By Bill Gallagher, CFP®, MPAS®

With more and more companies offering equity compensation packages to their employees, it is important for those receiving these benefits to understand the features of these different types of compensation. I would like to cover all of the popular forms of equity compensation, including:

• Restricted Stock Unit (RSU)
• Restricted Stock Award (RSA)
• Stock options
• Employee Stock Purchase Plan (ESPP)

This article will focus on restricted stock units (RSUs) and restricted stock awards (RSAs). I will then follow up with two more articles where I’ll address stock options and employee stock purchase plans. We will cover the basic features of each form of equity compensation and the taxation of these benefits.

Before we get into the features of restricted stock awards, I think it is important to cover some of the terminology associated with these plans:

• Grant Date – the date upon which the award is approved by the company’s board of directors
• Grant price – the fair market value of the stock on the grant date
• Vesting – the process through which shares are earned over a period of employment
• Vesting period – the time period over which shares become vested, as set out in the option grant agreement
• Vesting value – the fair market value of shares that vest on the vesting date

A restricted stock unit (RSU) is a right to receive stock after you have satisfied certain conditions imposed by your employer. The most common condition is to remain employed with the company for a certain amount of time. But other conditions may exist. For example, your employer may impose a condition that is based on you reaching a certain sales goal or your team completing a project before the deadline. If these conditions are not satisfied, then you do not receive anything. It is important to remember that when it comes to restricted stock units you do not own the shares until you have earned them – by satisfying the vesting period. This means that you will not receive dividends the company may pay prior to the date you met the conditions. However, some companies may provide a dividend equivalent for those that were granted RSUs.

When we compare RSUs with RSAs we will see many similarities however there are two important differences to keep in mind. Unlike an RSU, when an employee receives an RSA she receives the stock upfront, but she must earn the right to keep them – by satisfying the vesting period. Therefore, since the employee receives the shares upfront, she will be eligible to receive any dividends paid prior to the vest date. However, it is important to note that dividends paid on unvested stock will be considered compensation income, and therefore not eligible for the lower tax rates associated with qualified dividends. Another feature that is available with RSAs is the ability for the employee to make an 83(b) election. This feature can provide multiple tax benefits, which I will discuss later in the article.

Typically, equity grants are subject to a vesting schedule. This means that you receive a portion of the shares of stock over a certain period of time, as long as you stay employed with the employer. Let’s say that your employer granted you 500 shares of stock, subject to a vesting period of 5 years. This means that each year you are with your employer you will receive 100 each year for 5 years.

The good news is that in the majority of cases an employee does not owe tax when they receive a grant of restricted stock. However, when the employee has completed the vesting requirements and receives the shares, she will need to report the value of the vested shares as compensation income. The amount will be reported as wages and included on her W-2. Therefore, this value is subject to federal, state, Social Security, and Medicare tax withholding.

• Taxation Example: An employee receives an RSU grant for 100 shares of company stock, subject to a one-year vesting period. The total value of the shares on the grant date is $20,000 but the shares are worth $30,000 when she satisfies the vesting requirement one-year later. The employee will not have to report compensation income when she receives the grant. However, when the shares vest, she will need to include $30,000 as compensation income, which will be subject to tax withholding.

Since the $30,000 was included in income, this amount becomes the basis for purposes of measuring capital gains tax when she eventually sells the shares.

• Continuing our example from above, if the shares are sold for $35,000, she will have a capital gain of $5,000 (the difference between the market value at sale and her basis). If she held the shares for more than a 12-month period after the vest date, then the $5,000 gain will be considered a long-term capital gain, which will be subject to a more favorable tax rate. However, if the shares were held less than a 12-month period after the vest date, then the $5,000 will be reported as a short-term capital gain and taxed at her marginal tax rate.

As I mentioned above, the 83(b) election can provide multiple benefits, but there are some risks involved as well. When an employee makes an 83(b) election when she receives a grant of RSAs the tax consequences change. When the 83(b) election is made, the employee includes the full value of the shares as compensation income in the year in which she is granted. It is important to note that the IRS must be notified of the election within 30 days after you receive the stock. The benefits of the 83(b) election include:

• Since the employee pays tax at grant, she does not have to report any compensation income when the shares vest.
• Any dividends received before the shares vest will not be treated as compensation income. Instead, they can qualify for the lower tax rates.
• For capital gains purposes, the employee’s holding period for the stock begins on the date she received the grant. Therefore, the 12-month holding period for long-term capital gain treatment starts as of the date of grant, not the date of vest.

It might be helpful to review the 83(b) election in the context of an example.

• An employee receives an RSA grant for 1000 shares of company stock, subject to a one-year vesting period. The total value of the shares on the grant date is $10,000. She feels that the stock price will increase over the next year, so she decides to file an 83(b) election. Therefore, the $10,000 will be reported as compensation income in the year of grant. Let’s say that one year later, when the shares vest, the total value of the shares is $50,000. By making the 83(b) election, she avoids having to include the $50,000 as compensation income because she already paid the tax on shares. Therefore, she saved herself some significant tax dollars by reporting $10,000 of compensation income, instead of $50,000. In addition, she will qualify for long-term capital gain treatment on the sale of the shares sooner than had she not made the 83(b) election.

At this point you may be saying to yourself, “why wouldn’t an employee always make the 83(b) election when they receive restricted stock?” First, it is important to remember that the 83(b) election is only available for RSAs, and not RSUs. In addition, there are some risks that must be contemplated before making the election, including:

• The employee will need to report compensation income earlier than would otherwise be necessary.
• The value of the shares could decrease between the grant date and vest date. In this scenario the employee would pay more tax than necessary.
• The employee could terminate employment before the shares vest. In this situation, the employee would have paid tax when it would not have been necessary and get nothing back in return.

With equity compensation becoming more popular, it is important for employees to not only understand the form of equity they receive but to also understand the tax consequences. In addition, it is important to incorporate the equity you receive in your overall financial plan. How does equity impact your long-term goals and objectives? How does the equity fit into your risk tolerance and other investments? Should you make an 83(b) election? If you find yourself in the fortunate position where your company is providing you with equity compensation, then I would strongly recommend you reach out to your financial planner so that you can get a comprehensive look at how the equity compensation impacts your financial situation.