Many employers, especially in the technology industry, will compensate employees with shares of company stock through Restricted Stock Awards and Restricted Stock Units (RSUs). This type of equity compensation can have a significant impact on your ability to build wealth through owning shares of the company you work for, whether you work for a startup or a Fortune 500 company. Tax planning for Restricted Stock Units and Awards can help you to optimize the benefit of your equity compensation.
Restricted Stock Awards and Restricted Stock Units will have slightly different tax rules than if you were to purchase shares in your firm on the open market. It is important to understand these rules in order to maximize the wealth building opportunity of these shares. There are also some tax planning opportunities available and I will discuss the pros and cons of these in this post.
Tax Treatment of Restricted Stock Units
Restricted Stock Units (RSUs) are a common form of equity compensation at publicly traded companies and mature private firms. With an RSU shares are typically awarded based on employee performance metrics, the growth of the overall firm, or in some cases years of service. You do not have ownership of RSUs when they are awarded, so no tax is owed until the shares vest. Dividends are also not paid on unvested RSUs.
RSUs will become owned by you when they vest. A typical vesting schedule is time bound (such as 25% of your shares vesting each year for four years), although vesting schedules tied to other metrics are possible.
Taxes are owed on the RSU shares in the year they vest, whether or not you sell the shares. The taxable amount is based on the fair market value of the shares on the vesting day. This is considered compensation income, which is taxed at ordinary income tax rates. You will also owe social security, medicare, and state income tax. If your income is high enough you also may owe Net Investment Income tax on the shares.
There may be some cash flow planning required as your shares vest. While taxes are owed, there is no corresponding cash available to pay the tax unless you sell some of the shares. Your employer may withhold cash or sell shares on your behalf and send the proceeds to the IRS as a withholding. It is important to note that the withholding amount may be different than the actual tax owed.
Capital Gains
If you choose to hold the shares for at least a year after vesting, any future growth of these shares will be subject to the lower long term capital gains tax rate. In 2024 the top long term capital gains tax rate is 20% (plus potentially 3.8% Net Investment Income tax). The top ordinary income tax bracket is 37%.
Section 83i Election
If you work for a startup or other non publicly traded firm that offers RSUs you could find yourself unable to sell shares to pay the taxes owed at vesting. As of 2018 the IRS allows a section 83i election to defer the income taxes owed on non-liquid shares for up to five years or until your firm has a public offering. You would still need to pay the payroll taxes (Social Security and Medicare) in the year your shares vest. There are many restrictions and in my experience many firms do not offer this option (mainly because your firm cannot deduct your compensation until it is taxed), but it is worth asking your employer about this option if your shares are not liquid, and your tax obligation is large.
Tax Treatment of Restricted Stock Awards
Restricted Stock Awards (RSAs) are more common at startup and early stage private companies. They are similar to RSUs with a couple of key differences.
RSAs will be technically owned by you when they are awarded. As an owner of the shares you may receive dividends (assuming your firm pays them) and may participate in shareholder votes. RSAs will also have a vesting schedule, similar to RSUs. With RSAs any unvested shares can be forfeited if you separate from service with your firm prior to the vesting date.
The key difference between RSUs and RSAs is the timing of ownership. You are the owner of your RSUs when they vest. You are the owner of your RSAs when they are awarded, subject to forfeiture before they vest.
Because your Restricted Stock Units (RSAs) are subject to forfeiture, the typical tax treatment is that taxes are owed (at ordinary income tax rates) in the year that the shares vest, similar to RSUs.
Tax Planning with the 83b Election
Unlike RSUs, your Restricted Stock Awards (RSAs) do give you the option to choose to pay the tax prior to vesting. This is called an section 83b election. This election must be filed with the IRS within 30 days of the award. You would owe tax on the entire amount in the year of the award.
The advantages of an 83b election are that the clock to long term capital gains treatment starts immediately, and if the shares appreciate between the award date and vesting date, you get to pay tax on the lower amount.
The risk of an 83b election is if you forfeit your shares (such as separating from service prior to vesting) you do not get to take a corresponding deduction. You would have paid tax on assets you no longer have! Also, if the stock price falls between the award date and the vesting date you would have been better off waiting to pay the tax. Recognizing all of the income for tax purposes may also push you into a higher tax bracket.
Careful planning is required when considering a section 83b election.
Cost Basis When Purchasing Your Shares
While it is most common for RSUs and RSAs to be awarded to you as part of your compensation, in some cases you might pay for the shares, either at fair market value (FMV), or at a discount to FMV. The amount you pay for the shares reduces the taxable amount at vesting. For example, if you are awarded shares for purchase at $5 and the FMV of your shares when they vest (and you purchase them) is $8, you would owe ordinary income tax on the difference ($3). Your cost basis in the shares would be $8.
A situation where you may pay fair market value for the shares could be RSAs at an early stage start up. In this case your benefit is you are getting the opportunity to purchase shares that aren’t available to the general public at a relatively low price, assuming the firm is successful. When purchasing RSAs at fair market value you would want to make sure to file an 83b election within 30 days as you would not have any tax owed on the purchase.
Proper tax planning for Restricted Stock Units and Awards can help you on the path to wealth. As always, I recommend you find a qualified professional CPA or EA if you have questions specific to your individual situation.
