In addition to hourly wages or salary, employers often incentivize their employees with compensation in the form of company stock.  Company stock can be awarded to employees without restriction or can be awarded through an Employee Stock Ownership Plan (ESOP) or purchased through an employee stock purchase plan (ESPP). These plans can have various goals; for example, an ESOP makes employees owners in the company, which tends to align the goals of the employee and employer. An ESPP allows employees to purchase company stock at a discount, which is a nice company perk, thus retaining employees.

Here I will address yet another type of stock plan, in which a company makes a promise to employees that they will receive company stock in the future, but only if they meet certain conditions.  This type of stock is referred to as restricted stock.

Restricted stocks are unregistered shares that are issued to company executives as part of compensation.  They are nontransferable and must be traded according to special SEC regulations.  The restrictions include a vesting period, which is a period during which they cannot be sold or transferred. The employee must continue to be employed through to the vesting date; otherwise, the stock will be forfeited.  Common vesting schedules are:

  • 3-year cliff vesting: all restricted stock vests at once after three years
  • 4-year graded vesting: 25% of the restricted stock vests each year for four years

For example, an employee who has been granted restricted stock on a 3-year cliff vesting schedule who retires in year 2 would forfeit all the shares. An employee who has been granted 100 shares of restricted stock on a 4-year graded vesting schedule who retires in year 3 would receive the 75 shares which had vested before retirement; the other 25 shares which were still unvested at retirement being forfeit.

Other conditions to vesting may apply; for example, it is common to base vesting on company metrics such as achieving strategic objectives (product launches, market share goals) or more general business results such as revenue or profit targets.  Vesting can also depend upon personal performance, such as hitting a sales target, completing a project, or receiving positive performance reviews.  It is not uncommon for companies to make exceptions for employees who retire before their shares are vested.  For example, in return for an employee training their replacement, shares that are unvested upon retirement would not be forfeit.  Companies have wide discretion in these matters.

There are two types of restricted stock:

  1.  Restricted Stock Awards (RSAs), and
  2.  Restricted Stock Units (RSUs)

Although similar in many ways, there are some differences:

 

 

 

 

 

 

 

 

Real or Notional

RSAs are real company shares that are issued either from treasury stock, which consists of shares that the company holds in its own account, or they may be newly issued shares. Issuing RSAs from treasury stock does not dilute existing shareholders because the shares are already in existence. Newly issued shares increase the total number of outstanding shares and can lead to dilution for existing shareholders. Although real shares, RSAs have no value to the employee other than voting rights until they vest.

RSUs, on the other hand, are not real shares of stock at the time they are granted. Rather, they are “notional”; meaning they are only promises to deliver shares in the future, provided vesting conditions are met. When RSUs vest, real shares are granted, either from Treasury stock or newly issued shares.

Tax Basis

The Tax Basis of RSAs is their market value on the date of grant, while the tax basis of RSUs is $0, because there were no shares in existence on the grant date.

Taxation Upon Vesting

When RSUs vest, the fair market value on the vesting date is treated as ordinary income. This amount is subject to Federal income tax, State income tax (if applicable), and Payroll taxes (Social Security, Medicare, and additional payroll taxes such as the additional Medicare tax for high earners).  Payroll taxes apply because grants of restricted stock are considered a form of compensation for services rendered, so the IRS treats the vesting as a taxable event like wages.

RSAs receive the same exact tax treatment upon vesting, unless an 83(b) election was made at the time of the grant.  The election must be filed no later than 30 days after the grant date.  By filing the election, the recipient elects to be taxed on the fair market value (FMV) of the stock on the grant date, even though the stock is restricted and subject to forfeiture.  It results in capital gain treatment of any appreciation that takes place after the grant date, avoiding the ordinary income treatment that would have applied had the 83(b) election not been filed.

For example, an employee who is granted 100 RSAs at a FMV of $10 per share on the grant date and who makes an 83(b) election, would pay ordinary income tax and payroll tax on $1,000 in the year of the grant.  If the shares appreciate to $15 per share by the vesting date, and are sold at that time, capital gains tax would be paid on the $500 gain in the year of vesting and sale. If no sale takes place at vesting, capital gains would remain unrealized until the time of sale.

An 83(b) election cannot be made with RSUs, because as of the grant date, they are not yet real shares and have no FMV.

Considerations

Restricted stock is a form of “golden handcuffs”; a way to incentivize employees to stay with the company to the vesting date and perform.

RSUs present a simple question: Is it worthwhile in the employee’s personal and financial situation to continue to work until the vesting date and meet the other requirements to receive vested shares?

RSAs present the same question, but in addition they present a choice that affects the income tax result. A determination should be made within 30 days of the grant date to either:

  • File an 83(b) election, which will cause ordinary income and payroll taxation on the tax basis in the tax year of the grant, and capital gains tax on appreciation when the stock is sold at vesting or later, or
  • Decide against an 83(b) election, which will avoid any taxation in the grant year, but will cause ordinary income and payroll taxation on the value of the stock upon vesting, whether the stock is sold or retained, and capital gain on any unsold stock thereafter.

An 83(b) election can be a good choice for those who anticipate growth in the value of their shares or who plan to hold shares for a long period of time so as to receive long-term capital gains tax treatment. If, on the other hand, there is a high likelihood the shares will be forfeited, an 83(b) election may be unwise,  because there is no refund on the taxes paid in the grant year. The decision to make the 83(b) election can have quite an impact. For example, consider this example:

  With no 83(b) election 83(b) election made
Number of RSAs granted 20,000 20,000
Taxable Event In year of grant In year of vesting
FMV per share on grant date $5 $5
FMV per share on vest date $25 $25
Total FMV at time of taxable event $500,000 $100,000
Ordinary Tax Paid at 37% tax rate $185,000 $37,000
Payroll tax paid at 8% rate $40,000 $8,000
Cap Gain tax paid at 20% rate $0 $80,000
TOTAL Tax paid $225,000 $125,000

The large $100,000 tax savings here is the result of the very significant appreciation in the stock price. Note that with the 83(b) election, the $80,000 in capital gains tax may be deferred beyond the vesting date if the stock is not sold at that time.

RSUs are sometimes “cash-settled”, meaning that the employee receives cash instead of company stock at vesting. Upon vesting, the employer often automatically withholds at a very high rate of 40%, with the remaining 60% of shares or cash awarded on an after-tax basis.  The 40% withholding rate is designed to approximate the combination of both ordinary income tax in a high bracket plus the payroll tax.

The plans through which restricted stocks are awarded go by many different names, and the provisions vary from one plan to the next.  It is important to read the plan document to understand any plan, but the main features of restricted stock have been outlined here.

James Twining
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