Compensation at many high tech companies includes some form
of company stock. There are a number of different plans that are used singly or
in combination. In this article I focus on Restricted Stock and Restricted
Stock Units (RSU) granted to employees.
Restricted Stock and Restricted Stock Units (RSU) are somewhat different. If you are
granted Restricted Stock you actually own the stock. With RSU’s the company
promises to grant you the stock over a vesting period, typically 3 – 4 years. Dividends
earned before vesting are credited to a Restricted Stock owner. The particular
company plan determines whether an RSU holder has dividends credited.
In both cases you are restricted from doing anything until
you meet the company’s vesting requirements. The main vesting requirement is
typically to stick around as an employee. However there may be other
requirements such as meeting personal or company performance goals.
Income Tax and the Section 83(b) Election
Both Restricted Stock and RSU’s are taxed as compensation at
the time they vest. Income is recognized at the vest date and is the difference
between the vest date share price and the purchase price. Usually, you are not
required to pay anything at the time of the grant making the purchase price
zero.
The income from the vested shares is considered compensation
and thus subject to all the associated tax and withholding requirements. Most
companies automatically sell enough of the vested shares to meet these
withholding requirements. The withholding requirements include:
- Federal Income Tax: at your W-4 specified rate, or a flat 25%. The withholding rate will be the maximum rate if the value of the vested shares is more than $1M.
- State and Local Income Tax: California withholds at the maximum individual tax rate
- FICA: Medicare on the whole amount and Social Security up to the unfulfilled annual maximum.
In the case of Restricted Stock you have the option to make
a Section 83(b) Election. This election allows you to be taxed at the time of
grant based on the grant date share price. Making this election can
significantly reduce the amount of taxes paid for stock that is expected to
appreciate significantly over the vesting period. However caution should be
used in making this election as there is always the risk of the stock value
decreasing.
Vested Shares – What Now?
Assuming no Section 83(b) election you typically have the choice
of a same day sale of all shares or the automatic sale of just enough shares to
cover the withholding. If you just cover
the withholding you are left owning the remaining number of shares. You can
continue to hold them or sell them, subject to any insider trading restrictions
that may apply. If you hold the shares for over one year, any gain over the
vest date value would be taxed at the advantageous long term capital gain rates
when sold (15% in 2012). Any shares sold before 1 year are taxed as short-term
capital gains, at the same rate as your salary (i.e., ordinary income rates).
The best approach to take depends on a number of factors,
including the employer and your own financial situation. The place to start is
to think about the vested shares as part of your compensation. If you do a same
day sale of all vested shares you are essentially treating the value of the
shares as a bonus.
If you think the company stock will continue to increase you
may be inclined to hold onto the shares instead of selling immediately. However,
realize that doing so puts the ‘bonus’ for which you have already paid taxes at
risk. (Note: If you later sell the
shares for a loss you do have a capital loss. But the FICA you paid will not be
recouped.)
This choice requires a clear-headed, objective analysis of
the employer company and its stock valuation. If you work for a large,
established company with solid fundamentals you might be more comfortable about
taking a risk than if you are working for a small startup. But, remember that
while the large, stable company may have less risk of outright failure it also
may have less opportunity for significant stock increases. And in our current
volatile times you are exposed to the fluctuations in the overall stock market
in both cases.
Let’s assume you see a reasonable risk and a potential for
stock appreciation at your current company. The next place to look is your
personal finances. If you do not have budget or debt problems, have significant
savings and are on track to meet your financial goals (i.e. college funding,
retirement, etc.) it may make sense to hold onto the shares. However, if this is
not the case and you really need the funds now consider selling and being happy
with your ‘bonus’.
Another factor to consider is the annual vesting of more
shares. If you do not sell the vested shares they become an ever increasing
percentage of your total assets. Together with the rest of your compensation
you end up with a large part of your financial well-being dependent on one
company.
Last Word
Do the analysis and determine a strategy for the divestiture
of your Restricted Stock or RSU’s. If you also receive company stock from other
employer plans consider them as well. If you are not sure how to do this seek
help from a qualified financial advisor then objectively execute your strategy.
