Stock Investing 101 – Restricted Stock

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Restricted Stock

Restricted stock refer to a company’s issued stock that cannot be bought or sold without special permission by the SEC.

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Restricted Stock

What Is Restricted Stock?

Restricted stock refers to unregistered shares of ownership in a corporation that are issued to corporate affiliates, such as executives and directors. Restricted stock is nontransferable and must be traded in compliance with special Securities and Exchange Commission (SEC) regulations. The restrictions are intended to deter premature selling that might adversely affect the company. It typically becomes available for sale under a graded vesting schedule that lasts several years. Restricted stock is also referred to as “letter stock” and “section 1244 stock.”

Types Of Shares: Authorized, Outstanding, Float And Restricted Shares

How Restricted Stock Works

Restricted stock became more popular in the mid-2000s as companies were required to expense stock option grants. It is often used as a form of employee compensation, in which case, it typically becomes transferrable, that is, vests, upon the satisfaction of certain conditions, such as continued employment for a period of time or the achievement of particular product-development milestones, earnings per share (EPS) goals, or other financial targets.

Insiders are given restricted stock after merger and acquisition activity, underwriting activity, and affiliate ownership in order to prevent premature selling that might adversely affect the company. An executive may have to forfeit restricted stock if he leaves the company, fails to meet corporate or personal performance goals, or runs afoul of SEC trading restrictions. The SEC regulations that govern the trading of restricted stock are outlined under SEC Rule 144, which describes the registration and public trading of restricted stock and the limits on holding periods and volume.

An executive who leaves the company, fails to meet performance goals, or runs afoul of SEC trading restrictions may have to forfeit their restricted stock.

These shares may be restricted by a double-trigger provision. That means that an employee’s shares become unrestricted if the company is acquired by another and the employee is fired in the restructuring that follows.

Key Takeaways

  • Restricted stock is a form of executive compensation offered by corporations.
  • They are most common in established companies that want to motivate employees by giving them an equity stake.
  • Restricted stock represents actual ownership of shares but come with conditions on the timing of their sale.
  • The restrictions are intended to deter premature selling that might adversely affect the company, as well as to motivate managers to align their interests with the future of the company.

Restricted Stock Units vs. Restricted Stock Awards

Two variations of restricted stock are restricted stock units (RSUs) and restricted stock awards. A restricted stock unit is a promise made to an employee by an employer to grant a given number of shares of the company’s stock to the employee at a predetermined time in the future. Since RSUs are not actually stocks, but only a right to the promised stock, they carry no voting rights. An RSU must be exercised in order to receive the stock. An RSU that is converted to a stock carries the standard voting rights for the class of stock issued.

A restricted stock award is similar to an RSU in a number of ways, except for the fact that the award also comes with voting rights. This is because the employee owns the stock immediately once it is awarded. Generally, an RSU represents stock, but in some cases an employee can elect to receive the cash value of the RSU in lieu of a stock award. This is not the case for restricted stock awards, which cannot be redeemed for cash.

Taxation of Restricted Stock

The taxation of restricted stock is complex and is governed by Section 1244 of the Internal Revenue Code (IRC). Restricted stockholders pay tax on the capital gain or loss represented by the difference between the stock’s price on the date it vests and the date it is sold. In addition, restricted stock is taxable as ordinary income in the year it vests. This is converse to stock options which are taxed when the employee exercises his or her option, not when they are vested.

The amount on restricted stock that must be declared as income is the stock’s fair market value on the vesting date minus its original exercise price. However, the restricted stockholder may do a Section 83(b) election, which lets him or her use the price on the grant date, not the vesting date, for the purposes of calculating ordinary income tax. The tax bill must be paid sooner in this case, but it may be substantially lower if the stock appreciates between the grant date and the vesting date. The risk of taking this election is that if the restricted stockholder leaves the company before the shares vest, the shares are forfeited, and taxes already paid are non-refundable.

Equity Compensation 101: RSUs (Restricted Stock Units)

Equity Compensation 101: RSUs (Restricted Stock Units)

  • Restricted stock units (RSUs) are one way for companies to grant shares of company stock to employees.
  • The term “restricted” refers to the vesting schedule, or the specified period that must elapse before you’re paid the shares of stock.
  • You pay taxes on the value of the RSUs at vesting.
  • You pay taxes again when you sell the shares resulting from the vested RSUs.

Happy New Year! We’re approaching the time of year when your company will share your 2020 compensation package. Hopefully you will be getting a higher base salary, and/or a larger bonus. And if you work for a publicly-traded company like Clorox or Square, chances are that you also have equity compensation.

Restricted Stock Units (RSUs) are the most common way that employers grant company stock. Perhaps you’re about to receive the first RSU grant of your career, or you have a few years of RSU grants under your belt. Because many clients are unfamiliar with the mechanics of their RSUs, I’ve written this blog post to break it down in plain English.

RSUs: Background

RSUs represent company stock that will be given to you – but with strings attached. You must work at the company for a specified period before the shares of stock are paid to you. The vesting schedule defines how much time must elapse.

Vesting schedule

There are three categories of vesting schedules. As an illustration, let’s say you’re granted 120 RSUs in January 2020. The vesting, or your ownership of the company stock, proceeds as follows:

  1. Cliff vesting: after a certain amount of time has elapsed, you receive 100% of the shares. With a 3-year cliff vesting schedule, you’d receive 120 shares of company stock in January 2022.
  2. Graded vesting: you receive smaller chunks of shares at a regular frequency. With a 4-year graded vesting schedule, you’d receive 30 shares of stock every January, 2020-23.
  3. Hybrid of cliff and graded vesting. For example, a company pays 40 shares of stock in January 2020, and then 3-4 shares per month thereafter (e.g., 1/36 per month).

Value of Your RSUs

When you receive RSUs, you can approximate the value of the grant by multiplying the number of RSUs and the closing stock price on the date of grant. For example:

  • Grant date (and vesting commencement date): 1/2/2020
  • Total number of RSUs: 120
  • Stock price on 1/2/2020: $200 per share
  • Value of the unvested RSUs, before taxes: $24,000 (120*$200)

Note that on 1/2/2020, you’re 0% vested in the RSUs. Let’s say you’re subject to a 25%/year vesting schedule. You will be paid 30 shares on 1/2/2020, at which point you can calculate the actual value by multiplying 30 shares by the closing stock price on 1/2/2020.

Restricted stock units will always have value. This is true even if the stock price drops below the price on the grant date. Building on the example from above, let’s examine the value of your shares resulting from the RSUs vesting after one year:

  • Grant date (and vesting commencement date): 1/2/2020 (@$200/share)
  • Total number of RSUs: 120
  • Vesting schedule: 25% per year (30 shares on January, 2020-23)
Stock price drops to $150 per share on 1/2/2020 Stock price remains flat at $200, 1/2/2020 Stock price increases to $250 per share on 1/2/2020
Value of 30 shares on 1/2/2020 (before taxes) $4,500 $6,000 $7,500

In all three scenarios, the shares resulting from the RSU vesting are worth something, even if the stock price decreases since the grant date.

Taxes

Different taxes apply based on the RSU lifecycle:

At Grant At Vest At Sale
Taxes on RSUs N/A
  • Regular income tax
  • Medicare payroll tax
  • Social Security payroll tax
  • Capital gains tax

In the sections below, I discuss how taxes are calculated, and when you must pay the taxes in each phase

At Vest: How Taxes Are Calculated

You’re subject to tax when the shares are delivered to you at vesting. The market value of the shares at vesting is taxable income. Let’s say one year has elapsed, and you receive 30 shares of company stock of the 120 RSUs originally granted (25% per year vesting schedule). Assuming the stock price increased to $250 per share on 1/2/2020, your taxable income in 2020 as a result of the RSU vesting is $7,500 (30*$250).

The IRS (and your state and local tax authorities, if applicable), view this $7,500 as compensation income. This $7,500 income from RSU vesting is called “supplemental wages” by the IRS. This term refers to compensation paid to you in addition to regular wages. Common examples are bonuses, and RSU vesting.

At Vest: When You Must Pay Taxes

Your company is required to withhold taxes on the vesting date. Supplemental wages are subject to a mandatory and unique set of tax rates defined by the IRS (and your state/local tax authorities, if applicable).

Here are the tax rates on supplemental wages at the federal and state of California levels:

Federal income tax 22%
Social Security tax 6.2%*
Medicare tax 1.45%
Additional Medicare tax 0.9%**
State of California income tax 10.23%
State of California disability tax 1%***
Total 41.78%

*Assessed on the first $132,900 of wages in 2020. Any wages in excess of this annual limit aren’t subject to the Social Security tax.

**Your company is required to withhold additional Medicare tax of 0.9% if your wages exceed $200,000 in the calendar year.

***Assessed on the first $118,371 of wages in 2020. Any wages in excess of this annual limit aren’t subject to the California disability tax.

You can choose from several tax withholding methods:

  • Net Share Settlement: your company keeps a portion of the newly-vested shares equal to the tax needed for withholding. The remaining shares are then deposited to your brokerage account.
  • Same-Day Sale: immediately sell all of the newly-vested shares, and some of the proceeds are used to pay taxes. The remaining cash is deposited to your brokerage account.
  • Sell-to-Cover: all of the newly-vested shares are released to you. Then the broker sells enough shares to cover the taxes owed. You keep the remaining shares.
  • Cash Transfer: deposit outside cash to pay taxes.

According to the 2020 Domestic Stock Plan Design Survey by the National Association of Stock Plan Professionals, Net Share Settlement is by far the most popular choice.

Special Note on Federal and California State Taxes Owed at Vest

You now know that your company must withhold 22% for federal income tax. If your taxable income is greater than $83,000 for single filers ($165,000 if married filing jointly), you likely will still owe federal income taxes next April 15 th . To remedy this situation, you may need to pay estimated taxes. Consult with a financial planner or tax professional to have your individual situation assessed.

For California income tax, the mandatory withholding rate is 10.23%. For very high earners (>$345K for single filers, $690K for married filing jointly), you may need to pay California estimated taxes. Again, consult with a financial planner or tax professional to have your individual situation assessed.

Taxes at Sale of the Shares

Shares that resulted from your RSUs’ vesting have been deposited to your brokerage account. When you sell the shares, you must pay a separate set of federal taxes known as capital gains tax. This assumes the share price has appreciated since the vesting date.

Capital gains are income that arise from the sale of a capital asset. Examples of capital gains are gains from the sale of securities held for investment, including the sale of shares that you acquired from vested RSUs. Capital gains may be short-term (held one year or less) or long-term (held more than one year).

Short-term capital gains are taxed at regular income tax rates. If you’re a single filer with $175,000 taxable income, you’re at a 32% marginal tax rate.

Long-term capital gains are taxed at a special, lower rate:

  • For most people, the tax rate on long-term capital gains is 15%.
  • For high earners, the capital gains tax rate is anywhere from 18.8% to 23.8%.

Some states have capital gains tax as well. California doesn’t distinguish between short-term and long-term capital gains. Instead, California treats income from selling securities as regular income, as if it were another paycheck.

Let’s say you’re a single filer in California with $175,000 taxable income. Your capital gains tax would be as follows:

Short-term Capital Gains Tax:

  • 24% federal
  • 9.3% state

Long-term Capital Gains Tax:

  • 15% federal
  • 9.3% state
Sell Stock (Held 1 Year or Less) Sell Stock (Held >1 Year)

Your company will not withhold capital gains tax for you. You may need to pay estimated taxes in the “quarter” during which you sold the shares. The IRS’ definition of quarter-end is as follows:

  • April 15
  • June 15
  • September 15
  • January 15 of the following calendar year

Consult with a financial planner or tax professional to see whether you should pay estimated taxes now, or if you can simply wait until the April 15 th tax filing deadline.

What Happens if I Leave My Company?

If you voluntarily quit your company, most employers will forfeit the unvested RSUs. You can keep the shares that resulted from RSUs that vested prior to your departure date, however.

Most companies will accelerate the vesting of your RSUs in the event of your death or disability. You can then designate a beneficiary to receive payment of the shares that resulted from the accelerated vesting of the RSUs. Review your RSU award agreement to see if an accelerated vesting clause is included.

Next Up: What Should I Do With My Shares?

In my next blog post , I will discuss your choices when it comes to your company stock.

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