Restricted stock is often used as part of a compensation package for a key employee. In lieu of increased wages, restricted stock may be offered.
Specifically, restricted stock is a right to receive the shares of stock ONLY after you’ve satisfied specific conditions detailed by your employer. Often, this condition is continuing to work for the company for a stated period of time (more commonly known as a vesting schedule).
Upon reaching the prescribed conditions, the shares vest, and you own them outright.
Prior to this stated period of time, you have a “substantial risk of forfeiture.” Because of this risk of forfeiture, you do not own the shares. You can think of them as a future promise.
Said another way, should you leave the company prior to meeting the rules, you forfeit the restricted stock and receive nothing.
The Practical Use of Restricted Stock
As a practical matter, restricted stock is used as part of a compensation package to retain and reward key employees. It has potential advantages to both the employer and the employee.
From the employer’s standpoint, restricted stock has the ability to apply the “golden handcuffs” to employees. These handcuffs are applied by offering a promise of a future benefit should you remain employed.
For example, let’s assume Employee X is given 1,000 shares of restricted stock of a company that is worth $50 per share. Let’s further assume the restricted stock vests in 3 years.
For the employee to receive this future benefit (currently valued at $50,000), they need to continue to work with the company for 3 years. Leave early, and the $50,000 is forfeited. This promise of a potential $50,000 in the future may keep you working hard.
A shared benefit for the employee and employer benefit is the valuation opportunity with restricted stock. Continuing our example from above, the value of the shares will fluctuate between the time the shares are awarded and the time they vest. Should that price of the stock increase, so will the total value of the restricted stock units; and should the price go down, so will the overall value of the restricted stock.
For example, let’s assume $50/share goes to $75/share. Now the award is worth $75,000!
This shared upside and downside market volatility is a risk/reward mechanism that is shared between the employer and employee.
As such, the employee has a vested interest in doing everything they can to increase share value.
Restricted Stock upon Vesting
After satisfying the stated conditions detailed by your employer, the restricted stock will “vest.” Upon vesting, there are two items that should be considered – ownership and income tax.
Upon vesting, you own the shares of the stock outright. This means that you will have full ownership privileges that come with being a stock owner. Without being too detailed, control of the shares is a key ownership privilege. You can retain the shares, sell the shares and convert to cash, and receive dividends.
The value of your restricted stock is taxed as ordinary income subject to payroll taxes when they vest (assuming no 83(b) election is made).
Specifically, you are taxed because there is no longer a substantial risk of forfeiture. As such, you are responsible for paying income tax on the value received. The value is calculated as:
Number of Shares x Share Price at Vesting = Taxable Income
Depending on the number of shares, the share price, and your tax rate, the tax liability of vested restricted stock may be large. Continuing our example above, let’s assume the share price is $75 and the person’s tax rate is 33%. We can use this information to estimate the taxes due.
Step 1 – Calculate Taxable Income