One way companies reward key management personnel or highly compensated employees is through a mutually beneficial equity-based compensation program like restricted stock. Unlike employee stock ownership plans or other stock options, restricted stock — like the name says — comes with restrictions.
Restricted stock is usually part of a compensation package, issued to an employee through a vesting plan and distribution schedule based on performance or tenure; therefore, leaving the company means the employee would forfeit this compensation. Ideally, the company gets to keep talented employees without a huge cash outlay, and the employee receives a potentially lucrative benefit. Generally, at publicly traded companies, employees do not pay for the restricted shares when they are granted. Regardless of how the company’s stock price fluctuates, the benefit almost always carries a monetary value when it vests.
While restricted stock sounds like a win-win situation, it requires a considerable amount of financial and tax planning for the recipient. First and foremost, receiving stock as compensation often results in having a large position in a single stock. Even if the stock has done well, you likely need more diversification. Over time as your shares vest and the company stock continues to increase, you may find yourself overweight in one company. Concentrated positions like this mean a large portion of your overall wealth is dependent on the performance of one company: the company that pays you a salary and whose stock you own.
However, selling restricted stock isn’t always easy because of how it is taxed. When the restrictions lapse, your shares are taxed at ordinary income rates, which are frequently higher than capital gains rates, and if you’re not on top of things, you may be under withholding your taxes. Companies have two options to calculate the federal withholding: They can use an employee’s W-4 rate, which is more complicated than it sounds, or most often, they use a flat rate of 22% (in 2019) for supplemental payments less than $1 million. For those whose supplemental payments exceed $1 million during the year, employers must withhold the maximum individual tax rate of 37%. When your restricted stock is fully vested, your company can withhold the estimated tax due from your shares, but if you’re not in the 22% tax bracket, this may not be enough.
When you were granted the restricted stock, you may have been presented paperwork on Section 83(b) election. This filing lets the IRS know you want to pay the taxes on your restricted stock at the time of the grant rather than after it is vested. You then pay ordinary income tax based on the value of the stock on the grant date. By filing an 83(b) election, you report the income now in exchange for long-term capital gain treatment upon the sale in the future on any appreciation to the current value per share (assuming you hold the shares at least one year and a day). If the stock price increases, you should pay less in taxes on your restricted stock.
Section 83(b) sounds like a perfect plan, right? Well, you’re counting on the company stock to appreciate and that you won’t leave the company, forfeiting the unvested shares. The taxes paid to the IRS based upon the 83(b) filing is nonrefundable. If the company is a growing start-up, that could be quite a gamble.
Restricted stock plans can be very lucrative, and most employees are very fortunate to get one. However, before you laugh all the way to the bank, you need to consider how the stock position affects your overall financial plan, your income tax liability, and your overall investment diversification.