Over the past decade, the use of restricted stock awards has increased, and the state of education at companies about compensation structures leaves many executives with more questions than answers. So what is a restricted stock grant? These are gifts from a company to an employee of the firm’s stock and have different rules and tax treatments than an ESOP, an ESPP, or stock options like NSOs and ISOs. In future installments I will review the advantages and disadvantages of other plans, but this article will specifically address restricted stock grants and restricted stock units.

Stock grants generally have three components: grant date, grant value, and vesting period. The grant date is when you originally receive the award. The value is dictated by the granting company and usually has a basis of $0. The vesting period is the timeframe by which the shares are transferred to your ownership. The ultimate value of the award is based on the price of the stock as reported on the exchange. Sometimes, there may also be an increase or decrease to the award based on the company’s overall performance during the vesting period. Shares contained in the award must vest before they can be sold for money. Restricted stock grants will sometimes also pass dividends along to the recipient through what’s called dividend equivalents. Employees that own restricted stock grants also may have voting rights.

Example:

You receive a restricted stock grant for 10,000 shares on a 4-year vesting schedule with 25% of the shares vesting each year.

This is what’s known as a graded vesting schedule; your shares become available in equal installments over the specified time frame, typically three to five years. Alternatively, graded vesting schedules can also vest over varying intervals.

Vesting schedules can also have “cliffs.” This is when your shares vest completely over a stated period. This type of schedule is most common for performance-based goals or company performance.

Restricted stock units work very similarly but are not secured by cash or shares anywhere in the company. They are only a promise to pay, and can be fulfilled with cash or stock, although most companies choose stock. Because they are unsecured, they do not come with voting rights. They typically do not come with dividend payments either. However, companies can elect to provide dividend equivalents. These types of grants also have fewer options for how they are divested and treated for taxes.

Newly public companies, or companies that are purchased, have a slightly different approach to vesting. A liquidity event, like the IPO, a sale, or a merger may need to occur before shares vest. After such an event occurs the shares will vest 180 days later.

Why would an employer grant restricted stock?

Restricted stock affords employers some unique opportunities, however, the reasons behind granting stock to employees has very little to do with benefiting staff. Most stock grants serve as an additional form of compensation for key employees while allowing the company to forgo depleting cash to pay the compensation. 

Additionally, stock grants, unlike cash, have a built-in vesting schedule. This allows the company the ability to withhold the compensation (stock grant) from employees that quit or are fired prior to vesting.

Many companies also cite wanting to create an incentive for increasing employee productivity (many recent studies indicate that stock grants do not accomplish this objective) and align employee interests with those of shareholders.

Finally, a company may elect to grant restricted stock units instead of actually granting the stock because it would allow the company to control the timing of their compensation deduction. Restricted stock units also allow the company to potentially receive a larger deduction based on growth of the company’s stock. While I will cover 83(b) elections in more depth, restricted stock units are not eligible for this special tax treatment. Therefore, granting stock units instead of shares removes the administrative burden of tracking 83(b) elections.

Why would an employee want restricted stock?

Restricted stock grants always have value, even prior to vesting. Unlike non-qualified stock options or incentive stock options, which only have value when the company’s stock price rises above a certain price, the certainty of restricted stock grants can be appealing for employees. Where an option’s value is purely theoretical until it is exercised, a stock grant can be valued and tracked immediately. Even if the stock loses value after the grant date, the recipient will still receive the shares when they vest. Additionally, stock grants have fewer variables than stock options and therefore come with less decisions.

Stock grants will often come with dividend equivalents based on the actual dividends of the underlying stock. Stock options do not pay dividends to the holder. It is important to note that dividend equivalents have different tax treatment than actual dividends. When received, the payments are reported as wages on a W-2 and are taxed as income, not subject to the preferential tax treatment of qualified dividends (https://www.irs.gov/publications/p17/ch08.html). Restricted stock grants also typically come with voting rights, although it is possible for a company to issue stock awards without them. Restricted stock units do not come with voting rights.

Risks

However, restricted stock grants are not without risk. At the end of the day, these awards should be considered as compensation. Put differently, if you received a $200,000 cash bonus at the end of the year, would you use the money to purchase your company’s stock?

Most families have a substantial portion of their household’s financial health tied to their employers. Retirement plans, health insurance, life insurance, and income can all be affected by a company’s balance sheet. Receiving and holding company stock increases risk across the board.

Also, unvested grants are almost always forfeited at termination, either voluntary or involuntary. Remember, an employer’s motivation for issuing stock is about the benefits to the employer, not the employee.

An untimely death may also trigger forfeiture but may also accelerate vesting. Therefore, stock awards should be included in regular estate planning like any other asset. Most stock plans allow the participant to name a beneficiary in the plan and these decisions should be reviewed as part of your overall estate plan.

Regulation SEC 1.83-3(D) makes restricted stock non-transferable during the vesting period. This means you cannot gift your unvested shares to a family member or a charity. It also means that these shares cannot be assigned or pledged as collateral.

What are your options and the tax ramifications?

Essentially, the main decision stock grant recipients face is to sell or hold the shares after they vest.

Traditionally, grants will be taxed twice. Once on the value of the grant at vest and later when the stock is sold. When the stock vests, the recipient will pay income tax, including FICA, Medicare, and social security taxes on the value of the stock.

As you can see there could be significant tax obligations associated with each vesting period. This income is subject to mandatory withholding and must be paid in the year the vesting occurs. In order to facilitate paying taxes, most employers allow for shares to be sold at vest automatically.

Later, when the remaining shares are sold, the additional gain is subject to long or short term capital gains.

Consider two employees, Chad and Jeff. Each one receives the same 10,000 shares, subject to 3-year cliff vesting. Meaning, the entire amount vests at the end of a 3-year period. At vest, the stock is worth $25 so the total grant is worth $250,000 and their income taxed owed is roughly 40%. They elect to have their shares sold to pay their mandatory withholding on the stock as it vests. After the shares are sold to pay taxes they each have 6,000 shares worth $150,000. Six months later Chad sells all his shares when the stock is worth $30. He receives $180,000 but pays short term capital gains rates (ordinary income tax rates) of 40% (depending on the individual’s tax bracket) and nets $168,000 from the deal, having paid $112,000 in taxes. Jeff holds his shares until the end of the year. The stock is still worth $30 but the proceeds are taxed at more favorable long term capital gains rates (20% for high income earners). Jeff nets $174,000 after taxes, having only paid $106,000 to the government.

Employees can also make what’s called an 83(b) election, whereby they pay the taxes at the date of grant rather than the date of vest. This strategy only works for restricted stock grants, not restricted stock units. Recipients of restricted stock have 30 days to file an 83(b) election and it is irrevocable. The advantage of filing the 83(b) is to lock in the income portion of the grant at a (hopefully) lower price and extend the holding period of the stock to receive long term capital gain treatment for the proceeds.  When the shares vest, there is no additional tax due. Consequently, should you resign or be terminated, there is risk of the shares being forfeited despite the taxes you have already paid.

Consider the same two employees from the illustration above. Chad makes the 83(b) election and pays income tax on 10,000 shares when they are granted, at which time the stock is worth $15. His tax bill is $60,000 and he must pay it out of pocket. Jeff pays his taxes at the vest date ($100,000) and sells shares to do so. They each hold their shares for one year after they vest and sell when the stock is worth $30. Jeff pays $6,000 (20%) in long term capital gains and Chad pays $30,000. Jeff nets $174,000 and Chad nets $210,000. Chad makes more after taxes because more of the growth is subject to long term gains rates.

However, if Chad and Jeff leave the firm before the end of the 3-year vesting period, Chad will be $60,000 poorer without any recourse to recover his funds.

Other considerations

In addition to the points previously covered, there are several other considerations for executives regarding these plans. Stock ownership guidelines are typically in place for key executives and stipulate the number of shares that must be held during the year. Inquire with human resources if such guidelines are in place when your awards are granted, as well as any time before you sell. Also, pursuant to the Securities and Exchange Act of 1934, Section 16 stipulates that corporate insiders, senior executives, and all directors need to file special forms: 3, 4, and 5. Form 3 is the initial statement of beneficial ownership, form 4 is filed when there is a material change of ownership, and form 5 must be filed when there is a transaction that occurs outside of any reported on form 4. Finally, in 2006, the SEC adopted additional proxy and reporting requirements on restricted stock for executives.

Next steps

Restricted stock grants and units are complex areas of planning that require coordination with multiple professionals: a tax professional, a financial planner, and your estate planner. Because of their complexity, it is important for one of these people to have specific experience in this area to quarterback the discussions.

Thaddeus Schlaud is a Certified Financial Planner ® and the Director of Client Service at Gainplan LLC. He specializes in executive benefits and compensation. 

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