As a top-level executive, you know that Microsoft has been a trendsetter in different areas of its business over the years. Its equity compensation structure is no different. In fact, it made the move from offering its employees stock options to restricted stock units in 2003. Not long after—literally the next year—nearly 66% of corporations who participated in a survey mentioned that they had or were in the process of changing over their equity compensation plans to incorporate restricted stock units.
So, knowing that more than a decade ago many corporations saw the upside of offering restricted stock units to their employees, it’s important for you to know more about this type of executive compensation. Specifically, what does the restricted stock tax treatment look like when you’re offered these units? We will walk through all of that and more as we take a deeper look into restricted stock units from a tax planning perspective.
Restricted Stock Units vs. Stock Options
To adequately explain restricted stock tax treatment, it helps to briefly compare restricted stock units to traditional stock options. The biggest difference between restricted stock units (RSUs) and stock options is you receive the stock units at the market value when you become fully vested, which typically occurs from two to five years but can vary depending on the employer. This is different from traditional stock options, which have a grant price and an exercise price.
In the case of stock options, you hope the exercise price happens to be higher than the grant price. If, for example, your company stock declines in the time between the grant of the option and the time in which you can exercise, you will have actually lost money due to the market risk associated with stock options.
The tradeoff to the relatively risk-averse RSU is that you don’t have the market upside potential that you get with a stock option, meaning you don’t have the time to allow the stock to potentially grow and therefore generate additional income for you. However, many executives prefer the restricted stock unit for its simplicity and tax treatment.
Restricted Stock Tax Treatment
Once your restricted units are fully vested, you can expect to pay income tax on the current market value of the shares of stock. This is different from non-qualified stock options because the employee pays income tax at the time of exercise on that form of equity compensation.
With RSUs, an employee may opt to have their employer withhold a number of stock units from their payment to offset the income tax that would otherwise be owed on the compensation. Some employers will even automate this process so you receive your RSUs without any taxable incident.
If this is how your RSUs are set up, once you have received your shares, you are free to do with them what you want. You can turn around and sell the shares immediately or simply hold onto them. There is no additional taxable incident with the RSUs until you sell them, at which time you pay capital gains tax on the difference between the market value when you received the stock and the price at which you were able to sell the stock units.
When it comes to understanding restricted stock tax treatment, we can’t go without mentioning a tax strategy that could be advantageous for you, depending on your financial situation. It’s known as filing an 83(b) election [link to “When and Why You Should File an 83(b) Election”].
Filing an 83(b) Election
This IRS code provision allows you to frontload your tax bill on your RSUs. You might ask yourself, why would anyone want to do that? Because with RSUs, there is a chance that you could face a high income tax bill when your stock units become fully vested. Understanding this specific restricted stock tax treatment is important for executives. If you choose to utilize the 83(b) election, it means that you are paying the income tax (that otherwise would be owed when you become fully vested) on the RSUs when they are granted rather than waiting.
The benefit of this strategy is that if the stock price increases between the time the units are granted and the time in which you become fully vested, you will not owe tax on the larger amount but rather the smaller market value when the RSUs are granted. If you have the funds to pay the tax bill early, it may make sense for you in the long run. The one major downside to this strategy, however, is that if you fail to meet the vesting requirements, there is no refund on the taxes that you pre-paid to the IRS.
Being Offered Restricted Stock Units?
Just like any equity compensation strategy, understanding the ins and outs of the restricted stock tax treatment will benefit your overall financial portfolio now and in the future. Of course, you should not feel that you need to make decisions regarding your RSUs and their tax treatment alone.
When you are offered RSUs from your employer as a form of equity compensation, the first thing to do is consult with a trusted executive financial advisor who can advise on the best way to receive those units, how to integrate them into your overall financial portfolio, and the tax implications of this equity compensation. Having this expertise on your side can help you make the most informed financial decision possible regarding your restricted stock tax treatment.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for equity compensation planning. For more information on how Wade and the Carpenter Team can advise you on restricted stock tax treatment, reach out today for a complimentary consultation.
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