You or someone you know may have been offered participation in an employer’s restricted stock program and will want to know how such a program may affect your finances. An employer may utilize a restricted stock program both to compensate high level executives and professionals and to induce these persons to remain with the firm as it grows over time. The use of such a program often occurs in closely held private companies and is used to help ensure a firm’s progress towards both profitability and stability. As the name implies, restricted stock shares and restricted stock units are not liquid and the right to sell them is subject to strict limitations which are outlined in the program documents.[i]
Such a program may offer you restricted shares in the company or restricted stock units which may, at the appropriate time and under stated conditions, be converted to shares. Like stock options, an award of restricted shares (or units) often vests incrementally over months or years. This approach is an incentive to the recipient to stay with the company through the promise of receiving an increasing number of shares, as well as their potential to increase in value. The employee awarded such shares must remain in service with the employer in order to see the shares vest and receive the compensation. Vesting may be subject to a simple time requirement or also involve a performance requirement. [ii]
Effects of Vesting
Once awarded shares have vested, the holder typically is entitled to receive any dividends payable to the holders of shares in the company and to exercise any voting rights attributable to the shares. This is so even if the shares may not be sold at the time.
Before vesting, there is no income tax consequence for the employee since the right to receive the RS shares has not manifested. At the time of vesting, in the absence of additional restrictions, income tax as well as payroll tax (assuming the shares are treated as compensation) will become due on the present fair market value of the shares received. This is the employee’s ultimate responsibility, though the employer may withhold some or all of the taxes due.
An important question here is what present value the employer has assigned to the value of either the shares of restricted stock or the share units awarded. This value will help us understand the likely income tax consequences as well as the potential impact on your plan.
One approach to the income tax due on vesting is the ability of the employee to make what is called a Section 83(b) election. Such an election would require the employee to prepay the income taxes based on the value at the time of the grant. This would establish a cost basis in the shares and preclude future taxation of that portion of the share value upon a future sale. The risk, of course, is that the stock drops in value since the taxes paid cannot be recovered.
If allowed under the program agreement, the withholding required for income tax attributable to the vesting of units or settlement of shares may be satisfied by a sale of sufficient stock from the vested shares or by the employee making payment to the employer of the required amount. In the latter case, the employee would need to fund such payment from other resources.
What about a sale of the shares?
In the usual case, there will be no significant opportunities to sell restricted stock shares during the early years following the award. One exception is the occurrence of a sale or an IPO for the employer. In such case, the sale event accelerates the time for vesting, though the continued employment requirement would remain in effect. In the event of an IPO, there likely will be a period of time – a lock-up – during which the employee may not dispose of the shares.
In a sale situation, the employee may be required to sell, transfer and deliver the employees shares to the buyer (termed a drag along provision). One potential result of a sale may be that rights to shares or units that remain unvested will be forfeited in the event of a sale unless (a) there is accelerated vesting due to the sales event or (b) the successor/purchaser undertakes to continue them. This is one of many reasons it is important to carefully review the terms of the program agreement.
Although not usually the focus of the discussion, an employee should be aware of the rights of their family/heirs under the program agreement in the event of untimely death or disability. Most often, there is a right to transfer vested restricted shares for some level of compensation as opposed to an outright forfeiting of those shares. Alternatively, the shares and rights may vest in a family member, subject of course to the original restrictions on transfer or sale. Again, this is an important part of the agreement to review and understand.
Your Financial Plan
Understanding the impact the restricted shares or stock units may have on your financial plan will be an important point of discussion with your adviser. Central to this understanding will be a careful review of the program agreement and all its terms and conditions. An updated plan developed by and with your adviser, including what if scenarios based on different timing and values, will be very helpful in weighing the possibilities. In such modeling and analysis, care must be taken to incorporate all relevant factors, including not only our timing and value estimates, but also any assumptions concerning continued employment, tax rates and burden based on the client’s income and other related factors, the potential impact of the restrictions and more. Such an analysis is no more than an illustration of possibilities and no guarantee of what will transpire.
[i] Restrictions on shares generally prevent nearly any transfer other than a transfer to a family member where the recipient remains subject to the restrictions and the agreement.
[ii] Typically, upon the termination of employment for any reason, any shares or units that have NOT yet met the vesting requirements are forfeited.
George Chamberlin & Mentor RIA Consulting © 2017