Understanding the value of restricted stock

A vesting schedule defines how long it takes before you actually own the stock. Vesting schedules are detailed in the grant agreement. Typically, restricted stock vests over a period of years—with none vesting immediately, but certain percentages vesting at predetermined future dates (often over a three- to five-year period).

Vesting may be accelerated when certain circumstances occur:

• Death or disability
• Retirement at or after a specified age
• Change in corporate control (sale/merger)

While there aren’t any tax consequences associated with the grant of restricted stock, the grant will become taxable as compensation income (reportable on a W-2 form for that year) in an amount equal to the market value of the stock when it vests. This means that the income will be subject to federal, state, and local income taxes as well as FICA (Social Security and Medicare) taxes. Those taxes will be due even if no cash has been received.

You can recognize and pay your tax liability at the time the grant is first awarded, rather than when the vesting requirement is satisfied, with a §83(b) election. This election allows you to limit the amount of ordinary income that you would realize to the value of the restricted stock when it’s granted rather than when it vests.

This means that any future appreciation in the stock won’t be taxed until you sell it (at which point it will qualify for favorable long-term capital gains treatment assuming you’ve held it for at least a year). The holding period begins on the date of grant with a §83(b) election. Effectively, you’re able to convert a portion of what otherwise would be ordinary income in future years (when the grant vests) into a long-term capital gain and to defer payment of the tax on that gain until the stock is sold.

Keep in mind, however, that if you forfeit the stock after making a §83(b) election, you won’t receive a refund of any taxes you paid. Also, if the value of the stock decreases after the §83(b) election, the decrease would be treated as a capital loss not an ordinary loss, subject to the capital loss limitation rules. So §83(b) elections are typically made when you strongly believe the upside potential of the stock is significant and there’s a strong likelihood that your vesting requirements will be met.

If you don’t make the §83(b) election, each year the grants are vested you’ll recognize income and be taxed on the fair market value of the grant vested in that year. The date that the shares vest will also represent the start of the holding period for capital gains tax purposes.

You must file a signed statement indicating the §83(b) election with the IRS within 30 days from the date of the grant. A copy of the §83(b) election statement must also be provided to your employer and should be submitted with your tax return for the year that the election was made.

The sale of stock acquired from a grant is taxed as a capital gain or loss—measured by the difference between the selling price and price at the time of the grant or vesting (depending on whether or not the §83(b) election was made). The tax treatment of a capital gain as either short- or long-term is dependent upon the holding period prior to the date of the sale.

For federal tax purposes, the “fair market value” of an asset is the price at which the property would change hands between a willing buyer and a willing seller—without either being forced into the transaction, and with both having knowledge of all important facts. For publicly traded stock this isn’t an issue. But for a closely held business, the value could be more difficult to determine.

The most common practice is to allow you to receive any dividends declared and to exercise voting rights to the shares awarded. It’s important to note, though, that any dividends received prior to your shares vesting are not eligible for the federal tax rate on qualifying dividends (0%/15%/20% depending on your tax bracket), unless the §83(b) election was made.

The grant of restricted stock is a form of equity compensation that involves registered shares of stock that are subject to an agreement that’s “restricted” by the company. Restricted Stock issued under SEC Rule 701 are unregistered shares that are subject to sale restrictions under SEC Rules 144 and 145.

Restricted stock units are another form of equity compensation. RSUs are a promise from your employer to grant restricted stock at a specified future date once the specific conditions and vesting have been met. Once your RSUs vest your employer gives you the stock. Your stock is now considered ordinary taxable income. The taxes are based on the value of the stock on the vesting date. Once the taxes are paid, you may consider selling a portion of the stock to pay your tax bill. Lastly, review your overall asset allocation and risk tolerance in light of your additional stock to help you in making the decision to either keep it or sell it.

RSUs differ from RSAs in that any dividends paid on the shares while they are unvested are generally not paid to you and you will not have voting rights that come with owning the shares. With RSAs you have the option to do an §83(b) election.