Restricted Stock Explained
About a week ago, one very astute reader of the newsletter told me, “You mentioned restricted stock in last week’s article, but you don’t have an article about it on your site.”
What a better time than now! Restricted stock is known as a restricted stock award or a restricted stock grant. You get the shares at the time of the award. If you don’t satisfy certain conditions that are necessary for the restricted stock, then you forfeit the shares and the company takes them back.
The most common requirement is that you continue working for the company for a certain period of time. However, other conditions are possible.
Distribution Methods
Usually, the shares are in escrow until you satisfy the condition for earning the shares. Escrow is a term for saying a third party holds money, property, or company shares and are turned over to you upon fulfillment of a condition. The third party has possession of the shares even though you are the owner. This vesting arrangement makes it easier for the company to recover the shares if you forfeit them.
Even though you don’t have possession of the shares, the transfer into escrow makes you the rightful owner. As the owner, you can receive dividends and participate in shareholder votes.
Differences with Restricted Stock Units (RSUs)
Keep in mind, restricted stock awards are not the same as restricted stock units (RSUs). The difference between a restricted stock unit (RSU) and a restricted stock award is as follows. With RSUs you have to earn the right to receive shares and with restricted stock awards you receive shares upfront but have to earn the right to keep them.
Typically, with RSUs there are no dividend payments and no shareholder voting until the shares vest. With restricted stock awards you can receive dividends and participate in shareholder votes.
Taxes on Restricted Stock Awards
When given a restricted stock award, you have two tax choices. You can choose the 83b election, which is to pay ordinary income tax on the award when granted and pay long-term capital gains on the gain when you sell. Or you can pay ordinary income tax on the whole amount when it vests.
For example, there is a grant of 10,000 shares of restricted stock when the stock is worth $20 per share. In four years when the stock vests, it’s worth $40 per share. If you make the 83b election, you owe ordinary income tax of $70,000 (10,000 shares x $20 per share x 35% marginal tax rate). Four years later, if you sell the shares as soon as they vest, at $40, the long term capital gains tax is $30,000 ($200,000 gain x 15% long-term capital gain tax rate). In this example, your entire tax bill is $100,000.
Alternatively, if you don’t make the 83b election, you will owe ordinary income tax on the entire amount of $400,000. The ordinary income tax is $140,000 (10,000 shares x $40 per share x 35% marginal tax rate).
Tax Planning
The 83b election is an option for your tax planning. If you choose the 83b election, it reduces the amount of compensation income you report if the value of your stock increases during the vesting period. Additionally, it starts the clock running earlier for long-term capital gains. If the stock pays dividends, the dividends are eligible for lower tax rates with an 83b election.
On the other hand, you pay your taxes earlier than would be necessary with an 83b election. You also have to consider the probability that the value of the stock will fall during the vesting period, and you will pay more tax than necessary. The worst case is paying taxes after an 83b election and then forfeiting the stock. You paid a tax that you would have never had to pay!
On the bright side, if you get stock with a very low valuation and there is potential that it will rise substantially before vesting, an 83b could be a good choice. You would also need to have the cash on hand to pay the ordinary income tax and the long term capital gain tax for the 83b election.
Tax planning and cash management with restricted stock awards is complicated. In addition, there is investment risk based on the price of the company stock, both now and in the future. If you’re confused about how to do this on your own, send me a message or schedule a free consultation for a thorough explanation.