How Does Restricted Stock Work?

What is Restricted Stock?

Restricted Stock is a form of equity compensation that is granted to tech executives by their company, such as AMD, NXP, or Applied Materials. Yet, this type of equity award is less popular than Restricted Stock Units (RSUs). 

Restricted stock is different from RSUs in a few main areas. Restricted stock represents actual shares, has voting and dividend rights, and can start capital gains treatment early via an 83(b) election. RSUs are essentially a company promise to deliver shares at a future vesting date. RSUs are not eligible for the 83(b) election.

Restricted stock also differs from stock options. Restricted stock is considered full value, receives dividends, and the triggering event is the vesting date, not the exercise date.

What are the Restrictions?

Companies will typically issue this form of equity compensation to attract, retain, and financially motivate key employees. 

Restricted stock is subject to a vesting schedule, which is the main restriction. Awards are also subject to a substantial risk of forfeiture until the restrictions lapse at vesting. If an executive loses or leaves their job prior to vesting, they will forfeit their unvested awards. There may be company-specific exceptions.

The company can grant shares, but those shares cannot be transferred or sold until the vesting date. The vesting schedule is usually over a 3–4-year period and has a graded or cliff schedule.

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How Does Restricted Stock Work?

Value:

Restricted stock always has value, unlike stock options. The value is determined by the stock price on the date of vesting, not on the grant date.

Vesting:

Executives will gain full ownership rights upon the vesting date. Then, the share owners can keep, sell, or gift their stock shares. 

Taxation:

Tax is due upon vesting, after restrictions lapse and the shares are delivered. Restricted stock value is counted and taxed as ordinary income and subject to FICA, state, local, and potentially the additional Medicare tax. Like RSUs, restricted stock company withholding is typically 22%. If you are in a higher marginal tax bracket, it may be wise to set aside cash to cover the extra tax or consider making estimated tax payments.

Once restricted stock shares vest, future gains or losses will be subject to capital gain or loss tax treatment.

Voting and Dividends:

The good news is that holders of restricted stock generally have voting rights and receive dividends, even prior to the vesting date. This is because restricted stock is considered property, unlike RSUs. It is important to note that dividends are taxed as ordinary income (not qualified dividend income – QDI) prior to the vesting date, unless an 83(b) election is made.

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What are the Key Decisions?

83(b) Election:

The primary decision is if you want to be taxed at grant or vesting. An 83(b) election must be submitted within 30 days of the grant date.

The main benefit to being taxed at the grant date is the ability to start the capital gains holding period earlier than the vesting date. Clearly this can work in your favor if you expect the stock price to increase and still be employed! There are downsides, such as losing your job prior to vesting, a decreased stock price, or reduced cash flow that went to pay early taxes at grant.

Holding vs. Selling vs. Gifting:

Tech executives often wonder what they should do with their stock upon vesting. If they are loyal to the company and really believe in the stock, they might be inclined to hold. Other tech professionals sell the stock immediately at vesting because they need the cash or wish to invest in a more diversified investment portfolio. And some employees will donate shares to fulfill their gifting wishes and/or use gifting to help reduce taxes. 

The “right” decision is the one that aligns with your financial goals and plan. Everyone has unique financial circumstances, so there is not a standard decision that is best applied.

Concentration Risk:

This is a risk of equity compensation. It’s no surprise that owning a significant amount of company stock can subject you to higher levels of single stock concentration risk. Sure, having a lot of exposure to your company stock might be a way to rapidly increase wealth. But the risk also exists that the company goes in the opposite direction and deteriorates your wealth that you worked so hard to earn.

It’s prudent to consider what percentage your company stock represents as a share of your total investment portfolio. If the stock value is higher than 15-20% of your total portfolio value, you need to be mindfully aware of the risks.

A broadly diversified portfolio across stocks and bonds, countries, market caps, and sectors can help to reduce risk and improve the reliability of return outcomes.

Questions to Ask If You are Granted Restricted Stock:

What is the vesting schedule?

Should I consider an 83(b) election?

What is my company’s financial outlook?

What happens to my restricted stock if I leave the company?

What happens if I retire, get divorced, or become disabled?

Can I name a beneficiary?

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The foregoing content reflects the opinions of TwoTen Planning and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as financial, legal, tax, or investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. All investing involves risk, including the potential for loss of principal. There is no guarantee or assurance that diversification, strategies based on Nobel prize-winning research, or any investment plan or strategy will be successful. Consult an estate attorney or qualified tax professional for specific advice relating to those respective areas.

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