Restricted Stock and Restricted Stock Units: How are they Taxed?
Over the last seven years, restricted stock and restricted stock units (RSUs) have grown in popularity as incentive compensation tools, while the use of stock options has declined. So it’s important — for employers and employees alike — to understand their tax implications.
A restricted stock award is a grant of common stock that’s nontransferable and subject to forfeiture until it has vested. Typically, vesting requirements are tied to continued employment, achievement of pre-established performance goals or both. An RSU is a contractual right to receive stock (or its cash value) after the award has vested.
Advantages over options
For employers, stock options used to have a big advantage over other incentive compensation tools: They enabled companies to provide executives and other employees with valuable benefits without recording compensation expense on their financial statements. This advantage disappeared after the Financial Accounting Standards Board (FASB) amended its accounting standards for “share-based payments” in 2004, requiring companies to estimate the fair value of stock options on the grant date and report that value as compensation expense.
Options remain an attractive benefit, offering significant upside potential for employees. But restricted stock and RSUs also have some advantages. For example, they generally retain value despite market volatility, whereas options can become worthless in a down market. Also, from the employer’s perspective, restricted stock and RSUs generally involve fewer shares, so they cause less ownership dilution.
Sizing up the tax benefits
Restricted stock provides an attractive — but risky — opportunity for employees. If they make what’s known as an “83(b) election” to pay tax on the stock’s market value when they receive it, they can convert any future appreciation in value into long-term capital gains, which enjoy more favorable tax treatment. But it can be risky because, if they ultimately forfeit the stock, they’ll have paid tax on income they never receive.
Without an 83(b) election, employees are taxed at ordinary-income rates on the stock’s market value when it vests. If the stock appreciates in value, their tax bills will potentially be higher than they would have been under the 83(b) election — but if they forfeit the stock, they’re not taxed.
RSUs, on the other hand, aren’t eligible for the 83(b) election, so there’s no opportunity to convert ordinary income into capital gains. But they do offer a limited ability to defer income taxes. Unlike restricted stock awards, which become taxable immediately upon vesting, RSUs aren’t taxable until the employee actually receives the stock. So rather than having the stock delivered immediately upon vesting, the employer and employee can agree to delay delivery, which will defer the employee’s income tax. Keep in mind, however, that any income deferral must satisfy the strict requirements of Internal Revenue Code (IRC) Section 409A.
From the employer’s perspective, RSUs offer several benefits:
- With RSUs, the employer controls the timing of its compensation expense deduction because the expense is deductible when the stock is delivered. With restricted stock, the expense is deductible either when the stock is awarded or when it vests, depending on whether the employee makes an 83(b) election.
- RSUs may generate larger compensation expense deductions. If the stock price goes up between the time RSUs are awarded and delivery of the stock, the employer enjoys a larger deduction. With restricted stock, if an employee files an 83(b) election, the employer’s deduction is limited to the stock’s value at the time of the award. (On the down side, with RSUs, if the stock price falls, the employer’s deduction may shrink.)
- The employer avoids the administrative expense of issuing stock unless and until RSUs vest.
- Employees don’t have voting rights or receive dividends until they actually receive stock (although some RSU plans pay dividend equivalents).
For public companies, it’s also important to consider IRC Sec. 162(m), which places a $1 million limit on deductions for compensation paid to certain top executives. Some types of compensation are excluded from the limit, including “qualified performance-based compensation.”
This includes restricted stock and RSUs that vest based on pre-established, objective performance goals and meet several other requirements. A 2012 IRS ruling clarifies that, even if restricted stock or RSUs meet these requirements, any related dividends or dividend equivalents must separately qualify as performance-based compensation.
Weigh your options
Restricted stock and RSUs can be an attractive alternative to options. If your company is considering these incentive compensation tools, make sure you understand the relevant tax considerations for the company and its employees. And if you’re the recipient of such compensation, it’s important to understand the tax consequences — and the planning opportunities.
FICA refunds for severance pay?
Recently, the Sixth U.S. Court of Appeals ruled that severance payments made to employees in connection with the cessation of a business weren’t subject to FICA payroll taxes. In theory, the decision should apply to all severance payments made to employees involuntarily terminated in connection with workforce reductions, plant shutdowns and other similar situations, although the answer will likely depend on additional court rulings.
If your business has made significant severance payments — or you have received severance payments — consider filing a protective refund claim pending further developments on this issue.
Watch out for fraudulent tax returns
In an increasingly common scam, identity thieves use victims’ personal information to file fraudulent tax returns electronically and claim bogus refunds. When the real taxpayers file their returns, they’re notified that they’re attempting to file duplicate returns. It can take months to straighten things out, causing all sorts of headaches and delaying legitimate refunds.
If you have reason to believe that your identity has been stolen or may be stolen in the future (for instance, because you lost your wallet or documents containing personal information), consider participating in the IRS’s Identity Protection Personal Identification Number (IP PIN) Program. After completing and submitting an Identity Theft Affidavit (Form 14039), you receive a six-digit IP PIN. Once the IP PIN is issued, you’ll be unable to file electronically without it. And you’ll be issued a new IP PIN each year until the threat has passed.
You can also reduce your likelihood of becoming a victim by filing your return as soon as possible after you receive your W-2 and 1099s. If you file first, it will be the thief who’s filing the duplicate return, not you. And, of course, make every effort to protect your identity, such as by shredding documents with personal information and not giving out your personal information unless you’re absolutely sure the request for such information is legitimate.
The annual exclusion gift: A powerful tool
Don’t underestimate the tax-saving potential of an annual gifting program. For 2013, the annual gift tax exclusion has increased to $14,000 per recipient ($28,000 for gifts you split with your spouse). Consider this example: Dave and Susan decide that each year they’ll make the maximum annual exclusion gift to each of their five children and eight grandchildren. In just five years, they will have transferred $1,820,000 (5 × $28,000 × 13) free of gift tax and without using up any of their lifetime gift tax exemptions.