Equity Compensation: A Primer on Restricted Stock

As a corporate executive, you likely receive an annual letter detailing your compensation, including a portion in equity. This long-term equity compensation is often in the form of restricted stock, which might leave you wondering what exactly you’ve been awarded. Companies use these programs to incentivize performance and retain talent by aligning their employees’ financial interests with the company’s long-term success. Understanding the nuances of restricted stock, its tax implications, and how it fits into your overall financial strategy is crucial. Let’s dive into the details.

What is Restricted Stock?

Restricted Stock Awards are shares of company stock granted outright, subject to vesting requirements. Once you meet the vesting conditions, the shares belong to you, and you can sell or hold them as you see fit. There are several types of restricted stock, so you will want to consult your stock award agreement to understand the specific details of your grant.

How Does Restricted Stock Work?

Although there are different forms of restricted stock, they typically follow a similar lifecycle, divided into three periods: grant, vest, and sale.

Grant

The Grant Date is when you are awarded your restricted stock. The number of units you receive may be based on a specific dollar amount converted into shares using the stock’s fair market value (FMV), or it may be a set number of units granted for a particular award, not based on the stock price. At the grant date, there is no tax implication, as a risk of forfeiture remains until the recipient meets the vesting requirements. The grant date marks the start of the vesting period.

Vest

Restricted stock has vesting requirements, typically a period of time or a specific performance metric. Once these requirements are met, the recipient no longer risks forfeiture, creating a taxable event. The taxable income from the award vesting is calculated by multiplying the number of units granted by the FMV of the stock on the vesting date. This amount is reported as income on the employee’s pay statement. The company usually withholds federal, state, and FICA taxes. While you could pay the taxes by writing a check to the company, the best option is to have the company sell some of the shares you receive to cover the taxes. This approach allows for organic diversification out of the stock, removing the emotion from the sale, and ensures the withholding is calculated using the same stock price as the taxable income.

Note: The company is only required to withhold the statutory rate of 22% for federal taxes on supplemental income up to $1 million, so you may still owe taxes when you file your return. Your company may allow you to elect to withhold at a higher rate, which could make sense depending on your overall tax situation. Consult with your tax preparer to determine the best approach.

Sale

When you sell the shares you receive, you will have a capital gain or loss depending on whether the stock price has increased or decreased after the vesting date. The gain or loss will be short-term if you hold the shares for a year or less past the vesting date; otherwise, it will be long-term. The holding period starts on the vesting date. If multiple grants vest around the same time, selling any at a loss within 30 days of the vesting date may subject you to the wash sale rules.

Let’s put this all together by walking through an example:

• You are granted 100 restricted stock units on 2/15/2024 when the stock price is $5.
• The units will vest equally each year over the next four years, so 25 units per year.
• On 2/15/2025, 25 units vest when the stock price is $10. You will recognize taxable income of $250 (25 units x $10 per unit).
• You elected to have the company withhold shares to pay your taxes—assume taxes total 40% or $100 ($250 x 40%). This means they would sell 10 shares ($100 divided by the FMV of $10).
• You would receive 15 shares net of taxes, which you could then sell for cash flow.

In contrast, let’s assume you did not have the company withhold shares.

• In this case, you would receive 25 shares at vesting.
• You still recognize taxable income of $250 (25 units x $10 per unit) but you have opted to wait to pay the $100 in taxes.
• Now, it is time to file and pay your taxes and the stock price has fallen to $5. Your shares are worth $125.
• Given the decrease in the stock price, if you wanted to sell shares to pay the $100 in taxes, it would take 20 shares instead of 10.
• The opposite would be true if the stock price had increased to $20; it would only cost you 5 shares.

As you can see, by withholding the taxes at the time of vesting, you lock in the current stock value for both taxable income and withholding tax purposes while also benefiting from the appreciation from $5 to $10 over that year.

The Diversification Dilemma

Understanding the basics of your restricted stock award is just the beginning. How do you consider it as part of your broader financial plan? I typically start by asking my clients: if you had the option to receive your incentive compensation in cash, would you use the cash to purchase company stock? Most say no, recognizing that their livelihood is already significantly tied to the company’s performance. Diversification is a fundamental investment strategy to reduce risk, yet restricted stock concentrates your investment in a single entity—your employer. Given that you will likely receive new grants as part of your compensation each year, a straightforward strategy is to sell the stock that vests annually. This allows you to participate in the stock’s appreciation while diversifying methodically at various price points without letting emotions dictate your strategy.

The Cash Flow Conundrum

Annual compensation letters can be misleading, listing the value of equity compensation granted but not clarifying that these amounts will vest over future years. As a result, you might perceive an inflated sense of annual income, not recognizing that a significant portion is tied up in stock that won’t be accessible until it vests. Additionally, you must take action to sell your shares once they vest to create cash flow from your equity compensation. Otherwise, you will recognize the taxable income but have no cash to show for it.

Integrating Restricted Stock into Your Financial Strategy

So, how should you think about your restricted stock as part of your overall investment and cash flow strategy?

Understand Your Vesting Schedule: Keep track of when your restricted stock is scheduled to vest. This will help you plan for future cash flow and tax liabilities. Determine the impact of retirement, resignation, disability, or death on your stock award.

Plan for Taxes: Be aware that when your restricted stock vests, it is considered taxable income. Work with a financial advisor to ensure you’re prepared for the tax implications and understand how much of your stock will be withheld to cover taxes.

Consider Diversification: Evaluate whether you should hold onto your vested shares or sell them to diversify your investment portfolio. While holding company stock aligns you with the company’s success, diversification can protect your overall financial health.

Monitor Your Investment Concentration: Regularly review how much of your net worth is tied up in company stock. Aim to maintain a balanced portfolio that aligns with your risk tolerance and long-term financial goals. We recommend not having more than 5% in your company stock; however, this may be unavoidable for executives with specific holding requirements.

Align with Your Financial Goals: Integrate your restricted stock into your broader financial plan. Consider how it fits with your retirement goals, estate planning, and overall investment strategy. Restricted stock is a beneficiary-designated asset, like a life insurance policy. Ensure you have a beneficiary on file in case of your passing.

Conclusion

Restricted stock can be a valuable part of your compensation package, but understanding its implications on your cash flow and investment strategy is essential. By staying informed about the type of restricted stock you have, its vesting schedule, and the associated tax implications, you can make strategic decisions that align with your financial goals. If you need assistance navigating your compensation plan, don’t hesitate to reach out to one of our advisors. We’re here to help you make the most of your benefits and secure your financial future.

This information is believed to be accurate at the time of publication but should not be used as specific investment or tax advice as opinions and legislation are subject to change. You should always consult your tax professional or other advisors before acting on the ideas presented here.