Along with the formation of the startup, founders will usually set aside an employee incentive plan. Such a plan attracts future employees to work longer for the company, and releases cash pressure from the company as well. It is common to see a salary package that is constituted of both cash and equity. As for the equity, there are different types. The most common types are restricted stock units (RSU) and stock options.

RSUs v. Restricted Stocks

People are usually confused about these two terms because they look very similar to each other, but they are actually very different.

If you are granted restricted stocks, you own them on the date of the grant, however, since they are restricted, you cannot transfer them. Also, they are usually subject to a vesting schedule. You will need to purchase them either with cash, intellectual property, or another form of asset.

RSUs, on the other hand, are considered "phantom stocks", because they are not real common stocks of the company, but a promise of the company to award the employee a certain amount of common stock on a future date. The award date could be based on liquidation events or vesting schedules, or other conditions. The recipient does not need to pay to own the RSUs. When the condition is met, the company can choose to award stocks or cash equivalent.

RSUs v. Stock Options

A stock option is an option to purchase the stocks at a predetermined price within a period of time (usually 90 days). The price (also called exercise price) cannot be less than 100% of the Fair Market Value (FMV) of a stock on the date of the grant. Like most equity vehicles, stock options are usually subject to a vesting schedule as well.

There are two types of stock options: NSOs and ISOs. NSOs refer to non-qualified stock options and ISOs refer to incentive stock options. If the NSO has a readily ascertainable market value, it will be taxed when granted, otherwise, it will be taxed when exercised. In the latter situation, the taxed part = (FMV of the NSO on the exercised date - exercise price) * the number of NSOs. The proceeds are treated as compensation income and therefore, subject to federal and state income tax. As for the ISO, there is different calculation used to determine the tax obligation, called alternative minimum tax (AMT). It requires the optionee to pay a minimum tax each year if they hold the stocks for a period of time. If the optionee has paid AMT before, they can count it as AMT credit to reduce their future tax obligations. ISOs may qualify for long-term capital gain tax treatment if exercised but not sold within one year. This is a preferred treatment compared with the short-term capital gain tax, which typically has a higher rate.

Compared to stock options, RSUs are pure upside for the employee, so they are treated as compensation income and thus subject to federal and state income tax. Long-term capital gain tax treatment also applies to RSUs that are held for more than a year.

To sum up, RSUs and stock options are commonly used in employee incentive plans, but they are two different concepts and have their own advantages and disadvantages. The equity related tax issues are particularly confusing and complicated. If you have questions about taxes, I strongly recommend you to consult a tax lawyer or specialist for a more detailed and thorough explanation.