Taxes on Equity Compensation, What You Need to Know: Part 2
What comes to mind when you hear the words startups and equity compensation? If your first thought was stock options, that’s not surprising. But they’re not the only way to give equity. Restricted stock is another common tool for getting equity into the hands of key early employees.
In Part 1 we discussed the ins and outs of different types of stock options. This time we’ll look at restricted stock – which has become an increasingly popular way to award to stock. Here’s what you need to know about the different types, how they’re taxed, and when it can make sense to use them for at least a portion of your equity compensation.
Equity compensation – restricted stock
Just as with stock options, there is more than one type of restricted stock: restricted stock and restricted stock units (RSUs). Both offer a way to recruit, retain, and align key employees’ and other stakeholders’ incentives with your business’s long-term success.
Restricted stock versus restricted stock units: what’s the difference?
Restricted stock has all the rights other company shares do, including voting rights and dividend payments (if any are paid). So why are they called restricted? Even though restricted stock is actual company equity, its ownership and use are based on the holder meeting certain conditions. These usually include performance and tenure (aka vesting) requirements, plus restrictions on transfers. But you can also tie grants to specific events, such as an IPO, or sale of the company.
Restricted stock units (RSUs) on the other hand, are not actual company shares. Instead, they are a promise to give the holder the right to own a certain number of shares of company stock once they meet certain conditions. Similar to restricted stock, these conditions could be based on tenure/vesting, performance, individual or company performance, or a specific triggering event. If you don’t meet these conditions, you won’t receive the equity. All these pre-conditions, for restricted stock and RSUs, mean the IRS views them as having a “substantial risk of forfeiture.” And this plays into how and when it taxes them.
Tax treatment for restricted stock and RSUs
Just granting or receiving restricted stock or RSUs doesn’t trigger taxes for employers or employees. But if you own restricted stock, once the shares or RSUs vest you’ll owe ordinary income plus other employment taxes – think social security and Medicare – based on the fair market value of the shares at vesting. That’s true whether or not you actually sell your shares or cash in your RSUs. On the other side, employers are responsible for calculating and withholding federal and state (if any) taxes for their employees.
Once the stock or RSUs are sold, capital gains taxes might be due, based on the difference between the sale price and the price at vesting. The rate you’ll pay depends on how long you held onto the shares. If you held them for less than a year, you’ll get taxed at ordinary income tax rates. If you hung onto them for more than one year, you’ll pay taxes at the lower long-term capital gains rate — ranging from 0% to 15% to 20% depending on filing status and income. Not all states impose a capital gains tax, but several of those that do, including California, New York, and Oregon, tax them as ordinary income.
One potential strategy for lowering your tax bite from restricted stock, but not RSUs, is through an 83(b) election. Basically, this lets you pay taxes on restricted stock you receive upfront when the stock value and related taxes are lower than if you wait until your shares vest. But there are tradeoffs (and restrictions) to doing this, including having to make a potentially large tax payment before you’ve realized any value from your grant.
Restricted Stock versus stock options – key differences
Unlike stock options, which can and do expire worthless, restricted stock grants are likely to offer some value even if their value at vesting is less than what they were worth at the time of the initial grant. Like NSOs, they don’t have restrictions on who you can award them to.
As an employer, you can take a tax deduction for RSUs or restricted stock you’ve awarded employees once the shares or RSUs vest, and the employees recognize the related income. Restricted stock grants can also save you out-of-pocket costs since both are non-cash forms of compensation. That in itself is a big help when you’re struggling to build cash flow and compensate key hires.
When might it make sense to grant restricted stock?
In the early days of your business, equity compensation whether options or restricted stock can be a great way to concentrate your team’s focus on the long-term while enabling them to share in any potential upside. Just as with stock options, you want to reserve restricted stock (actual shares or RSUs) for key employees. And depending on what stage your company is in, early and high-growth, versus later stage and/or public, one might make more sense versus another.
A good tax or accounting professional can walk you through the pros and cons of different types of equity compensation, help you to structure your equity compensation plan in a way that’s likely to help you meet your strategic goals, talk through how to optimize vesting schedules, and advise you on the tax implications of each.
Are you looking for guidance on structuring your equity compensation plan, 83(b) elections, or want to know more about corporate or individual tax returns? Contact our tax and accounting experts here.