Understanding The Life Cycle of Restricted Stock

Restricted stock is used by employers to give their employees shares of company stock.  Often included as part of a compensation package, restricted stock can be used as a method to incentivize and retain key employees.

Restricted stock can be simple in the sense that the value of the shares is tied to the market price of the company stock.  This can be especially straightforward for publicly traded stock.  While everyone hopes that the stock price will increase and become more valuable, that is not always the case.  Sometimes, the stock price will go down.

However, one very positive feature of restricted stock is that, more often than not, it will have at least “some” terminal value.  Even if the company stock price drops dramatically below the grant price (the price at the time of issue), the recipient of restricted stock may still have the opportunity to sell the shares for “something”, albeit less than they may have hoped for.

In short, restricted stock works like this:

  1. The restricted stock is given.
    1. At this point, the recipient has no control over the stock and pays no taxes.
  2. The restricted stock vests after a specified period of time.
    1. The recipient now has ownership rights and is taxed on the stock.
  3. The owner of the stock can keep the stock or sell the stock.

That’s it!  Easy, right?  Well, on the surface it seems to be.  Below the surface, however, there is a bit more to think about.  Keep reading to learn more.

Restricted Stock at Grant and Pre-Vested

The day that restricted stock is awarded is known as the grant date.  The grant 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 the recipient of the award has no ownership rights to the stock.

During this restricted period, one could think of restricted stock as a future promise.  A promise that says, “In “X” years from today, as long as you remain with our company, you can gain the right to own  the shares.”

During this promissory period, the recipient of the unvested restricted shares has:

  1. Not yet been taxed on the shares.
  2. No rights to dividend payments.
  3. No right to sell the shares.

It’s not until the restricted shares vest that the recipient is taxed, has rights to dividends, and has the right to sell the shares.  Essentially, vesting is synonymous with ownership. When the restricted shares vest, they become unrestricted and the recipient has total control and ownership of the stock shares.

Restricted Stock at Vesting

Restricted stock vests upon a pre-determined 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 it is often 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 vest each year, beginning two years from the grant date.

Regardless of the vesting schedule, shares that vest are taxed as earned income.  This means that you may be responsible for various taxes, including earned income tax, payroll tax, state tax, and local income tax.

The amount of earned income attributable to the stock vesting can be easy to calculate.  Simply multiply the amount of vested shares by the share price at vesting.  If you have 1,000 shares that vest at $20 per share, you will claim $20,000 of ordinary income (1,000 x $20 = $20,000).  In a 25% tax bracket, the vesting of shares will result in a tax bill of $5,000.

The Tax Bill – Cash vs. Cashless Exercise

Depending on the value of the vested shares and the amount of available cash on hand, some recipients of restricted stock may have a difficult time paying the income taxes associated with the vesting of restricted stock.  The greater the amount of shares and the greater the share price, the higher the potential tax liability will be.

Fortunately, employers have a  solution, called a “cashless exercise.

In a cashless exercise, the recipient will immediately sell the vested shares that equal the impending tax liability.  Following the example above, if $5,000 is the expected tax due, 250 shares (250 x $250 = $5,000) will be sold immediately after vesting to cover the cost.  The recipient will be left holding 750 (1,000 – 250 = 750) shares of stock.

Alternatively, those wishing to retain as many shares as possible can elect to do a “cash exercise.”  In a cash exercise, the recipient chooses to retain 100% of the shares and covers the taxes due from other personal assets.

Restricted Stock After It Vests

When restricted stock has vested and the appropriate taxes have been paid, the shareholder owns the shares outright.  Generally, the owner will choose to take one of the following routes: hold the shares or sell the shares.

Hold the Shares

The owner has the right to hold the shares indefinitely.  If they hold the stock, they have normal stock ownership rights, such as the right to dividends.  They also have the right to sell the shares whenever they choose.  By holding the shares, the owner is subject to normal market volatility that comes with owning a company stock.  Should the stock price go up in value, the owner wins.  Should the stock price go down, the owner loses.

While owning company stock can be a good thing, owning too much might lead to concentration risk, which is basically the risk of having too many eggs in one basket*.  How much company stock is too much?  One rule of thumb suggests 10% is a target allocation.  In addition to this rule of thumb, you should consider your personal risk tolerance and investment goals; careful consideration should be given to holding too much company stock in one’s personal portfolio.

Sell the Shares

When the vested stock is sold, taxes may be owed AGAIN.  Depending on if and when the owner chooses to sell the shares, the owner may incur a capital gain (or loss) that is either short-term or long-term.

If the owner sells 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 the owner sells the shares more than one year from the vesting date, the gain will 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.

The 83(b) Election – A Tax Opportunity

An 83(b) election can be made when restricted stock is granted.  With an 83(b) election, the recipient is choosing to be taxed on the value of the shares when they are granted (not when they vest, as is normal protocol).

For a hypothetical example, let’s assume that you are issued 1000 shares at $5 per share.  In this example, the recipient will need to claim $5,000 in income taxes (1000 x $5 = $5,000) at the time of the grant, if electing an 83(b).

In the future, when you sell the shares, the difference between the grant price and the 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 we continue the hypothetical example above and assume the price at vesting is $100, we can assume that $95,000 will be taxed at long-term capital gain (the gain from $5 to $100 multiplied by the amount of shares).  Comparing the two options, we can calculate a tax savings of $17,100:

  • 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

However, there is risk with an 83(b) election.  Should the stock price go down in value, a person who chose an 83(b) election will have paid more in taxes than if they hadn’t chosen the 83(b).

Generally, 83(b) elections are used for restricted stock with low grant prices and the expectation that the stock is highly appreciable.

What Else is There to Know?

Ultimately, restricted stock is a benefit that is used to attract, retain, and reward employees of a company.  With restricted stock, the recipient has limited control over when they obtain ownership of the shares of stock and how the shares will be taxed.

With that said, restricted stock may be a fantastic opportunity to participate in the potential growth of a company.   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.

Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.

* Diversification does not guarantee a profit or protect against a loss.

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