Tax Guide to Restricted Stock and Restricted Stock Units (RSUs)

Sometimes, companies will compensate their employees by giving them shares of restricted stock or restricted stock units. Just like other types of compensation, the value of restricted stock and restricted stock units are subject to federal and state taxes, including Social Security and Medicare taxes. The interesting thing is that restricted stock and restricted stock units typically are not taxed immediately when granted, but at a later point in time when the restricted stock or restricted stock units vest.

Restricted stock and restricted stock units are slightly different from each other. But they share one thing in common: an employee cannot sell, transfer or give away this stock. That’s because employees are prohibited from transferring ownership in the stock until some point in the future. Once this restriction goes away, the stock is said to vest, with the result that the employee is now free to sell, transfer or give away the stock. It is at this vesting event, when the stock becomes freely transferable, that the value of the restricted stock or the restricted stock unit becomes taxable.

After vesting, the employee holds onto the stock for a period of time, and then eventually the employee might sell the stock. When the stock is sold, it will be taxed again, but only on the increase in value between the time the stock vested and the time the stock was sold.

Restricted Stock – What is It?

When a company grants restricted stock, the employee gets stock in the company, but that stock is subject to restrictions. Typically, the person owning the stock is prohibited from selling or transferring ownership of the stock to someone else. These restrictions are conditioned on the future performance of substantial services. (Basically the company says, “Here, take this. You own it, but you cannot sell it. And if you stop working for us, you have to give it back.”) Once you work at the company for the specified amount of time, and the restrictions go away, the stock is then vested to you. Vesting simply means that the restrictions on the stock go away, and you are now free to sell, transfer, or dispose of the stock as you see fit.

Restricted Stock Units – What are They? And How are They Different?

Restricted stock units (RSU) are slightly different than restricted stock.

When a company grants restricted stock units (RSU), the employee will not receive stock in the company until the RSU vests. Until then, the only thing the employee has received is a piece of paper promising that the company will give them shares of company stock at some point in the future. The employee will need to continue working for the company to be eligible to receive the shares of stock. (Basically the company says, “We promise to give you stock in the company at some point in the future as long as you keep working for us.”)

Tax Treatment in General

In general, restricted stock and restricted stock units are taxed at two points in time: when the restricted stock or restricted stock units are vested to you; then again when you sell the stock.

Alternatively, individuals can choose to have their restricted stock taxed when granted (instead of when vested), which can sometimes produce a lower tax impact. This choice is made by filing what’s called an 83(b) Election.

An 83(b) election is not available for restricted stock units. That’s because all the employee has received is a promise of stock in the future, not the stock itself. An 83(b) election is possible only in the situation where a worker receives property (such as stock) in connection with the performance of services. Since an employee has not received any property at the time an RSU is granted, an 83(b) election would not be possible.

Tax Treatment at Vesting

The fair market value of restricted stock and restricted stock units are taxed as part of an employee’s compensation, in the year that the restricted stock or restricted stock units are vested to you. This compensation is subject to withholding for federal and state income taxes, plus Social Security and Medicare taxes. The fair market value of the stock reflects the prices at which the company’s stock is trading on the open markets. Or, if the company is still private, the fair market value is based on a formal appraisal of the company’s valuation.

For example, suppose Andy was granted 10 shares of restricted stock in his company. On the day these shares vest, the company’s stock is trading at $5 per share. That means the fair market value of Andy’s ten shares is $50 (which is 10 shares multiplied by $5 per share). On the date these shares vest, Andy’s wage income increases by $50.

Since the government views restricted stock and RSUs as wages upon vesting, employers need to withhold tax just like they would with an employee’s normal salary. This creates a problem: where does the cash come from needed to pay the tax withholding? There are three possible solutions to this problem. (1) The employee pays cash directly to their employer to cover the tax withholding. (2) The employee may have the tax withholding come out of his or her regular pay (which means additional taxes will be deducted from the regular pay). (3) Some of the vested shares can be sold to generate enough cash proceeds to cover the tax withholdings. Employees choose how to handle the tax withholding at the time their restricted stock or RSUs are about to vest.

Alternatively, employees can choose to have their restricted stock (but not their RSUs) taxed at the time the restricted stock is granted, rather than when the restricted stock vests. This is done by making an 83(b) election.

Special Case of an 83(b) Election for Restricted Stock

As described above, as a general rule, the value of restricted stock is taxed when the stock vests. But there’s a special rule that enables a person to choose to be taxed at an earlier point in time, when the restricted stock is granted. This special rule is referred to as an 83(b) Election, so named because it refers to section 83(b) of the Internal Revenue Code.

Individuals who make an 83(b) election are choosing to have the value of restricted stock taxed when the restricted stock is granted rather than when the stock is vested. Why would a person choose to be taxed at an earlier point in time? Because of the value of the stock on the grant date might be much lower than the value of the stock on the vesting date.

Let’s return to the example of Andy. He owns 10 shares of restricted stock. When the company originally granted the stock to Andy, the stock was trading at $2 per share. Now, when the restricted stock has finally vested, the company’s stock is trading at $5 per share. If Andy had made an 83(b) election, he would have been taxed on $20 (the value of 10 shares on the grant date) instead of being taxed on $50 (the value of 10 shares on the vesting date). The remaining $30 gain is still taxable, but will be taxed as capital gains income when the stock is sold.

Looking back in time, we can see that Andy would be better off if he had made an 83(b) election. If we assume Andy is in the same tax bracket in the year of the grant and in the year of vesting, then Andy will pay less tax if he makes an 83(b) election. That’s because Andy’s tax on the $20 of additional income on the grant date is less than the tax on $50 of additional income on the vesting date.

Of course, 83(b) elections do have some drawbacks. An individual might not be in the same tax bracket in both the year of grant and the year of vesting. Furthermore, the value of the stock could go up or down between the grant date and the vest date. And the individual cannot take a wait-and-see attitude, as 83(b) elections must be filed within 30 days of the grant date. Finally, the stock could be forfeited if the employee stops working for the company; and in this situation the employee will have paid tax on stock she or he doesn’t get to keep if an 83(b) election was made.

Typically, an 83(b) election makes sense in the following situations:

  • The employee pays the full fair market value for the stock. In this situation, the 83(b) election does not result in any additional income. The 83(b) election prevents any increase in value between the grant date and the vest date from being taxed as compensation income upon vesting.
  • The employee expects the stock to increase in value, and taxing the value of the stock on the grant date is favorable compared to taxing the value of the stock on the vest date.
  • The employee is willing to bear the risk that some or all of the stock will be forfeited if the employee stops working for the company.

Tax Treatment When Stock is Sold

After vesting, the employee owns shares of stock that are freely transferrable. At some point, those shares might be sold. Selling the shares will trigger a new tax impact. The individual reports capital gain income for the difference between the gross proceeds from selling the stock minus the adjusted cost basis of the stock. Adjusted cost basis means the price the employee paid to purchase the stock, plus any compensation income from when the stock was granted or vest, plus any brokerage fees and commissions.If the stock is held more than one year from the vest date (or from the grant date if an 83(b) election was made), then the gain from the sale of the stock is classified as long-term gain subject to the lower capital gains tax rates.

If the stock is held one year or less from the vest date (or from the grant date if an 83(b) election was made), then the gain is classified as short-term gain and subject to the ordinary tax rates.

From a tax perspective, if the stock price has appreciated, people should consider holding onto their stock more than one year, so the sale is taxed as long-term capital gains at a lower tax rate.

Tax Move Takeaways

  • Consider whether or not to make an 83(b) election every time a company grants restricted stock.
  • Review your tax withholding options before the restricted stock or RSUs vest.
  • If appropriate from an investment perspective, consider holding the shares for more than one year so that gains are taxed at the lower long-term capital gains rates.

Table: Summary of the Tax Treatment of Restricted Stock and Restricted Stock Units

Restricted Stock Restricted Stock Units
  Without 83(b) Election With 83(b) Election 83(b) Election

not available

Grant not a taxable event compensation income increased by FMV of the shares on the grant date not a taxable event
Vest compensation income increased by FMV of the shares on the vest date not a taxable event compensation income increased by FMV of the shares on the vest date
Basis Price paid for the shares plus amount included in compensation income Price paid for the shares plus amount included in compensation income Price paid for the shares plus amount included in compensation income
Holding period Starts from vest date Starts from grant date Starts from vest date
Sale or Transfer Recognize gain or loss as the difference between the selling price and the adjusted cost basis. Recognize gain or loss as the difference between the selling price and the adjusted cost basis. Recognize gain or loss as the difference between the selling price and the adjusted cost basis.

 

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