Restricted Stock and RSUs: Your Essential Guide

This guide will demystify restricted stock and RSUs, covering everything from the basics to the nitty-gritty of vesting and taxation. Let's dive in!

1. The Lowdown: Restricted Stock and RSUs - What Are They?

Think of restricted stock and RSUs as a way your company grants you actual shares. They're "restricted" because they come with a catch: you can't freely sell or transfer them until certain conditions are met, usually tied to how long you work for the company or specific performance goals.

Here's the key differentiator from stock options: with restricted stock and RSUs, the price on the grant date doesn't matter for their inherent value. Even if the stock price drops, your shares are still worth something.

Example: You get 2,000 shares of restricted stock when the market price is $22. If, by the time they vest, the price has dipped to $20, your grant is still worth $40,000 before taxes. If you had options with a $22 exercise price, they'd be "underwater" and essentially worthless.

Because they guarantee some value, companies typically grant fewer restricted shares or RSUs than they would stock options.

2. Siblings, Not Twins: Restricted Stock vs. RSUs

While closely related, restricted stock and RSUs have some notable differences:

• Restricted Stock:

  • Direct Share Grant: You are actually granted company shares upfront.

  • Restrictions Apply: You can't sell or transfer them until vesting requirements (employment length or performance goals) are met, or if vesting accelerates due to a life event (disability, death) or corporate event (merger).

  • Shareholder Rights: During the restricted period (vesting period), you typically receive dividends and have voting rights like any other shareholder.

  • The 83(b) Election: This is a big one! With restricted stock, you have the option to be taxed on the grant date instead of the vesting date (more on this in the taxation section).

• Restricted Stock Units (RSUs):

  • Promise, Not Shares: No actual stock is issued to you at the time of the grant. RSUs are essentially a promise from your company to give you a specific number of shares (or a cash equivalent) once vesting conditions are met. It's more of a bookkeeping entry until then.

  • No Shareholder Rights: Consequently, RSU holders generally don't have voting rights and don't receive dividends on the underlying shares before vesting. (However, some companies may pay "dividend equivalents" on RSUs, which is a cash payment equal to the dividends).

  • No 83(b) Election: Because you don't actually own the property (the shares) until vesting, you cannot make an 83(b) election with RSUs.

3. The Waiting Game: Understanding Vesting Schedules

Vesting schedules determine when those restrictions lift for restricted stock or when the shares are actually delivered for RSUs. They can be:

• Time-Based: The most common, requiring you to work at the company for a set period.

  • Graded Vesting: A portion of your grant vests at regular intervals over a period (e.g., 25% each year for four years).

  • Cliff Vesting: 100% of the grant vests all at once after a specified service period.

• Performance-Based: Tied to achieving specific company or stock-market targets.

Example of Graded Vesting: You're granted 5,000 shares of restricted stock with a four-year graded vesting schedule, 25% vesting each year. On the first anniversary of your grant, 1,250 shares vest, and so on for the next three years. Once each portion vests, you're free to sell those shares.

Important Note: Termination of employment almost always stops vesting. Exceptions are rare and usually depend on your plan and agreement (e.g., in cases of death, disability, or retirement).

4. The Taxman Cometh: Understanding Taxation

This is where it gets a bit technical, but crucial to understand!

• When You're Taxed:

  • Restricted Stock: You're taxed when the restrictions lapse, which is typically at vesting.

  • RSUs: You're taxed when the shares are delivered to you, which is almost always at vesting. (Some RSU plans allow for deferral of share delivery, which can delay taxation).

• What You're Taxed On: Your taxable income is the market value of the shares at vesting. This is considered compensation income and is subject to federal income tax, employment taxes (Social Security and Medicare), and any applicable state and local taxes. This income will appear on your Form W-2.

• How Taxes Are Paid: Your company will withhold taxes at vesting. They typically offer several ways to cover this, including:

  • Share Withholding/Tendering: The company takes a portion of your newly vested shares to cover the taxes.

  • Sell-to-Cover: A portion of your shares are immediately sold to cover the taxes.

  • Deduction from Salary: Taxes are deducted from your regular paycheck.

  • Payment by Check: You pay the taxes directly by check.

• Selling Later: When you eventually sell your vested shares, you'll pay capital gains tax on any appreciation above the market price of the shares on the vesting date. If you hold the shares for more than a year after vesting, these gains are typically taxed at the lower long-term capital gains rate.

The Section 83(b) Election (Restricted Stock Only!)

This is a powerful option for restricted stock, but it comes with risk. With an 83(b) election, you choose to pay taxes on the value of the stock at the grant date instead of the vesting date.

Why consider it?

• Lower Tax Bill (Potentially): If you're confident the stock price will significantly increase between the grant and vesting dates, you pay taxes on a lower value, potentially saving you money.

• Earlier Capital Gains Holding Period: It starts the clock for your capital gains holding period earlier, which can be beneficial for long-term capital gains tax treatment when you eventually sell.

The Risk: If you leave your job and forfeit the grant before vesting, you cannot recover the taxes you paid at grant.

Example: You get 4,000 shares of restricted stock with a $18 grant price.

• No 83(b) Election: You're taxed at vesting on the market value at each vesting increment (e.g., $20, $25, $30, $33). Total ordinary income: $108,000.

• With 83(b) Election: You're taxed at grant on $72,000 (4,000 shares x $18).

If you eventually sell all shares for $50,000, without the 83(b), your capital gain would be $92,000 ($200,000 - $108,000). With the 83(b), your capital gain is $128,000 ($200,000 - $72,000). The 83(b) allowed you to convert $36,000 from higher-taxed ordinary income to lower-taxed capital gains!

Remember, the 83(b) election is not available for RSUs.

5. Performance Matters: When Goals Dictate Vesting

Some restricted stock and RSU grants aren't just about time served. They can be tied to specific performance goals like total shareholder return or earnings per share. These are very similar to "performance shares" or "performance units."

• Performance-Contingent Restricted Stock: Shares are issued upfront and held in escrow until performance targets are met. You have voting rights and receive dividends during this period.

• Performance-Accelerated Restricted Stock: Shares vest after a certain time, but they can vest earlier if specific targets are achieved.

• Performance-Vesting RSUs: Shares are not issued until (or unless) performance-related vesting occurs. No voting rights or dividends until then.

These goals can be highly customized and often include multipliers for exceeding targets. For example, a pharma company might accelerate vesting if a new drug gets market approval or hits certain sales figures.

The Bottom Line

Restricted stock and RSUs are a fantastic way to participate in your company's success. By understanding their basic concepts, the differences between grant types, how vesting schedules work, and the tax implications (especially the 83(b) election for restricted stock), you'll be well-equipped to make the most of these valuable equity awards. Always consult your company's plan documents and consider speaking with a financial advisor for personalized guidance.