Restricted stock units, commonly known as RSUs, are a unique form of stock-based compensation often paid to executives and key employees. Put simply, RSUs represent compensation in the form of company stock – rather than by more traditional methods (salaries, bonuses, fringe benefits, etc.). Restricted stock units are used by companies as an incentive to attract and retain top talent. The rationale is that by offering stock ownership in the company, employees are motivated to proliferate productivity and profitability. If the company performs well and its stock price increases, employees will recognize a financial benefit – a symbiotic relationship for all parties involved. The RSU “life cycle” usually has three phases: granting, vesting, and selling. This article will discuss the pivotal terms and tax treatment for each.
The Granting of RSUs
This stage is simply a conditional promise made by the company to deliver shares of stock to the employee on a future date(s). Those date(s) could be known or unknown at the time of the grant, depending on its terms. In certain circumstances, grants can be time-based, meaning that the employee must remain employed at the company as of a particular date before the stock will be delivered. In other circumstances, grants are milestone-based, meaning that the company or employee must complete a specific action before the stock will be delivered. For example, those milestones may be that the company undergoes an initial public offering (IPO) or that the employee completes an identified work-related project. If the terms of a grant are time-based or milestone-based, they are called “single trigger RSUs.” Whereas grants that are both time-based and milestone-based are called “double-trigger RSUs.” Regardless, there are absolutely no tax implications upon the granting of RSUs.
The Vesting of RSUs
This stage activates the employee’s stock ownership rights. When this occurs, the employee will recognize ordinary income based on the fair market value of the stock transferred. That’s calculated as follows: the total number of shares times the price per share. This brings with it good and bad news. The good news is that federal income taxes, state income taxes (if applicable), and FICA taxes will be automatically withheld, and the net amount of cash or stock will be delivered to the employee. The bad news is that the amount of federal income tax automatically withheld may not be sufficient to cover the employee’s federal tax liability. This occurs when the employee’s marginal tax rate is greater than the withholding rate on supplemental wages, such as RSUs. The withholding rate on supplemental wages less than $1 million is 22%. To better illustrate this, let’s look at a “real-life” Chicory Wealth client example:
- Suppose a single taxpayer with no dependents has a taxable income (comprised solely of taxable wages) of $300,000. They will be situated in the 35% federal marginal tax bracket and their 2023 tax due, without regard to the Additional Medicare Tax on earned income, will be $76,895.
- Let’s assume the taxpayer receives $100,000 of RSU income, increasing their taxable income to $400,000. They will remain in the 35% federal marginal tax bracket and their 2023 tax due, again without regard to the Additional Medicare Tax on earned income, will be $111,895. Thus, this $100,000 of RSU income added $35,000 to their total federal tax.
- The problem here is that this $100,000 of RSU income will only have $22,000 in federal income tax withheld based on the supplemental wage withholding rate. In essence, this transaction will cause a $13,000 withholding “shortfall,” which will likely result in an unexpected balance due to the IRS come tax time.
This same problem may or may not transpire at the state level. For Georgia residents, for example, it will not be a problem. That’s because the Georgia state withholding rate on supplemental wages is the same as the maximum Georgia state marginal tax rate. Both are 5.75%. But for California residents, for example, it will be a problem. The California state withholding rate on supplemental wages is 10.23%, but the maximum California state marginal tax rate is 12.3%. For the reasons outlined above, it’s extremely important that folks notify their tax accountant if they have recently had RSUs vest or if they expect RSUs to vest in the near future. In certain situations, specific measures can be taken to quantify, minimize, or even completely offset the forthcoming tax bill(s).
The Selling of RSUs
The final stage of the RSU life cycle only applies if vested RSUs are deposited as shares, rather than sold and delivered as cash. At this point, the employee has the option of holding the shares and selling them later for various reasons. Deciding when to do so can be complicated and should be discussed with your financial advisor. Employees might choose to hold their stock purely out of company loyalty or because they believe the stock’s price will continue to climb. Alternatively, employees might choose to divest to reduce single-stock exposure and mitigate overall risk within their investment portfolio. Lastly, some employees may need to generate cash to fund other important financial goals, and selling stock could be a way to accomplish this.
From a tax standpoint, the tax treatment of selling RSUs depends on timing. If the sale occurs within one year of vesting, the employee’s gain (selling price less vesting price) will be taxed as ordinary income. If the sale occurs after the employee has held the shares for longer than one year, the employee’s gain will be taxed as a capital gain. If the stock price has increased substantively since vesting, the latter option will likely result in a lower tax liability.
The most important thing to keep in mind with restricted stock units is to be proactive. These equity awards can be a tremendous way to build wealth or foster financial security. Tactful and prudent RSU-related tax planning is a fundamental step in developing a healthy financial plan.
Should you have additional questions, please contact Jeff Audi at [email protected].