Restricted Compensation: Your Guide to Restricted Stock and Restricted Stock Units (RSUs)

November 17th, 2023 by Blake Pinyan

Restricted Stock and Restricted Stock Units (RSUs) represent distinctive forms of Equity Compensation, marked by notable differences when compared to Stock Options. In this exploration, we will dissect the definitions of Restricted Stock and RSUs, unraveling their unique characteristics. Following this, we will delve into a discussion of the similarities and differences between the two. Subsequently, the spotlight will shift to taxation, accompanied by illustrative examples to help you better understand the intricate tax rules. Lastly, we’ll conclude with a perspective from Anchor Bay.

Overview

Restricted Stock and RSU awards entail the issuance of company shares to you as part of your compensation. Notably, you do not pay out of pocket for the shares and are rather granted them based upon your role with the company.

The term “Restricted” in Restricted Stock and RSUs signifies that the shares do not legally belong to you until they vest. During the restricted phase, you lack control over the shares and cannot sell them prior to vesting. Vesting, synonymous with Stock Options, designates the date when the shares become accessible to you. Vesting conditions, outlined on the grant sheet, specify precisely when the shares will come into your possession, making it a pivotal piece of information that cannot be overlooked.

Restricted Stock and RSUs can be awarded to employees, directors, and consultants, without a limit on the granted value, similar to Non-Qualified Stock Options. Like Incentive Stock Options, Restricted Stock is non-transferable during the restricted phase, preventing gifting to others or entities. Unlike Stock Options, Restricted Stock does not have an expiration period. Moreover, Restricted Stock provides the owner with:

• Voting rights
• Entitlement to dividends
• The option to make an 83(b) election
• The presence of physical shares associated with the award.

RSUs closely resemble all the characteristics of Restricted Stock, with a few notable distinctions. In contrast to Restricted Stock, RSUs do not:

• Confer voting rights
• Provide entitlement to dividends
• Allow the ability to execute an 83(b) election and
• Lack physical shares associated with the award

The absence of physical shares is particularly noteworthy, as RSUs are often described as phantom compensation – no actual shares are issued at the grant, and they are only released upon vesting. RSUs represent a commitment to issue shares once the specified vesting conditions are met.

Fundamentally, both Restricted Stock and RSUs hold value from the outset, contingent on the company’s stock being worth more than $0 per share. Likewise, as mentioned, there is no out-of-pocket cost to acquire these shares; they are granted to you as part of your compensation.

Tax Implications

The complexity of Restricted Stock and RSUs becomes evident when considering the associated tax implications. These forms of compensation trigger a series of tax events, beginning with the vesting date. On this date, you are taxed as compensation income on the value of the shares that have vested. Compensation income encompasses Federal Income, State/Local Income (if applicable), Social Security, and Medicare taxes. In other words, the value of the shares on the vesting date gets added to your W-2.

Although the company typically withholds taxes on your behalf when the shares vest, it’s essential to be aware that this is done at a flat rate, known as the supplemental income rate, which may not align with your personal marginal tax rate. Understanding this misalignment is crucial, as the vesting of Restricted Stock may lead to additional taxes owed when filing, even after company withholding.

Various methods exist for withholding taxes, with “Share Surrender” being a common approach where the company holds back a certain amount of shares for taxes and provides you with the net amount. Alternatively, the company may sell some of your Restricted Shares to cover taxes or withhold the respective amount from your paycheck. The company’s stock plan ultimately dictates the specifics of withholding.

To illustrate the tax mechanics of Restricted Stock and RSUs, consider the hypothetical example of Emily, who was:

• Granted 1,000 Restricted Stock Shares of ABC Company Stock on 10/08/2022.
• All 1,000 shares vest after a year on 10/08/2023
• The share price on that date being $20
• Emily is taxed $20,000 ($20 share price x 1,000 shares) as compensation income.

Compared to Stock Options, the grant date is less vital for Restricted Stock and RSUs. The crucial factor is the share price on the vesting date, as it determines the initial taxation. You lack control over the shares before vesting, which is why you are taxed once the shares vest and come into your control.

Upon vesting, the shares officially become Emily’s, and she has the option to hold, sell, or gift them. The decision to sell or hold determines the second form of taxation—capital gain (or loss). The compensation income recognized upon vesting establishes a new cost basis for tax purposes. This adjusted cost basis, representing the taxed amount, is used in calculating capital gains or losses when the stock is sold.

For instance, if Emily sells immediately after vesting, the capital gain tax impact is likely minimal if anything due to the adjusted cost basis. However, if she sells later, the capital gain tax will depend on factors such as the sale price and holding period. Specifically:

• If Emily sells the stock after a year from vesting, the holding period will be long-term
• If the stock is sold prior to a year from vesting, the holding period is short-term.
• Whether it’s a short-term or long-term capital gain determines the tax rate applied.
• Long-term capital gains are taxed more preferentially at the Federal level than short-term.

In Emily’s case:

• Her 1,000 shares vested at $20 a share on 10/08/2023
• Taxed at $20 a share for 1,000 shares, a total of $20,000 was added to her W-2 as compensation income
• Emily’s cost basis, adjusted from $0 to $20 a share upon vesting, then determines any future capital gains or losses
• If Emily sells immediately after vesting at $20 a share, there is no capital gain
• If she sells on 01/15/2024 at $23 a share, her short-term capital gain would be $3 a share, or $3,000 total
• If Emily waits until 11/23/2024 to sell at $30 a share, her long-term capital gain would be $10 a share, or $10,000 total

Navigating the tax landscape of Restricted Stock and RSUs requires careful consideration of compensation income upon vesting and subsequent capital gains or losses based on holding periods and sale prices after vesting.

Decisions to Make

Individuals granted Restricted Stock/RSUs face several critical decisions.

• Firstly, the company may require your acceptance of the grant before the shares are pledged to you
• Therefore, you must decide whether to accept the grant, taking into consideration the tax implications upon vesting
• Additionally, a significant decision arises when you must determine whether to hold the shares or sell them upon vesting. This decision, arguably the most important, depends on various factors, including your cash flow needs, belief in the company, overall portfolio diversification, existing concentration in the company stock, tolerance for risk, expectations for future grants, and more.

Pay Attention to Details

Another crucial consideration with Restricted Stock/RSUs is the existence of forfeiture provisions. Notably, there’s a risk of losing your shares if you leave your company before they vest. Additionally, examining your grant sheet to understand the triggers for the vesting of shares is essential. Vesting may be tied to the length of employment or specific performance targets/goals, often referred to as Performance Shares or Performance Vested Restricted Stock. Also, be attentive to the grant sheet as it may outline circumstances in which the vesting period could accelerate or change, such as life events (retirement, death, disability) or company events (merger, acquisition).

Anchor Bay Perspective

From the perspective of Anchor Bay, there are two critical points to take away from this article.

1. Recognize that Restricted Stocks/RSUs inherently hold value from the beginning, and their taxation is determined on the vesting date. Unless the company is of no value, the shares promised to you will indeed have some value, and this is delivered without any out-of-pocket cost. The indirect cost comes in the form of taxation on the vesting date.
2. In contrast to Stock Options, where you have some control over selecting the date and price for tax purposes, Restricted Stock/RSUs do not afford you that level of control. You generally won’t have the authority to choose the vesting date. Therefore, it’s crucial to be mindful of the tax impact and integrate it into your overall tax projection.

Consider taking the time to develop a strategic plan or seek professional guidance to stay on track. Equity Compensation is complex, and the key to navigating it successfully is to be intentional in your approach.