Restricted stock and the terminology you should know

Restricted stock awards or restricted stock units can be ways for companies to add incentive to employee compensation packages. If you are receiving restricted stock awards or restricted stock units from your employer, it is important to understand the various terms and potential federal tax consequences. State and local taxes may vary.

In this article, you’ll get a quick grounding in restricted stock awards and restricted stock units to help you better understand, evaluate, and plan.

Restricted stock, restricted stock units and stock options are not the same

It’s not uncommon to find restricted stock awards/restricted stock units and stock options discussed within the same topic. Although often confused, these are not the same type of employee stock plan benefits. Likewise, restricted stock awards and restricted stock units are often confused for one another. Trying to apply terminology from one to the other can lead to misunderstanding. Restricted stock awards are subject to transfer restrictions and forfeiture conditions, and restricted stock units are the promise of stock or its cash equivalent a company awards you—typically at no cost—but that may not be fully yours until certain conditions are met. In contrast, stock options are the option to purchase said stock at a specific price at a future date. Both restricted stock awards and restricted stock units are generally taxed when they vest. Stock options generally need to be exercised and have different implications regarding timing and tax.

Restricted stock awards and restricted stock units and vesting

Restricted stock awards or restricted stock units may be granted as part of an employment package. For restricted stock units, at a specified date after grant, you would receive the actual shares—or the cash equivalent. Check your plan document for details. Until then, you must wait before the stock becomes your property. This period of waiting is called vesting. For restricted stock awards, you are awarded a specific number of shares which may not be sold or transferred until vesting.

Vesting follows a schedule stated by the employer. It can be a graded schedule in which certain amounts of shares are distributed to you over time, or it can be a cliff schedule which means all shares are vested at once on a future date.

• Graded schedule: As an example, if you receive 1,000 shares as part of your restricted stock grant, they may be vested at 250 shares each year starting in the second year. The value of each set of vested shares is the market value at the time of vesting.

 

• Cliff schedule: With this schedule, all shares become available after a certain number of years. For example, all 1,000 restricted stock shares can vest after three years of service.

 

There are usually additional provisions regarding vesting. For example, if you retire, die or become disabled, restricted stock awards or restricted stock units may vest immediately. There can also be provisions as to what happens when the company is bought out or if you quit. It’s important to know the answers for all these scenarios so you can be prepared ahead of time and make an informed decision.

Restricted stock awards, restricted stock units and risk of forfeiture

One of the main attractions for employers to issue restricted stock award or restricted stock unit grants is that they may incentivize employees to stay with the company. If an employee wants the full value, they must remain with the company until all shares have vested. And during this time before vesting, the shares are generally not taxed.

For some employees, the vesting of restricted stock awards or restricted stock units is based on performance. During each year of employment, the employee must hit certain performance metrics before stock shares vest. Additionally, employers may require employees to not only hit performance metrics but also remain at the company for a certain amount of time. 

Tax implications after vesting

Once shares have vested, employees may become confused on the tax implications. The primary tax event occurs once the shares have vested. When the restricted stock award shares vest, the value of your vested shares are taxed as ordinary income (subject to potential earlier taxation if you make an election under section 83(b) of the Internal Revenue Code. Consult your tax advisor for more information). When the restricted stock unit shares vest, you are taxed on the ordinary income on the value of the shares when they are delivered following vesting.

If you hold the shares for an additional year, you could potentially take advantage of long-term capital gains if the stock increases in value—but those gains will only be for gain above your cost basis since vesting, and not the full value of the vested shares.

Vested restricted stock awards or restricted stock units are categorized as “supplemental” wages on your W-2. Be aware that withholding on vested stock does not guarantee that your full tax due on the income will be satisfied.

There are a few ways to pay your tax bill, depending on the type of award and the terms of your equity plan:

• Share surrender: This method uses some of your shares delivered upon vesting to cover tax withholdings.

 

• Direct payment: If you want to keep all your shares, you can pay your tax withholding amounts directly to your employer or have the taxes withheld from your paycheck.

 

An Internal Revenue Code section 83(b) election is only available for restricted stock awards, and not for restricted stock units. This election provides you with the option to pay taxes on the fair market value of your restricted stock award at the time of grant. This decision needs to be made early on (within 30 days of grant).  When deciding on a section 83(b) election there are many scenarios and additional rules to work through, so you should discuss this option with a tax professional.

If a tax deferral arrangement under Internal Revenue Code section 83(i) is available through your company, you may be able to choose to defer some taxes on your restricted stock units. You’ll still pay FICA and Medicare taxes at the time of vesting, but it’s possible that federal income taxes can be deferred if a section 83(i) election is made. If this is a possibility, you will need to determine if this is the best course of action for your situation. There are numerous requirements for and limitations on section 83(i) elections. You should consult with a tax professional. 

What does this all mean?

As restricted stock award and restricted stock unit shares are vested through a schedule or at once, it’s important to plan and anticipate their financial impact. This can mean considerations for your savings, portfolio allocation, retirement, and other areas of your financial life. To better understand the full scope vested shares may have, it’s best to speak with a financial professional.