Today we are going to cover What is a Restricted Stock. While this is similar to a Restricted Stock Unit, there are some key differences. And before we jump into breaking this down, Restricted Stock is also sometimes referred to as Restricted Stock Awards, Restricted Stock Grants or just Stock Grants. For this explanation I will just stick with Restricted Stock.
Restricted Stock provides the same benefit as a Restricted Stock Unit. A key difference is you get the shares immediately with Restricted Stock. However, these shares are kept in escrow, but what exactly does this mean?
If you recall with Restricted Stock Units, you do not get the shares until you meet the vesting requirements, which are often time-related. A similar concept takes place with Restricted Stock and escrow. The shares sit in escrow and although they are yours, they really aren’t until you meet the requirements to get them out of escrow, especially as far as taxes are concerned. The vesting conditions to get them out of escrow are often the same as Restricted Stock Units.
However, there are two main differences with Restricted Stock. They are both related to the fact you get the shares, even though they are in escrow.
The first is you get dividends and have shareholder rights. So, if your company’s stock has a regular dividend you get to receive those if you have Restricted Stock. Now, because tax law treats restricted stock as though you do not own the stock, the dividends are not reported by your employer as dividends, but instead are treated as compensation. They show up on your W-2 as income. Basically, these dividends will not qualify for lower tax rates until they are fully vested. There is a way to deal with this which we will talk about in a minute.
With shareholder rights you get to do things like vote on shareholder issues. I’ve never met too many people excited about voting rights, except this means they are typically allowed to attend shareholder meetings, which can be interesting.
Okay, now onto the big main difference, and some would say advantage, of Restricted Stock versus Restricted Stock Units. The ability to do an 83b Election.
We will cover 83b Elections in greater detail in another episode of our mini-series, however, I will hit the high points here.
First reminder, 83b Election only applies to Restricted Stock. Not to Restricted Stock Units or standard Nonqualified Stock Options. The 83b Election treats the Restricted Stock shares as if they were vested when you received them.
When you receive the Restricted Stock, you have one of two choices. The first is to do nothing and treat them as regular old Restricted Stock. The other option is to file the 83b Election form within 30 days of award of the stock. This election must be filed with the IRS.
The only thing I want to mention with Restricted Stock where you choose not to do the 83b Election is how they are treated for tax purposes. I’m going to refer to these shares as Traditional Restricted Stock.
As I mentioned earlier, dividends are treated as compensation income with Traditional Restricted Stock.
Now, when the shares fully vest your shares will be taxed as compensation income at the fair market value of the shares minus anything you paid for the shares. For example, if your Traditional Restricted Stock award is 1,000 shares and the share price is $30, well, your award is worth $30,000 on the date it vests. Since you paid nothing for the shares your compensation income is that full $30,000 amount. Had you paid $20 per share then your compensation income would be $10,000. This is the difference between the fair market value of 1,000 shares at $30 a share for a total value of $30,000 minus the $20,000 you paid for 1,000 shares at $20 a share.
If you hold onto the stock after it vests and sell it down the road, the difference between the price when it vested and the fair market value down the road is treated as capital gains. This is consistent with how Restricted Stock Units are taxed. Following the earlier example, let’s say you held onto those 1,000 shares that had a fair market value of $30 a share once they vested. You wait 10 more years to dispose of them and they had a great run. The value is now $100 a share. The $70 difference between the $30 a share and $100 a share is treated as long-term capital gains. This is nice because capital gains are often taxed at a lower rate than compensation income. So, you now have a capital gain of $70,000, but hopefully paying a much lower rate than $70,000 of compensation income.
So, what exactly does the 83b Election do and is it an advantage? By going this route you’re treated as if the shares were vested when you receive them. This means you report compensation income immediately when you receive the stock. The compensation income is the value of the stock when you receive it.
Additionally, under 83b dividends qualify for dividend rates, which are typically at a lower rate. Now, when your Restricted Stock fully vests and is no longer in escrow, there is no tax consequence, assuming you did the 83b election. This is because the election treated it as though it was vested once you received it.
Taxes when you sell those 83b Restricted Stock shares are treated with the holding period starting on the date you received the stock. Remember that your basis will be the amount you paid for the stock, if you did pay anything, increased by the compensation income you reported.
A key item to point out here regardless of which route you go with Restricted Stock, is that although there is taxable income, there may not be any actual cash coming your way, unless you sell the shares that are now vested. If you have not sold the shares, you still have to report income and pay taxes. Don’t fret too much about how to pay this bill as my experience is employers will dispose of the necessary number of shares to pay the associated taxes. Just be careful that if your Restricted Stock compensation income numbers are large you could get pushed up into a higher tax bracket and your employer is withholding based on a lower bracket. This could easily come into play with two income families and the Restricted Stock holder’s employer is only calculating withholdings based on the that holder’s income. So, double check withholdings and do the proper tax planning.
The final point I want to make is related to the 83b election advantage provided to Restricted Stock. For traditional Restricted Stock, you do not have the ability to say when shares will be vested. Meaning once they vest the shares will automatically become yours and any gain will be additional compensation income. This is where people say it is like a cash bonus. This is easy for planning purposes, but doesn’t provide you any flexibility in those years where your income may be higher or lower. You know, so you could do some tax planning with them.
But, with the 83b election, you do have more ability to plan for taxes. By choosing the 83b election, you move up the timetable for when the shares are considered vested and accelerate the compensation income hit. I will touch more on this in the 83b election episode, but just keep this tax planning concept in mind.
I think that is enough to answer the question of what is a Restricted Stock. Come back next week for what is a nonqualified stock option.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.