Restricted Stock, RSUs, and Tax Implications

By Devan Hickman December 16, 2022

Compensation is one of the largest expenses for many businesses and, therefore, it’s no surprise that it has expanded in forms, complexity, and methodology. One popular form of compensation is equity, which has become increasingly popular for many companies with stock. It provides employees an incentive to stay with their employer in hopes of a rising stock price and a large payout after a new product launch or IPO. Granting equity is also a way for the employer to encourage company loyalty and hard work without a major cash outlay. In this article, we will focus on restricted stock, RSUs, and employer considerations when it comes to timing, payroll withholding and taxation.

What is restricted stock?

Restricted stock is stock that is granted to an employee which is nontransferable, until certain conditions have been met, and subject to forfeiture for various causes, such as resignation, termination or failure to attain specific performance benchmarks. It is usually granted as a bonus or form of additional compensation. Commonly, the stock is granted upon a vesting schedule and becomes available to the grantee in portions over a set number of years. This is known as graded vesting. Stock can also be granted via “cliff vesting” which conveys the stock in its entirety at a specific point in time. Depending on the company, the grantee may receive dividends on their shares even before vesting. Additionally, some plans offer unvested shareholders voting rights whereas in others, this is reserved until vesting is completed.

How do RSUs differ from restricted stock?

RSU stands for Restricted Stock Unit. Although this sounds the same as the aforementioned restricted stock, there is a crucial difference. Primarily, an RSU is a promise to grant a number of shares to an employee at a specific time or milestone. Again, a vesting schedule comes into play here. RSUs are issued as units (not stock), and they represent an employee’s right to receive, at a future date, a specified number of shares of stock. Once the vesting period elapses, the employee is eligible for the stock promised. Until the applicable requirements are met, the stock is neither transferrable nor deliverable. The vesting period in this case corresponds to a waiting period of eligibility. Usually with RSUs, the recipient does not have voting rights or receive dividends until payout.

Section 83 and 83(b) election

Section 83 of the Internal Revenue Code sets forth the guidance for property transferred in connection with performance of services. The taxation of restricted stock falls under this section, and states that the taxpayer must recognize as income the “fair market value of such property… over the amount (if any) paid for such property” (I.R.C. § 83(a)). The section goes on to state that the compensation “shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable” (I.R.C. § 83(a)).

This is important to note because with restricted stock (more on RSUs next), the stock is subject to forfeiture. Therefore, only at the time the benchmarks are met and/or vesting is completed shall the stock be deemed income to the employee, as opposed to the day the stock is granted.

Conversely, employees may make an election to include all of the stock in their incomes in the year of grant, as opposed to after vesting when the stock is truly safe from forfeiture and freely transferrable. This election is called an 83(b) election as it is laid forth in I.R.C. § 83(b). The section allows an employee to opt out of deferring the income tax on the stock and instead include as compensation in year of grant.

The following example shows the tax impact of the 83(b) election.

Facts- Sean Smith is granted 1,000 shares of restricted stock when the stock is $1/share. These shares vest 25% per year over the next 4 years. He pays nothing for the shares.

Stock price after 1 year is $2, after 2 years is $25, after 3 years is $50 and after 4 years is $100.

Option 1- No 83(b) election

Total ordinary income recognized by the time shares are fully vested is $44,250.

After the first vested year, Sean recognizes as income and pays ordinary income tax on $500 (250 shs x $2). After the second year, he recognizes income of $6,250 (250 shs x $25), after year 3- $12,500 (250 shs x $50) and finally, $25,000 after year 4 when the shares are fully vested (250 shs x $100).

Important note for employers and employees- if vesting is done in tranches (as in the above example) income is recognized and the applicable taxes are due each year as the stock vests, as opposed to recognition at the end of the vesting period.

Option 2- 83(b) election

In year 1, Sean pays ordinary income tax on $1,000 because he is recognizing all shares as income in the year of grant.

When Sean eventually sells his shares, he will be taxed on the proceeds (less basis of $1,000) using the favorable capital gains rate.

In this case, making the 83(b) election shifts most of the tax to the generally more favorable capital gains rate. The catch, however, would be if Sean left the company before his stock vested. In that case, Sean would have paid ordinary income on shares he never received, and there is no tax remedy to make himself whole. Additionally, if the stock price decreases after the grant date, he could potentially have paid more tax than he would have had he not made an 83(b) election. At the end of the day, the 83(b) election is often a gamble that the stock price will increase over time and not decrease.

An important distinction- Section 83(b) does not apply to RSUs. An employee who is granted RSUs may not make the election to recognize the income in the year of grant because no actual stock is issued at the time- just the “promise” to grant shares in accordance with the units. For RSUs, there is only one date on which income is recognized, and this is the day of vesting when the employee has the right to the stock. At that point, ordinary income will be recognized.

Employer Considerations

From an employer’s perspective, the FICA taxes and payroll withholding for restricted stock are required as the stock vests unless an 83(b) election is made. If an 83(b) election is made, withholding is required at the time of grant. Both the employer and the employee should be cognizant of liquidity in terms of covering the income tax liability as well as the payroll tax remittance.

Regardless of timing, payroll taxes, federal income tax and state and local tax (when applicable) must be withheld- just as with regular salary- when it comes to restricted stock. When designing a restricted stock plan, an employer should consider how they will approach payroll tax remittance. Some companies have a mandatory policy in which they automatically sell some of the employees vested shares to cover the necessary withholding. Other companies and stock plans give the employees an option to pay with their own cash, which maintains their stock position. If the company does not automatically sell shares to cover the tax, they will need sufficient cash for withholdings and the employee needs cash on its part to cover income tax liability.

The date on which the stock-based compensation is considered income to the employee is when withholding for FICA and federal income tax is required. Employers remit payroll withholdings in monthly or semi-weekly deposits. However, if withholdings in any period amount to more than $100,000, the remittance is due the next business day. Paragraph (c)(3) of 26 CFR §31.6302-1 states, “…if on any day within a deposit period (monthly or semi-weekly) an employer has accumulated $100,000 or more of employment taxes, those taxes must be deposited by electronic funds transfer in time to satisfy the tax obligation by the close of the next day.” For employers, this is imperative to know and plan for as the penalties for not abiding by this timeframe are steep. It also can impose some payroll tax requirements that extend beyond the stock-based transaction: Per the IRS website, if the next day rule applies during the year, “…you become a semiweekly depositor for at least the remainder of the calendar year and for the following calendar year.” For details on the $100,000 Next-Day Deposit Rule, see Chapter 11 of Publication 15.

There are various strategies to navigating the withholdings and remittance in terms of liquidity. If the employer knows that a vesting date is approaching and wants to avoid a cash shortage, it could proactively:

• Withhold more cash from employee’s regular salary (this would be at the request of the employee by adjusting their withholdings)
• Make an early payroll tax deposit (when cash is readily available) with the IRS using estimated withholding amounts
• Sell a portion of the vested shares to cover withholding (“net withholding”)

Examples of net withholding are as follows:

Sean Smith recognizes $10,000 of ordinary income when his restricted stock vests. His shares are worth $500 each. He is in the 25% tax bracket and therefore owes $2,500 of federal income tax.

1. Sean sells 5 of his shares (5 x $500= $2,500) to cover the tax withholding and Sean is left with 15 shares of stock.
2. Sean’s employer sells all of his stock upon vesting, withholds $2,500 for taxes and Sean receives the remaining $7,500 in cash (not stock).

These are two examples of net withholding options that employers may wish to mandate or offer as options. Since all companies have differing cash positions, strategies and ratios to contend with, stock policies vary greatly from employer to employer.

Conclusion

In summary, granting stock as a form of compensation can be lucrative to both the employer and the employee, but it is imperative to know the regulations regarding this method. When designing restricted stock plans and/or RSUs, employers should have a solid plan and understanding of key dates, cash requirements, and penalties for failing to remit timely.