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Restricted Stock Unit (RSU) Taxation Explained: Rules and Planning Strategies

Updated: Jan 24

Restricted stock units (RSUs) have become an increasingly popular form of equity compensation, especially at tech companies. But Restricted Stock Units come with unique rules around taxation that are important to understand.

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With the right planning, RSUs can provide significant income and wealth-building opportunities. But you need to proactively manage tax obligations to maximize the value.

RSUs and Their Mechanics

RSUs, or Restricted Stock Units, represent a form of equity compensation wherein employees are allotted company stock shares, which they obtain upon fulfilling specific conditions. These conditions often adhere to a vesting schedule spanning three to four years and may include event-based criteria, such as the company's IPO, referred to as a double-trigger RSU. Unlike stock options, RSUs don't require any purchase; once the vesting conditions are satisfied, they automatically become the employee's ownership at their Fair Market Value (FMV).

Employers increasingly utilize restricted stock units as an alternative to stock options in equity compensation packages. RSU benefits include:

  • Requires less upfront cash compensation from companies at grant compared to options

  • Aligns employee incentives to stock price growth just like stock options

  • No strike price or downside stock risk for employees

  • Receipt of shares is guaranteed at vesting, unlike options

  • Easy to understand and track compared to options

The simple promise of RSUs is that you will receive a certain number of shares of the company’s stock according to the vesting schedule, typically 3-5 years. If all conditions are met, the shares are delivered. It does not involve a strike price or the need to exercise options.

For this reason, RSUs are sometimes more attractive than stock options, especially if the company’s share price is volatile or pays low/no dividends. However, RSU taxation involves some key considerations.

RSUs are now granted by 86% of U.S. publicly traded companies, a significant increase from the mere 3% reported in 2000. In contrast, the prevalence of employee stock options in public companies decreased from 100% to 47% over the same period. - National Association of Stock Plan Professionals & Deloitte Study

Key Points to Understand About RSUs:

  • RSU holders do not have actual ownership of shares or voting rights until the shares are delivered.

  • RSU Vesting Rules and Requirements

  • For RSUs to deliver their promised future shares, recipients must satisfy certain conditions known as vesting requirements. Typical RSU vesting rules include:

  • Time-based vesting - Right to receive shares vests incrementally over 3-5 years (ex: 25% each year)

  • Continued employment vesting - Requirement to remain employed during vesting term

  • Accelerated vesting - Full vesting if company is acquired or upon executive's termination

  • Cliff vesting - Shares vest all at once after a set timeframe rather than incrementally

  • Graded Vesting - Shares vest incrementally rather than all at once

  • Failure to adhere to the vesting rules of the plan, like leaving the company prior to full vesting, can also result in RSU forfeiture.

RSU Taxation at Vesting

RSU taxation comes into effect only upon the fulfillment of the vesting schedule. For restricted stock, the total vested stock is taxable as ordinary income in the vesting year. Given that RSU income is classified as supplemental income your employer is required to withhold taxes and the withholding rate can fluctuate between 22% and 37%. At the end of the year, the W-2 will include the value of the RSUs at the time of vesting as ordinary income.

To illustrate, suppose you have 1,000 RSUs that vest when the stock is valued at $50 per share. Your total income at vesting would be 1,000 x $50, equating to $50,000. This $50,000 will be considered part of your overall ordinary income and subject to Federal and state income taxes as well as Social Security, Medicare and Unemployment taxes.

Upon stock vesting, you have the following choices:

Same-day sale: You sell all the stock, and you receive the remaining cash after deductions for withholdings.

Sell to cover: The employer sells sufficient shares to cover tax withholding, and you retain the remaining shares, which can be sold at your discretion. (This option is often automatically applied by employers.)

Cash transfer: The employee uses cash to cover the necessary tax withholding. If you contribute more cash than required for withholding, you gain ownership of all the shares, and they can be sold or held as long as you desire.

RSU Taxation at Sale

A same-day sale is a straightforward process. Your shares vest, and you promptly sell the entire amount. Because the vesting and sale occur rapidly, there is usually minimal, if any, short-term capital gain or loss. The gain or loss essentially reflects the difference in price between when the shares vested and when you executed the sale. Given that most of these transactions are automated, the price tends to remain relatively stable, if it changes at all, before the shares are sold.

Both the sell-to-cover and cash transfer options result in you retaining company stock after vesting. This implies that you have the flexibility to hold onto the stock for as long as you prefer. However, before settling on either of these choices, it's crucial to be aware of some important considerations.

Pros: If you anticipate that the company stock will outpace the broader stock market, and your prediction proves accurate, you have the potential to see faster growth in your investment compared to investing in stocks outside the company. Notable instances include tech giants like Nvidia, Apple, Facebook, and Netflix, where this strategy has proven beneficial for investors who chose to hold onto their shares.

Cons: Maintaining concentrated positions in individual stocks increases your vulnerability to market volatility, as your net worth becomes intricately linked to the company's performance. Enron serves as a poignant example, where a significant number of employees held company stock, and the collapse of the company resulted in substantial losses for many employees, impacting a significant portion of their life savings.

Capital Gains: If you retain the stock after the RSU vests, you will eventually experience either a capital gain or a capital loss, depending on whether the stock's value rises or falls. Your cost basis is established as the stock's value at the time of vesting, and the gain or loss is determined when you decide to sell it.

Keeping the stock for under a year results in a short-term gain or loss, subject to taxation at your ordinary income rate. If the stock is held for a year or more, the gain or loss becomes long-term and is taxed at a more favorable capital gains rate.

it's crucial to be aware that if your income reaches a certain threshold, the capital gain from selling the stock in either scenario might be subject to an additional Net Investment Income Tax (NIIT), adding an extra 3.8% to the gain. A significant number of our clients, including executives, software developers, and individuals in high-income fields, often face the situation where they are liable for the Net Investment Income Tax (NIIT) on all their investment income.

1099-B errors and double taxation traps: At the year-end, the brokerage firm, responsible for executing trades to sell your shares, reports the sales on Form 1099-B. This form has a section (box 1e) meant for reporting the cost basis of the sold shares, ideally reflecting the market value on the day the shares vested. However, it's not uncommon for brokerage firms to indicate $0 in box 1e on Form 1099-B. Overlooking this detail can lead to double taxation on the same stock.

For instance, if the $0 cost basis is overlooked when the actual cost basis is $50,000, and you sell the shares for $75,000, you might end up paying capital gains tax on the entire $75,000 instead of the correct gain of $25,000. This is a common pitfall for RSU recipients, especially when using online tax software or working with tax preparers who might not be familiar with the nuances of RSUs and the necessary adjustments to the cost basis.

Maximizing the Benefit with an 83(b) Election

Unique to restricted stock plans, Section 83(b) of the IRS tax code allows recipients to elect to be taxed on the fair market value of the shares at the time of grant, rather than waiting until vesting.

The benefit of this 83(b) election is it allows the capital gains holding period to start earlier. Paying taxes up front at grant establishes a lower cost basis for the shares. Then any future share price appreciation gets taxed at preferential long-term capital gains rates rather than ordinary income rates after holding for over a year from grant date.

However, the downside is you end up prepaying taxes on shares that may never ultimately vest if you leave the company. The taxes already paid cannot be recovered if shares are forfeited before vesting.

An 83(b) election must be filed within 30 days of the grant date. Consult with a tax professional to assess if this strategy could potentially reduce your total taxes from RSU compensation.

83(b) Election Example:

John receives a restricted stock grant of 5,000 shares which are trading at $10/share on the grant date. He files an 83(b) election so $50,000 fair market value is taxable as compensation in the year of grant.

Two years later, the shares vest when the stock price is $15/share. Because John already pre-paid tax via the election, this $75,000 value at vesting receives no additional tax.

John sells the shares a year after vesting when they are trading at $20/share for $100,000 total proceeds. The original $50,000 grant value was already taxed at ordinary rates. The additional $50,000 gains ($100k minus $50k cost basis) receive long-term capital gains treatment, a preferential tax rate.

Without the election, the entire $100,000 would be compensatory ordinary income taxable at vesting. The 83(b) election saved John from higher ordinary income tax rates on the appreciation.

RSU Tax Filing Requirements

Your company will include the market value of any vested RSUs during the year on your Form W-2 as taxable compensation, combining it with your salary and other earnings.

You report this W-2 wage income on your standard Form 1040 personal tax return. Applicable income taxes withheld on the RSUs are claimed on Form 1040 Schedule A as taxes paid to reduce your total income tax obligation.

No additional informational statements are required, unlike non-qualified stock options which require Form 3921 reporting from the company. You simply include the RSU value from your W-2 when filing taxes.

Planning to Minimize RSU Tax Burden

Though RSU taxes at vesting are unavoidable, some strategies can help minimize the impact:

  • Increase income tax withholding rate on salary to cover incremental RSU taxes

  • Make estimated quarterly tax payments after large RSU vesting events

  • Vest in years where you have deductions or other write-offs to offset the income spike

  • Vest before residing in a higher tax state or municipally if moving

  • Consider the impact of the Alternative Minimum Tax with large vesting events

  • Discuss implications with a tax advisor before vesting if possible

Understanding tax obligations well in advance enables taking steps to mitigate the burden. Be proactive in your planning.

Frequently Asked Questions on RSU Taxation

Many questions arise around how RSU income is taxed. Here are answers to some key ones:

Are RSU grants taxable at the time of grant?

No. RSU grants are not a taxable event. Taxes only apply once the units vest in the future and convert into shares.

Are RSUs taxed at the federal and state level?

Yes, the value of your vesting RSUs is subject to both federal and state wage income taxes in the state you reside in. Applicable federal and state taxes will be withheld.

How are RSUs reported to the IRS?

Your employer includes the value of vested RSUs on your Form W-2 along with your other compensation. You report this W-2 income on your individual 1040 tax return.

Are RSUs subject to FICA taxes for Social Security and Medicare?

Yes, RSU income, just like salaries and bonuses, is considered earned income and is subject to applicable FICA taxes for Social Security and Medicare up to the annual limits.

How can taxes be minimized on RSUs?

Not many options exist due to the ordinary income treatment, but increasing income tax withholding, making quarterly estimated payments, and waiting to sell shares until qualified for long-term capital gains can help.

What if my RSUs vest after I leave the company?

RSUs that vest post-termination are still considered taxable compensation to you. The income will be reported on a Form W-2 and applicable taxes withheld.

Are supplemental taxes on RSUs deductible?

Unfortunately, any supplemental income taxes or trading commissions paid on RSU transactions cannot be deducted or written off.

The Takeaway - Restricted Stock Unit Taxation and Planning Strategies

As you can see, RSU taxation follows the same path as ordinary wage income. But with the right planning, you can reduce and manage the tax impact. Consult with a qualified tax professional to minimize your burden.

RSUs represent an increasingly popular alternative to stock options that offer some key advantages, but also introduce unique tax treatment. Managing taxes at grant, vesting, sale, and in between takes some work. But the effort pays dividends in maximizing your income from this valuable form of equity compensation. Consult the experts at United Tax Advisors to ensure you fully capitalize on restricted stock units.


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