What Are Restricted Stock Units (RSUs)?
Restricted stock units refer to shares of stock that are subject to certain restrictions, such as a vesting schedule or transferability restrictions. RSUs, on the other hand, are a promise to deliver shares of stock in the future, subject to certain conditions being met. Many corporations grant RSUs to executive with the purpose of incentivizing them to add as much value to the company as possible so they can benefit in the increasing stock price. They can also be granted to employees at various levels.
RSUs are a form of restricted stock, which means they are ‘restricted’ in some form. RSUs typically have a vesting schedule and are only owned by the employee once they become fully vested. The fact that they have a vesting schedule is the ‘restriction’ for the RSUs.
It is worth noting that another form of restricted stock is called restricted stock awards, or RSAs, which are essentially RSUs without the vesting schedule.
Here is an article about restricted stock units.
How Are Restricted Stock Units (RSUs) Taxed?
RSUs are subject to ordinary income tax when they vest, but the amount of income recognized is typically based on the fair market value of the stock on the vesting date. The fair market value is generally determined by the closing price of the company’s stock on the vesting date. This is different from incentive stock options, which are taxed at the capital gains rate and tax liability is triggered when the options are exercised.
Here is an article on employee stock options.
RSUs can also be subject to capital gains tax, but this would only apply to any gain in the stock price, after you sell the stock, that may have occurred after they stock was issued to you that created a profit. Capital gains tax only applies to the gain in value that occurs after the stock is issued, not the entire value of the RSUs.
For example, if you are issued $10,000 worth of RSUs as part of your compensation package, you will pay ordinary income tax on $10,000. If you choose to hold onto $5,000 worth of stock (not sell) and the stock increases to a value of $7,000, you will need to pay capital gains tax on the $2,000 value increase.
Are RSUs Taxed Twice?
No, RSUs are not taxed twice. However, it can seem like RSUs are taxed twice if you hold onto the stock and it increases in value before you sell it. RSUs are taxed at the ordinary income tax rate when they are issued to an employee, after they vest and you own them.
RSUs can trigger capital gains tax, but only if the stock holder chooses to not sell the stock and it increases in value before the stock holder sells it in the future. In other words, if the stock increase in value after you’ve paid ordinary income tax on it, and you sell it in the future at a profit, you will need to pay tax on that profit.
Below is an example that shows both tax scenarios and outlines that RSUs are only taxed once:
- Alice is an executive of a fast-growing company and receives RSUs are part of her executive compensation package.
- Alice has $25,000 worth of RSU stock vest in 2019, meaning Alice now owns the stock outright.
- Alice now has a tax liability on the $25,000 worth of stock, which is taxed at the ordinary income rate.
- In order to pay the tax, Alice chooses to sell half of the stock immediately, but does not immediately sell $12,500 worth of stock.
- The $12,500 worth of stock appreciates by $2,000 in 2020 before Alice finally sells her position of $14,500.
- Alice is now liable for paying capital gains tax on the $2,000 appreciation.
- This $2,000 was value created by holding onto the stock and it performing well, and was not value granted in the RSU issuance. Thus, the $2,000 was not previously taxed at ordinary income rate.
Here is an article on RSU tax.
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Ordinary Income Tax vs. Capital Gains Tax
As the example above outlines, when RSUs are issued to an executive or employee, they are taxed at the ordinary income rate. The only time capital gains tax comes into play is when the recipient of the RSUs choose to not sell the stock immediately and it appreciates in value before selling it.
In summary:
- Ordinary Income Tax: RSUs are taxed at the ordinary income rate when issued, typically after a vesting schedule.
- Capital Gains Tax: RSUs are only exposed to capital gains tax if the stockholder holds onto the stock and it appreciates in value before selling it. The profit (amount of value increased through appreciation) is what is exposed to capital gains tax.
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Section 83(b) Election
The Internal Revenue Service (IRS) allows for restricted stock shareholders to report the fair market value (FMV) of the stock when it is granted, as opposed to when the employee earns it through vesting. This is called the Section 83(b) Election.
The benefit of this is seen through the tax rate. Given the shareholder has elected to report the FMV on the grant date, they will only be exposed to capital gains tax on any appreciation of the stock that occurs during vesting. This is especially useful when the shareholder plans to hold the stock for a long time.
Here is an article on Section 83(b) Elections.
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Understanding RSUs, Vesting Schedules, and Taxes
As the name of restricted stock units imply, there is a ‘restriction’ for the employee in order to get the stock. This restriction is realized in the form of vesting. Below are the different types of vesting:
- Time-based Vesting: Time-based vesting is exactly what it sounds like. An employee’s shares become vested over time at their employer.
- Milestone-based Vesting: Milestone-based vesting is when stocks vest as an employee completes certain value-creating milestones for the company.
- Hybrid Vesting: A hybrid vesting schedule would include both time and milestone achievement goals.
Vesting and Taxes
The most important thing to understand about RSUs, vesting, and taxes is when the RSUs vest, their ownership is transferred to the employee or executive and they immediately have tax liability on the value of the RSUs.
In other words, if you are granted $10,000 worth of RSUs and they fully vest in the 2020 calendar year, you will have tax liability on the $10,000 worth of stock – which will be at the ordinary income rate.
Here is an article about vesting stock.
Reporting RSU Tax on Tax Return
Given restricted stock is routinely granted as a form of employee compensation, you will usually see it reported on your W-2. Typically, employees withhold taxes on behalf of their employees, which will go against what you owe when doing your taxes.
If your employer does not withhold tax on your RSUs, you will likely be responsible for paying estimated taxes on their value. With all estimated taxes, you’ll need to send the IRS quarterly payments which estimate the amount of tax you’ll be liable for at the end of the year.
Restricted stock is also regulated by the Securities Exchange Commission (SEC) since it is routinely granted to executives that are ‘in the know’ about a company. For this reason, it is exposed to insider trading rules.
Here is an article on reporting RSU taxes.
Getting Help With RSU Taxes
Restricted stock and RSUs can be complicated to navigate from a legal and tax standpoint. RSUs and other forms of employee compensation are typically put in place using a legal agreement. If you need help with this type of employee compensation agreement, feel free to post a job in the ContractsCounsel marketplace for free to get bids from qualified lawyers.
ContractsCounsel is not a law firm, and this post should not be considered and does not contain legal advice. To ensure the information and advice in this post are correct, sufficient, and appropriate for your situation, please consult a licensed attorney. Also, using or accessing ContractsCounsel's site does not create an attorney-client relationship between you and ContractsCounsel.
