A Restricted stock award (RSA) is one type of equity compensation that employers can offer to boost employee retention and better align the financial interests of staff and executives to the organization's success, measured by the share price. For restricted stock awards to yield any value, employees must first satisfy the vesting requirements, which may be time or performance based. RSAs allow employees to make a choice about when to pay income tax on the award - a boom-or-bust wager about the future of the company and the terms of the award. Although very similar to restricted stock units, restricted stock awards are not the same thing.
(Note: this article is intended to provide an overview of restricted stock awards and the various tax considerations at play. This article is not a substitute for personalized tax or legal advice from a CPA, tax advisor, or attorney. Darrow Wealth Management does not provide tax or legal advice; for inquiries regarding your personal tax or employment situation, consult a CPA or employment attorney in your area.)This article will cover the following topics:
- What is a restricted stock award?
- Tax treatment of restricted stock awards
- Should you make an 83(b) tax election?
- Restricted stock vs restricted stock units
- Additional resources
What is a restricted stock award?
A restricted stock award is a type of stock compensation plan where employees or executives are granted (or may purchase) a specified number of shares of company stock (or cash equivalent) to be received at a later date, after vesting requirements are met.
Depending on the stock plan and terms of the grant at the company, a restricted stock award (RSA) will include varying features:
- Cost: shares in RSAs can be given to employees, offered at a discount to fair market value (FMV), or granted at the current market price. If you must purchase the shares, you will do so upon accepting the grant, but won't actually receive the shares until they vest. Restricted stock is typically awarded.
- Vesting requirements: vesting requirements for restricted stock awards can be time-based or performance-based. If you leave the company prior to vesting or the individual or company-based performance requirements are not met, you will typically forfeit the shares and receive nothing. Time-based vesting is often gradual where vesting occurs between 3 and 5 years.
- Upon vesting: assuming the vesting requirements have been met, the company may deliver the shares, a cash equivalent, or a combination of the two. For individuals who were required to purchase shares, the risk that the award will become underwater increases with the purchase price.
How restricted stock awards are taxed
The taxation of restricted stock awards is one of the more unique features of this type of equity compensation. Individuals have some say in how their RSA is taxed through the choice to either make an 83(b) tax election or take no action and proceed with the default tax method.
Regular tax treatment of RSAs
The default taxation of restricted stock awards is as follows: no tax is due when the grant is accepted, but at vesting, the difference between the fair market value of the stock and the amount you paid for the shares (if any) is considered ordinary income. If you receive cash instead of shares or opt to sell the shares immediately upon vesting, there will be no additional tax consequences. For individuals who hold the shares for at least a year after they vest, the subsequent gain (if any) will be taxed at more favorable long-term capital gains rates when the shares are later sold. The short-term capital gains rate is currently identical to the rates for ordinary income.
Choosing an 83(b) tax election
An 83(b) tax election enables restricted stock award recipients to pay ordinary income tax on the award before it vests - the amount to be included as ordinary income is the difference between the fair market value of the stock at grant and the amount (if any) the employee paid for the shares. Any subsequent gain or loss after the shares vest would be considered a long-term capital gain or loss and tax would only become due in the year the shares were sold.
Here's a simplified example:
Regular tax method:
Ben has an RSA and accepts an award of 100 shares of stock for $0/share when the stock is trading at $30/share. Subject to time-based vesting, 4 years later, the restrictions lapse on his award in full when the stock is trading at $50/share. Ben decides to hold the stock for 13 months, then sells all 100 shares when the stock price is $60/share.
At vesting, Ben owes ordinary income tax on the difference between the stock price at vesting ($50) and what he paid for the shares ($0), times the number of shares awarded. In this example, $5,000 is included in his regular taxable income. Ben's new basis is $50/share. When he sells the stock after meeting the long-term capital gain holding requirements, he will have a capital gain of ($60 - $50) x 100 = $1,000.
We'll use the previous assumptions, but assume Ben makes an 83(b) tax election instead. Within 30 days of accepting the grant, Ben makes an irrevocable 83(b) election with the IRS and notifies his employer. Though he has 4 years until his shares vest, he must pay ordinary income tax on the difference between the stock price at grant ($30 x 100 = $3,000) and what he paid for the shares ($0), which equals $3,000. Ben's new basis is $30/share and his holding period starts now, even though he cannot access or sell the shares. 4 years later, Ben is fully vested in the RSA, but since he plans to hold the shares there is no tax consequence. When he sells the stock 13 months later, he will have a capital gain of ($60 - $30) x 100 = $3,000 which will be taxed at more favorable long-term capital gains rates.
Should you make an 83(b) election?
As one might expect, there are a number of pros and cons for investors to weigh when considering making an 83(b) tax election.
Some of the advantages of making an 83(b) election include:
- Potential to reduce your overall tax liability. Assuming the RSA vests and is later sold for a gain, the entire spread between the sale price and the amount the employee originally paid for the shares will be subject to taxation at some point as either ordinary income or capital gains. It is beneficial for taxpayers to skew as much of that spread as possible towards long-term capital gains instead of regular income (in 2019 and 2020, the highest LTCG tax rate is 20% compared to the highest marginal tax bracket of 37%).
- More control over increases to your ordinary income. An individual's adjusted gross income (AGI) and modified adjusted gross income (MAGI) are used for a number of important calculations regarding your tax situation, including what tax deductions or credits you qualify for, your marginal tax rate, whether the 3.8% net investment income tax applies, your ability to make tax-deductible contributions to a traditional IRA, Roth IRA eligibility, and so on. Because the FMV and purchase price at grant are known inputs, before making an 83(b) election you can work with your CPA or accountant to simulate how the increase in your ordinary income might impact your overall tax picture. Those who do not make this election lose their ability to control the timing and amount of ordinary income they may recognize in the future.
- Potential to avoid ordinary income taxation altogether. If a restricted stock award is offered at full fair market value, then there is no spread to include in the individual's ordinary income. This situation does not preclude the investor from making an 83(b) election, but that doesn't mean it is riskless. The executive must still pay for the shares out of pocket and risk forfeiting the award if vesting requirements aren't met or the potential that the stock price will never appreciate.
- Start your long-term holding period early. With an 83(b) election, the holding period to determine the nature of the capital gain (or loss) begins when the election is made, instead of at vesting. Assuming everything goes according to plan, it's possible to sell the shares upon vesting for long-term capital gain treatment.
Drawbacks to making an 83(b) election:
- There's no guarantee you'll ever receive the shares. As discussed, making an 83(b) election does nothing to ensure you will vest in the restricted stock award or indicate their potential future value. If you are given the shares as an award, the full amount will be included in your taxable income for the year. If you must purchase the shares at full value, it may make more sense to consider the election, but the primary considerations then shift to whether to accept the award at all given your outlook for the stock price and longevity at the company.
- Risk of overpaying for the stock...and your tax liability. The stock market is notoriously volatile, and individual company stocks pose the greatest risk. If the share price at vesting falls below the FMV at grant, making the 83(b) election would have backfired, as you would have paid tax on a larger spread (assuming tax rates and your tax situation remain constant). If the stock price has also fallen below your purchase price once you've vested, you can either sell the stock at a loss or hang onto it in hopes it will one day recover.
- Irrevocable and non-refundable. The 83(b) election cannot be reversed and your cash outlay (if any) to purchase the shares is also non-refundable.
- Cash-intensive. Tax payments for an 83(b) election must be made from the employee's cash flows. If the election is not made, the individual may have the option to satisfy the withholding by asking the stock plan administrator to either withhold shares or sell shares to cover the estimated tax payment. Keep in mind that the estimated withholding may be insufficient, so it's important to work closely with your tax advisor.
Do I have restricted stock units or a restricted stock award?
Restricted stock units (RSUs) are similar to a restricted stock award in a number of ways but there are a few key differences. In either type of equity plan, vesting may be time or performance-based and cash or shares could be delivered upon vesting. Unlike RSAs, individuals receiving restricted stock units are never required to pay for the shares - therefore, unless the stock goes to $0, a vested award will always have some value.
Assuming a restricted stock award recipient does not make an 83(b) election, the tax treatment for RSUs and RSAs will be the same for employees of publicly traded companies. An 83(b) tax election is not permitted for holders of restricted stock units. Employees with either type of equity compensation run the risk of forfeiting the award if they leave prior to meeting the vesting requirements. Some other differences include receipt of dividends and voting rights for restricted stock award.
More resources on managing stock compensation
Equity plans can offer employees additional income or even a cash windfall, but there are important financial and tax considerations at play. Holding a concentrated stock position could mean paper-profits are never realized and the lack of a properly diversified portfolio can increase the risk of loss. A well-designed strategy takes your entire financial situation into account, including your risk tolerance, future employment plans, cash needs, and how best to allocate potential proceeds between multiple goals. Consider working with a financial advisor at Darrow Wealth Management to help you develop a plan to maximize the benefits of your restricted stock within the context of your whole financial life.