purchasing their employers’ stock at a discounted rate at specific intervals.
ESPPs are only available for publicly-traded companies, where employees can contribute part of their monthly compensation towards purchasing their employers’ stock at a discounted rate at specific intervals. For example, discounts can often range from 5 percent to 15 percent of your stock’s fair market value.
When an ESPP is qualified, “employees are not taxed on the discount at the time when they buy stock. Instead, they later pay capital gains on the profits realized when they sell their shares.” In non-qualified ESPPs, “the difference between employee stock price and fair market value at purchase is taxed as ordinary income.”
Regardless of the differences between RSUs and ESPPs, offering stock ownership to your employees is highly beneficial to both your team and your startup. With actual employee ownership, you can create a culture of dedicated, happy, productive employees, all directly contributing to the success of your startup.

You often want to reward employees who joined early on with a startup. One way to way to thank you to your team? Award them equity. Luckily, there are several options for granting ownership in their startups. However, when you start digging into the options, it seems more like alphabet soup than compensation and ownership structures.

Two types of vehicles used to grant ownership include RSUs and ESPPs. RSUs (or restricted stock units) incentivize your employees to stay with your startup, helping it perform at its best. RSUs also permit you – as the founder – to defer issuing any startup shares until restrictions and vesting are met. This deferral helps you delay any share dilution.

An ESPP is an employee stock purchase plan. These plans can be qualified or non-qualified by the IRS. ESPPs are only available for publicly-traded companies, where employees can contribute part of their monthly compensation towards purchasing their employers’ stock at a discounted rate at specific intervals.

When employees have a vested interest in your startup, they are often more engaged and willing to promote its culture and values. They also are interested in the company performing above-board, as it directly benefits them. This alone bodes well for your attraction and retention of top talent along with the overall success of your startup.

Despite similar purposes, RSUs and ESPPs are different employee compensation structures. In this article, we’ll break down the differences between RSUs and ESPPs as well as their benefits.

What Are RSUs?

RSUs, or restricted stock units, are “unsecured, unfunded promises to pay cash or stock in the future and are considered nonqualified deferred compensation,” subject to the Internal Revenue Code.

Typically, one RSU represents one stock share. These stock units are generally not taxable when granted; however, they are taxed once the restricted stock units vest. Vesting is a process where the employees become entitled to the granted stock over a period of time, such as three years.

Upon vesting, RSUs are assigned a fair market value. The Internal Revenue Service considers RSUs fully taxable upon vesting. After a portion of the stock shares is withheld to pay taxes, the employee receives the balance of the shares and may sell them at their discretion.

Restricted stock units do not carry shareholder voting rights. Employees holding RSUs may vote on startup matters once the restrictions on the shares lapse and the RSUs are converted into common shares. Additionally, once vested, employees can receive dividends as well.

The Tax Benefits of RSUs

RSUs enjoy favorable tax treatment. Here are some key benefits for your startup’s employees:

Taxed Upon Vesting. With RSUs, the stock units aren’t taxed until vesting, not upon grant. The taxable amount is the market value of the shares at vesting. This taxable amount is considered compensation for federal and employment taxes and any state and local taxes.
Capital Gains Treatment. Once vested, if the employee sells the shares, they will pay capital gains tax on any appreciation over the market value of the shares on the date of vesting.

What is an ESPP?

So, now that we know what RSUs are, what is an ESPP plan? An ESPP is an employee stock purchase plan. These plans can be qualified or non-qualified by the IRS. Unlike other retirement plans, ESPPs do not fall under the purview of the DOL.

ESPPs are only available for publicly-traded companies, where employees can contribute part of their monthly compensation towards purchasing their employers’ stock at a discounted rate at specific intervals. For example, discounts can often range from 5 percent to 15 percent of your stock’s fair market value.

When an ESPP is qualified, “employees are not taxed on the discount at the time when they buy stock. Instead, they later pay capital gains on the profits realized when they sell their shares.” In non-qualified ESPPs, “the difference between employee stock price and fair market value at purchase is taxed as ordinary income.”

Shareholders who already own at least five percent of employer stock are not permitted to participate in the ESPP.

Digging Into the Details of ESPPs

Like other retirement plans, ESPPs have enrollment periods for employees. These enrollment periods often occur twice per year; for example, enrollment may occur on January 1st and July 1st. Employees can choose to set aside between one and 15 percent of their salary, up to the $25,000 IRS contribution limit per calendar year.

Let’s look at how this contribution limit works. If your employee elects a 10 percent contribution, then the maximum contribution limit would be $22,500 ($25,000 worth of stock x 10% discount ($2,500) = $22,500 maximum contribution).

In this same example, the 10 percent contribution is taken from your employee’s salary pre-tax. In other words, the 10 percent contribution will decrease the employee’s taxable pay by 10 percent.

As the employer, you’ll deduct the selected contribution amount from the employees’ paychecks. Then, after six months, the employee will reach a purchase date. On this date, the employee’s balance in the ESPP will be used to purchase startup stock.

Lookback Provisions for ESPPs

ESPPs can offer a lookback provision, which is an attractive option. This is how the lookback provision works. An ESPP’s lookback provision based the stock purchase price on the price either at the beginning of the offer period or at the end of the purchase period, whichever is lower. The stock purchase price is not based on the price at the time of purchase.

Let’s look at an example:

If your startup’s stock price is $100 at the start of the offer period and then $110 at the end of the six-month purchase period.
Your ESPP has a 10% discount on the purchase date based on the lower price at the beginning of the offer period or the end of the purchase period.
The ESPP will purchase the stock for $90 (a 10 percent discount from the start of the offer period. Although the discount is 10 percent, your employee realizes more gains as the stock is currently valued at $110.

Some companies may have lookback periods from six to 24 months, giving employees some potential big wins.

The Tax Benefits of ESPPs

ESPPs enjoy favorable tax treatment. Here are some key benefits for both the startup and its employees:

Taxed Upon Sale of Shares. Employees only incur taxes when they sell their ESPP shares. They are not taxed when purchased.
Upon the sale of Shares. When employees sell their shares, the realized income can be treated as either ordinary or capital gains.
Capital Gain Treatment. Employees can enjoy capital gains treatment on the sale of the shares if the stock shares are held for at least two years after the option is granted and at least one year after the employee buys the stock. Further, the employee must stay employed by your startup until at least three months before the option is exercised.
Ordinary Tax Treatment. If the above holding-period requirements aren’t met, the employee will be taxed at the regular tax rates, which are, of course, much higher than capital gains taxes.

Regardless of the differences between RSUs and ESPPs, offering stock ownership to your employees is highly beneficial to both your team and your startup. With actual employee ownership, you can create a culture of dedicated, happy, productive employees, all directly contributing to the success of your startup.

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