TRUST & ESTATE PLANNING

Understanding Restricted Stock and RSUs

01.11.2022 - John S. Traynor, CFP, CPWA

Restricted stock and restricted stock units (RSUs) are two ways a company may compensate employees through ownership in the company. If you’ve received restricted stock or RSUs, you may have questions about how your awards work and how they’re taxed.

What are Restricted Stocks and RSUs?

Restricted stock is company stock that is given to you by your company, usually as part of a bonus or additional compensation. The stock usually follows a vesting schedule, meaning you receive partial grants of shares in increments over a period of time. In some circumstances, you may have shareholder voting rights, or even receive dividends on the shares before they vest. But until vesting, restricted stock is not yours to sell, and you may lose it if you leave the company before your shares vest. Once your restricted stock shares vest, you own them outright and can sell them at any time.

Restricted stock units (RSUs) give you the right to own company stock when you meet certain vesting requirements. But RSUs are not actual stock in the company as is the case with restricted stock. You can think of RSUs like an unfunded promise to give you a specific number of shares in the future as you meet the vesting schedule. Unlike restricted stock awards, RSUs typically do not offer shareholder voting rights or dividends unless your company’s plan allows them. Because of the flexibility RSUs give to employers, RSUs are more commonly used than restricted stock awards. 

How are Restricted Stock and RSUs different from stock options?

Restricted stock and RSUs are different from stock options in that restricted stock and RSUs are grants of company stock to an employee, while stock options only give an employee the option to purchase shares at a predetermined price in the future. 

With restricted stock and RSUs, there are typically two steps involved in obtaining them: (1) you receive an award of shares, and (2) the shares vest according to a schedule over time. Stock options can also be subject to vesting but you must still purchase the shares, albeit at a discounted price.

How are Restricted Stock and RSUs taxed?

When restricted stock or RSUs are granted to you, they are not taxed at that time because you do not own the stock yet. As your restricted stock or RSUs vest, however, they become part of your compensation for that year and are reported on your W-2.

The amount of tax on your shares is based on the market value of the stock on the day that it vests. For example, if you have 1,000 shares valued at $30 when they vest, you’ll pay income tax on $30,000 (1,000 x $30). At vesting, the value of your stock is subject to federal, Social Security and Medicare taxes as well as state and local taxes, if applicable, just like your ordinary salary.  

The value of your stock when it vests also establishes your cost basis in the shares for capital gains tax purposes. If you later sell the stock, you’ll pay capital gains tax on any appreciation over your cost basis in the stock.  For example, If the market value of the stock was $30 per share on the vesting date and you sell the stock three years later when its market value is $50 per share, you’ll pay capital gains tax on the $20 per share of appreciation.   

How can taxes be minimized on Restricted Stock grants?

It’s possible to make what’s called an 83(b) election to potentially reduce the tax impact of restricted stock. This election allows you to pay income tax on your restricted stock shares when you receive them, rather than in each year as they vest. If the value of the stock at the time of award is substantially lower than when it vests, an 83(b) election can yield significant tax savings.

Founders and executives who receive large amounts of restricted stock have found 83(b) elections particularly attractive because typically their stock may have little value at the time of the award but may appreciate significantly by the time it vests. This way, there is little tax paid at the time of receipt. And, any appreciation may be taxed at the lower capital gains rate vs. the ordinary income tax rate (as long as they hold the stock for over a year after it vests) when they sell the shares.  

However, this strategy is not without risk. You must make an 83(b) election within the first 30 days after receiving a restricted stock grant. If you leave the company before your restricted stock vests and you forfeit your stock, you would not get a refund on the income taxes you paid. You may also overpay in taxes if the share value declines over the vesting schedule.

 

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