As you progress in your career, especially if you work in corporate America, one of the first changes you see is in your compensation. Instead of simply getting an increase in pay, corporations often incentivize their employees, and attract new hires, by offering equity - or the opportunity to buy equity - in the corporation.
To that end, we're kicking off a series walking you through the different types of equity-based compensation and employee benefits.
If you're needing to read these articles to figure out what's being offered to you, then congratulations, because being offered equity-based pay means you're likely on that right track professionally! Hopefully these posts provide some clarity and allow you to form an action plan.
In Part 1, we covered Restricted Stock Units, or RSUs for short.
In Part 2, we covered Stock Options, both Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs).
In Part 3, we covered Employee Stock Purchase Plans.
In Part 4, we covered Employee Stock Ownership Plans, and in our final post in the series, today we cover Restricted Stock Awards, or RSAs!
In discussing equity-based pay, we're breaking each form of compensation into one of two types:
- Will Be Yours: equity in the company that you WILL have if you meet certain conditions
- Could Be Yours: equity in the company that could be yours if you meet certain conditions AND have the money to pay for it
The Restricted Stock Units we covered in Part 1 are Will Be Yours benefits; if you meet the terms required for them to vest, you will get your shares of stock.
The Stock Options covered in Part 2 are a Could Be Yours benefit. A company gives you the option to buy a certain number of shares at a predetermined price, and those shares could be yours IF you have the money to pay for them within a set period.
In Part 3 we covered Employee Stock Purchase Plans, another could be yours benefit. Companies offer their employees the right to buy common stock at a discount to its fair market value, but the employees only owned the stock if they decide to purchase.
In Part 4 we covered Employee Stock Ownership Plans (ESOPs), which can operate as either a Could Be Yours benefit, where the employee must contribute their own funds to buy into ownership, or Will Be Yours benefit, where the only requirement is that the employee stay long enough to meet certain vesting requirements.
Today, in our final part of the series on equity compensation, we are covering another Will Be Yours benefit: Restricted Stock Awards (RSAs).
I left Restricted Stock Awards until the end so as not to be confused with the Restricted Stock Units Covered in Part One. These forms of compensation have many similarities but also some key differences in terms of taxation and ways to affect the timing of taxation.
In discussing RSUs in part one, we mentioned the term vesting schedule. For RSUs, the vesting schedule determines when shares of company stock will actually be awarded to an employee. Until the time outlined in the vesting schedule has passed, however, the employee doesn't actually have any company stock; they simply have the promise that at a future date they will receive the shares (or the cash value of those shares). Thus, the 'Restricted' in Restricted Stock Units can be seen as referencing the time restrictions that must be met for the employee to receive their shares.
Conversely, the shares associated with RSAs are issued to the executive at the time of grant, but are HELD by the employer until they've vested. I say executive because in many cases, RSAs are granted to executives at early stage companies in lieu of a high salary that the new organization may not be able to afford.
At the time of grant, the employee may or may not be required to pay a purchase price for the RSA shares. And after paying any applicable purchase price for their shares, the vesting period begins.
Unlike RSUs, the recipients of RSAs still have some limited rights associated with their shares prior to vesting, such as their voting rights. But prior to the vesting of an RSA, an organization typically has the right to repurchase any RSA shares granted to an executive who leaves the organization. The executive would likely get their money back, but wouldn't be able to participate in any appreciation of the shares. This restriction prevents the executive from receiving the RSA at grant and immediately leaving with their shares. If they choose to leave, the company essentially rescinds the award. So while the 'Restriction' in RSUs refers to the period of time the employee must wait to receive company stock, the 'Restriction' in RSAs refers to the time the executive must wait before they have full ownership rights in their granted shares. This wrinkle is a seemingly small but important difference, because it means that while RSUs are a true form of equity pay measured in the value of company stock, RSAs are actually more of a gift or an ... Award ... of company stock.
Now, let's address the taxation of RSAs as compared to RSUs, finishing with a yet to be covered concept called an 83(b) election.
Taxation of RSAs
An employee who has been granted RSUs would have no tax implications at the date of grant. Why? Because they do not own any shares at grant; they instead own them as they vest according to the schedule. And as these shares vest, they will pay taxes on them. But we've now covered that the recipient of an RSA IS an owner of the date of grant; they would simply risk having any unvested shares being repurchased by their company should they leave early. This difference means that they are subjected to taxes on their RSAs at the time of grant, instead of at the time of vest.
In terms of what taxes they pay and when, it depends on the appreciation of said shares at the time they VEST.
Let's look at an example.
Our executive pay $5 per share for their RSAs at grant date. Because the value of the shares rose to $10 per share by their vesting date, the executive would owe ordinary income taxes on the difference between the vest date and grant date prices.
Now let's assume the executive holds their shares until the value rises to $15, then decides to sell.
By selling their shares for $15, the executive now owes capital gains tax on the difference between the sale price and vesting date price. Whether the gains are considered short-term or long-term will depend on the holding period after vesting. Shares sold for a profit less than one year after vesting will be short-term gains, subject to ordinary income tax. Shares held at least a year and a day after vest will be long-term capital gains, taxed at either 15% or 20%.
It's important to note that shares don't always increase in value after vesting, in fact they could decrease. If they do decrease and are then sold, there would be a loss based on the amount of taxes already paid.
The executive paid ordinary income tax on the difference between their $10 vest price and $5 grant price, but they sold at eight dollars per share. While this transaction would still be considered a gain (they bought at $5 and sold at $8), they would take a loss on the taxes they paid for the difference between the $10 vest price and $8 sale price. And should the value of the shares have fallen further before being sold, maybe even falling below the purchase price, our executive could be subject to a total loss.
The IRS has given RSA recipients a tool to (hopefully) minimize their potential for a large ordinary income tax event at the vesting of the shares. It's called an 83(B) election, and it could potentially reduce the risk of selling at a loss as well.
What is an 83(b) election?
By utilizing an 83(b) election, an RSA recipient can choose to pay taxes on their shares at the date of grant, rather than risking a large increase in the share price by the vesting date.
Let's go back to our example to see the difference
Because there has been no gain in the share price at grant, our executive owes no ordinary income tax on the transaction. Additionally, if the vesting of the shares occurs more than a year after making the election, they could immediately sell them upon vesting for a long-term capital gain.
This seems like a no-brainer, but there are several risks to consider before making this election:
- 83(b) elections must be made within 30 days of the RSA grant. The 30-day requirement doesn't give you much time to make a decision on whether there's a benefit to frontloading the tax on any unvested shares, or wait until they vest and pay the taxes at that time. The decision is consequential because ...
- Should you leave the organization before the shares have vested, you will have paid tax on shares which you never controlled and could be repurchased. While having stock that loses value or is taken from you prior to vesting would typically permit you to claim a capital loss, 83(b) rules only allow losses up to the amount you paid for the stock. This rule means if you received the stock grant at no cost and it later became worthless or the shares were repurchased, you would not be able to claim a loss.
Executives who do decide to exercise an 83(b) election on shares that later appreciate can reap the tax benefits of paying mostly capital gains tax as compared to ordinary income tax plus capital gains, and also reduce the holding period requirement needed to qualify for long-term gains.
By this point, we've reviewed 5 different forms of equity-based compensation and equity awards. Believe it or not, there are other forms of equity grants we have yet to cover, but I feel this series is an excellent start. Hopefully your career is progressing and you're positioning yourself to receive or decide between some of these benefits we've covered the past few weeks, and here's hoping one of them leads to a major wealth event for you!