Companies often look for creative ways to compensate their employees. Most personnel are familiar with a bonus check, holiday gift cards or perhaps a company-paid trip. Another way companies reward key management employees or highly compensated employees is through equity-based compensation. One mutually beneficial equity-based compensation program is restricted stock.
In a restricted stock program, employees are compensated with a number of shares of company stock subject to certain restrictions. Stock is usually nontransferable and subject to forfeiture under certain conditions. A company may require the employee remain with the company for a certain number of years before the shares are completely vested, or the vesting schedule may be tied to company or employee performance. Generally, with publically 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 nearly always carries a monetary value when it vests.
Let me illustrate with an example: You receive a promotion to a high-profile position in your company. As part of your compensation package, you are awarded 15,000 shares of company stock with a vesting schedule over the next five years. After the first year in your position, 1,000 shares vest, meaning you will have full ownership of 1,000 shares. At your second anniversary, 2,000 shares will vest, and so on until your fifth year, when your remaining 5,000 shares vest. However, if you leave the company before the third year in your position, you forfeit 12,000 shares of unvested stock. Sometimes restricted stock is awarded each year. Therefore, if you leave the company, you leave some compensation on the table.
Restricted stock plans differ from stock options in that a stock option is only of value if the fair market value of the company’s stock is greater than the exercise price. For example, your company’s stock is selling today for $50 per share. Your company offers you the option to purchase 1,000 shares at that price with a one-year vesting period. In one year, you have the right to exercise your option to purchase the shares at $50 each. However, your option is only of value if the company’s stock price has increased to more than $50. With our restricted stock example, after one year, your 1,000 shares are worth their fair market value the day they are fully vested. Thus, a restricted stock plan may be the more coveted benefit. An equivalent number of restricted stock shares is nearly always worth more than an option.
A restricted stock program is beneficial to the company in several ways. First, it reduces the cash compensation the employer pays out, therefore helping the company’s current cash flow. Second, it serves as an incentive to the employee, as a result of the vesting schedule. Third, restricted stock shares generally come with voting rights during the vesting period. Thus key employees should have a voice in decisions that shape the future of the company. Restricted stock also offers employees tax-deferred compensation as the shares are not taxed when granted unless otherwise elected.
Taxation
One of the most important aspects of restricted stocks, however, is how they are taxed, as they are part of your compensation package.
Since restricted stock is subject to a vesting schedule, you do not own the stock shares until the vesting requirements are met. When the restrictions lapse, your shares are taxed at ordinary income rates, which are almost always higher than capital gains rates.
The IRS requires the employee to provide the required withholding of ordinary income tax at the time the shares vest. Generally, when employees are notified they have shares that will vest soon, they are given the options for paying the tax due. You should be able pay the income tax to your company by check, wire, payroll deduction, or by withholding shares.
For example, you have 1,000 shares that will vest at the end of the month. Your company notifies you that the estimated closing price of the stock is $35. On that day, $35,000 will be included in your wages, subject to federal and state ordinary income tax and employment taxes. Based on this, your estimated taxes due on the 1,000 shares should be $11,673—a flat federal withholding rate of 25% on supplemental payments, 6% for Georgia state taxes, and Medicare tax of 2.35%, assuming you have maxed your Social Security earnings though your wages and are required to pay an additional Medicare tax. You have the option to have 333 shares—calculated by dividing the estimated tax liability by the estimated closing price—withheld to cover your tax liability. In this case, you actually receive 667 shares after the taxes are withheld.
Alternately, when you were granted the restricted stock, you may have been presented paperwork on a 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.
Let’s say you are granted 15,000 shares that vests in five years. If the current value of the stock is $15, your shares are worth $225,000. 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 over $15 per share (assuming you hold the shares at least one year). If the stock price increases, you should pay less in taxes on your restricted stock. However, if you were to leave the company, forfeiting the unvested restricted stock shares, the taxes paid to the IRS based upon the 83(b) filing is nonrefundable. You are also counting on the company stock to appreciate in the future.
Most often a Section 83(b) election is recommended when you are granted shares of a growing start-up company. However, for Fortune 500 companies, the stock price may not grow as exponentially as a start-up might. This is a situation where discussing your options with a tax adviser or C.P.A. would be beneficial.
If you receive restricted stock as part of your compensation package, you are most definitely fortunate. You also most definitely need to consider how this benefit affects your overall financial plan, including your tax planning and portfolio diversification.
Planning Issues
If restricted stock is a large component of your compensation, you may be underwithholding your taxes. Companies have two options to calculate the federal withholding. They can use an employee’s W-4 rate; however, this is extremely complicated, as the company must combine the income from all the stock plan transactions with an employee’s other income for the year, and then derive the employee’s marginal tax rate using a complex formula. The other option, which a majority of employers use, is a flat rate for supplemental payments. This is currently 25% for those whose supplemental payments are less than $1 million. For those whose supplemental payments exceed $1 million during the year, employers must withhold the maximum individual tax rate of 39.6%.
Let’s say you have 1,000 shares that should vest at the estimated stock price of $35 a share. Your company assesses a federal withholding at the flat 25% rate on your vested stock of $35,000. If your taxable income is more than $125,450 for single or $146,400 for married filing jointly, you will have withheld less tax on the $35,000 than your marginal rate. For taxpayers in brackets higher than 25% but have supplemental income less than $1 million, the supplemental rate falls short of covering the tax liability, which can lead to an unexpected balance due in April. By working with a tax adviser, you can either adjust your W-4 withholdings to make up for the shortfall in withholding on your restricted stock, or you can make an estimated tax payment(s).
Another potential pitfall you may have with restricted stock is lack of diversification. Typically, you exercise options to realize the value of the options due to either a need for the funds or to diversify your investments. You are granted the right to exercise your options; thus, you purchase at a discount, and typically sell the shares the same day at a much higher rate to generate your cash profit. Alternately, restricted stock does not often coincide with a monetary need. Rather you are given shares that vest over time. The shares are placed in your account noting the restrictions. When the restrictions lapse, you likely withhold shares to cover the required tax. The remaining shares stay in your account.
Over time as your shares vest and the company stock continues to increase, you may find yourself overweight in one company. Such concentrated positions 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. While your company may not be the next Enron and end bankrupt by an accounting scandal, your industry may experience a prolonged period of slow earnings growth. Of course, selling company stock you’ve acquired over the course of several years will likely require the help of a financial adviser and tax consultant to pay close attention to assist in minimizing the tax impact of a stock sale.
At Henssler Financial we believe you should Live Ready, which includes understanding how equity based compensation may complicate your financial plan. If you have questions regarding your restricted stock, the experts at Henssler Financial will be glad to help. You may call us at 770-429-9166 or email at experts@henssler.com.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
