Employers can grant their employees shares of company stock in a few different ways. One option is to provide restricted stock, which is often included as part of a compensation package. Companies may want to make grants of restricted stock to key employees as a way to incentivize and retain this top talent.
In theory, holding company stock might make you more likely to work harder or perform at a higher level because you receive a direct reward in exchange: an appreciating value on stock you hold. Of course, the stock price may not go up at all (and can even drop), regardless of how hard employees who receive the grants work to make the business successful.
Specific Benefits That Make Restricted Stock Appealing
You could say this about any form of equity compensation — that it can work as an incentive and retention tool – but restricted stock might be particularly attractive to you as the employee because it may be easier to value than other types of equity comp.
For example, the value of the grant is usually equal to the restricted shares granted multiplied by the current market price of the company stock. The value is even easier to calculate if the stock trades publicly.
Another benefit to holding restricted stock is that even if the stock value drops, your grant could still be worth something when the grant vests.
In fact, even if the company stock price drops dramatically below the stock price at the time of issue, you may still have the opportunity to sell the shares for some value, albeit less than you may have hoped for.
How the Restricted Stock Lifecycle Works
Here’s what to expect if your company offers you restricted stock: First, they award the grant. Generally speaking, you do not yet control the stock at this point, meaning you cannot sell it. You might have limited control, but you don’t owe taxes on this yet, either. After a specified period of time (usually stated in the grant award documents), your restricted stock begins to vest. Once it vests, you officially own the stock, can liquidate the shares, and are subject to the requisite income tax due on the value of the grant.
At this point, you can decide whether or not to keep the stock in hopes the price goes up, or you can sell the stock and redirect the proceeds elsewhere.
On the surface, restricted stock is reasonably simple and straightforward. That can make it an attractive compensation award. But don’t confuse “simple” for “easy to manage.” There may be a bit more to think about if you find yourself on the receiving end of this type of compensation.
Before Vesting: Restricted Stock at Grant
The grant date is the day your company awards restricted stock to you. This date is important because it’s used as the start date for the vesting schedule.
During the period between the grant date and the vesting date, the stock is “restricted” and you have no ownership rights to the stock.
At this point, you can think of your restricted stock like a future promise. That promise says something like, “In X years from today, as long as you remain with our company, you earn the right to own the shares.”
During this pre-vested period, you:
- Are not taxed on the shares.
- Have no rights to dividend payments.
- Do not have the right to sell the shares.
It’s not until the restricted shares vest that you have rights to the stock (and when you owe taxes on them). When they vest, you then own the shares and have control over what you do with them.
At Vesting: Ownership of Restricted Stock
Restricted stock vests on a predetermined schedule, set forth in the rules established by the employer. Often, vesting schedules will be on a “cliff” or a “graded” schedule.
With cliff vesting, 100% of the restricted shares vest after a specified period of time. This time frame can vary, but is commonly three years from the grant date.
With a graded schedule, a set percentage will vest each year for a set period of years. For example, 20% of your shares might vest each year, beginning two years from the grant date.
Regardless of the vesting schedule, shares that vest are generally taxed as compensation income. This means you may be responsible for paying the income tax, payroll tax, state tax, and local income tax on the value of the shares.
The amount of earned income attributable to the vested stock is generally easy to calculate. You can multiply the number of vested shares by the share price at vesting.
Say you have 1,000 restricted stock shares that vest at $20 per share. You will likely report $20,000 of income because 1,000 shares multiplied by the $20 share price at vesting = $20,000. If we assume a 25% tax bracket, this will result in a $5,000 tax bill.
How to Pay for the Income Tax Due on Vested Restricted Stock
All else being equal, the greater the number of shares vested and the higher the company stock price at vesting, the higher your potential tax liability will be.
Depending on the value of your vested restricted stock and the amount of cash you have readily available, it might be difficult to pay the income tax due on vested restricted stock.
One potential solution for this requisite cash call is a cashless exercise (or a sell-to-cover). In a cashless exercise, you choose to sell some of your vested shares immediately to create the cash needed to cover the tax due.
If we continue the example from above, we know we owe $5,000 in income tax. If you didn’t have $5,000 in cash available to pay this bill, you could sell enough shares to cover the tax bill.
Specifically, 250 shares need to be sold (250 shares x $20 = $5,000) will need to be sold. This typically occurs at the same time the shares vest and the proceeds are used to cover the tax bill. After the sale, you still own 750 shares (1,000 shares that vested – 250 shares you sold = 750 shares retained).
If you wish to retain as many shares as possible, you might want to do a cash exercise instead. In a cash exercise, you pay for tax due from your personal assets, often writing a check to do so. In our example, this means writing a check for $5,000 but you get to keep 1,000 shares of stock.
What to Do with Restricted Stock After Vesting
When your restricted stock vests and you pay the taxes owed, you own the shares outright. From here, you generally have two options: hold the shares or sell the shares.
Option 1: Hold the Shares
If you hold the stock, you have normal stock ownership rights. That includes the right to dividends, gifting, transferring, and so on.
You may also have the right to sell the shares at your discretion. By holding the shares, you do subject yourself to normal market volatility that comes with owning a single stock position.
Should the stock price go up in value, so too will the value of the stock you hold. Of course, you face the risk of the stock price dropping — and the value of your asset with it.
Owning company stock can be a good thing, but owning too much might lead to concentration risk. Concentration risk is when you have too many eggs in one basket and lack diversification*.
How much company stock is too much? One rule of thumb suggests 10%-15% of your net worth is a reasonable target. A better answer, however, may come from considering your personal risk tolerance and investment goals and how a single stock position fit into those.
Option 2: Sell the Shares
You could sell your shares instead of holding onto them. Be aware that when you sell your vested stock, you might owe additional income tax on top of what you already paid when the shares vested
If you sell the shares within one year of the vesting date, the capital gain or capital loss will be subject to short-term taxation. Short-term income is taxed at your marginal tax rate.
If you sell the shares more than one year from the vesting date, gain will likely be taxed at more favorable long-term capital gain rates. Long-term capital gain rates may be taxed from 0% to 20%, depending on your total income.
If you sell at a loss, you may be able to use some or all of the loss to offset other income, or carry the loss forward to future years.
Restricted Stock and the 83(b) Election
If you have restricted stock, you may be able to do an 83(b) election when the stock grant is awarded. You can check your plan document to determine if you are eligible.
With an 83(b) election, you choose to be taxed on the value of the restricted stock award when it is granted — not when the shares vest. This could make sense if you strongly believe the value of the stock will rise in the future.
Let’s assume you receive 1,000 shares of restricted stock at $5 per share. If you did an 83(b) election, you owe taxes when you receive the grant of stock. 1000 shares x $5 share price = $5,000 in income taxes you should plan to pay.
In the future, when you sell the shares, the difference between the grant price and the final sale price is taxed as a long-term capital gain, not ordinary income (assuming the sale is at least one year from the date of the grant).
If the price of the shares is $100 when they vest, we can assume that $95,000 will be taxed at long-term capital gains rates ($95,000 is the gain you made if the stock price went from $5 at grant to $100 to vesting, multiplied by the number of shares).
Comparing the two options, you would save $17,100 in this scenario if you chose the 83(b) election:
- No 83(b) election – $100,000 (value at vesting) x 33% (tax bracket) = $33,000
- 83(b) election – $5,000 x 33% (tax bracket) + $95,000 x 15% (long-term capital gain) = $15,900
This being said, you do take on more risk with an 83(b) election. Should the stock price go down in value, filing an 83(b) election will have caused you to pay more in taxes than you would have if you did not file for the election.
You’re also subject to the risk that you will leave the company prior to the shares vesting. If you do, you will have paid income tax on something that you never actually received.
Generally, 83(b) elections may be attractive for restricted stock that has a lower current value and the expectation that the stock is highly appreciable.
What Else Is There to Know About Restricted Stock?
Ultimately, restricted stock is a benefit that is used to attract, retain, and reward employees of a company. Receiving grants of restricted stock could make for a fantastic opportunity to participate in the potential growth of a company.
But you also need to understand the tax implications of receiving this stock, which includes knowing how much you might owe in taxes and when. You should also think through how holding a lot of company stock can impact your overall portfolio and progress toward your financial goals.
As with any sound investment plan, careful consideration should be given to how restricted stock fits, if at all, into your investments and overall financial plan.
* Diversification does not guarantee a profit or protect against a loss.
The above numbers are for illustrative purposes only and do not attempt to predict actual results of any particular investment.
None of the information in this document should be considered tax advice. Please consult with your tax advisor for more information concerning your individual situation. Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.