How Restricted Stock & Restricted Stock Units (RSUs) Are Taxed

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How Restricted Stock & Restricted Stock Units (RSUs) Are Taxed

Employee remuneration is a significant expense for most businesses; thus, many choose to pay at least a part of it in stock. This sort of remuneration has two benefits: it minimizes the amount of money that businesses must pay out while simultaneously serving as an incentive for employee productivity.

There are many different kinds of stock compensation, each with its own set of laws and restrictions. Executives who get stock options are subject to a unique set of regulations that limit the situations in which they may exercise and sell them. This article will look at the taxation of restricted stock and restricted stock units (RSUs).

How Restricted Stocks and RSUs Are Taxed

What Is Restricted Stock?

Restricted stock is stock awarded to an executive that is nontransferable and susceptible to forfeiture under specified circumstances, such as termination of employment or failure to satisfy company or personal performance goals. The restricted stock is also often made accessible to the recipient over time under a graded vesting plan.

Although there are rare exceptions, most restricted stock is awarded to executives who are regarded to have “insider” information of a firm, putting it subject to SEC Rule 144’s insider trading restrictions. Failure to follow these rules may also result in forfeiture. Restricted shareholders have the same voting rights as any other sort of shareholder. Since the mid-2000s, when corporations were forced to expense stock option awards, restricted stock grants have grown in popularity.

What Are Restricted Stock Units?

RSUs are essentially similar to restricted stock options, but they vary in important ways. RSUs are an unsecured commitment by the employer to issue a certain number of shares of stock to the employee after the vesting schedule is completed. Some plans allow for a cash distribution in place of stock, but most plans require real shares of stock to be issued—but only if the underlying covenants are satisfied.

  Tax Deed Definition

As a result, the stock cannot be distributed until the vesting and forfeiture conditions are met and release is authorized. Some RSU programs enable employees to choose when they want to receive their shares, which may help with tax planning. RSU participants, however, do not have voting rights on the shares throughout the vesting period, unlike regular restricted shareholders, since no stock has been issued. Each plan’s regulations govern whether RSU holders get dividend equivalents.

How Is Restricted Stock Taxed?

Restricted stock and RSUs are taxed differently from other types of stock options, such as employee stock purchase schemes, which might be statutory or non-statutory (ESPPs).Those plans normally have tax repercussions on the day of exercise or sale, while restricted stock usually becomes taxable after the vesting schedule is completed. The whole amount of vested stock in a restricted stock plan must be recorded as ordinary income in the year of vesting.

The amount that must be disclosed is calculated by reducing the stock’s initial purchase or exercise price (which may be zero) from the stock’s fair market value as of the day the stock becomes fully vested. The difference must be recorded as regular income by the shareholder. If the shareholder does not sell the stock at the time of vesting and instead sells it later, the difference between the selling price and the fair market value on the date of vesting is reported as a capital gain or loss.

Section 83(b) Election

Shareholders of restricted stock may elect to report the fair market value of their shares as ordinary income on the day they are given rather than when they become vested. The capital gains treatment continues to apply, although it starts at the moment of gift. Because the stock price at the time the shares are awarded is frequently substantially lower than at the time of vesting, this option may significantly minimize the amount of taxes paid on the plan. The method is particularly beneficial when there is a longer length of time between when shares are awarded and when they vest (five years or more).

  Regressive Tax Definition

Example: Reporting Restricted Stock

Both Sam and Alex are senior executives of a huge firm. They each get 10,000 shares of restricted stock for free. On the award date, the firm stock was trading at $20 per share. Sam chooses to disclose the shares upon vesting, but Alex chooses Section 83(b) treatment. As a result, Sam reports nothing in the year of award, but Alex is required to record $200,000 as regular income.

The stock is trading at $90 per share five years later, on the day the stock becomes fully vested. Sam will have to declare $900,000 of the stock balance as ordinary income in the year of vesting, but Alex will not have to report anything until the shares are sold, in which case they will be eligible for capital gains treatment. As a result, Alex must pay a lesser rate on the bulk of the earnings, but Sam must pay the maximum possible rate on the full gain earned during the vesting period.

Unfortunately, the Section 83(b) option carries a significant risk of forfeiture that exceeds the typical forfeiture risks inherent in all restricted stock schemes. If Alex leaves the firm before the plan vests, all rights to the whole stock amount may be forfeited, even if the $200,000 in shares awarded was recognized as income. Alex will be unable to recoup the taxes he paid as a consequence of this election. Some plans additionally require the employee to pay for at least a part of the stock at the grant date, which might be recorded as a capital loss in these cases.

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Taxation of RSUs

RSUs are taxed differently than traditional restricted stock programs. Because no real stock is granted at the time of issuance, no Section 83(b) election is authorized. This implies that the value of the stock may only be stated once over the plan’s lifetime. The amount reported will be equivalent to the fair market value of the shares on the day of vesting, which in this instance is also the date of delivery. As a result, the value of the stock is reported as ordinary income in the year it vests.

The Bottom Line

There are several types of restricted stock, and the tax and forfeiture regulations connected with them may be quite complicated. This article simply covers the highlights and is not intended to be tax advice. Consult your accountant or financial counselor for assistance.

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