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Compensation is a key element used by employers to attract and retain talent. Employers have several common tools besides basic salary or wages to offer their employees when setting up a compensation package. One of the more common ways to pay an employee beyond wages is through stocks. These are often structured as a restricted stock unit (RSU) or a stock grant, especially for start-up companies who may not have a lot of cash on hand. Rather than provide more upfront cash via salary or wages, a start-up can elect to provide RSUs or stock grants instead.
An RSU is defined by the IRS as “unsecured, unfunded promises to pay cash or stock in the future.” The IRS considers them a form of nonqualified deferred compensation. Typically, an RSU is equivalent to one share of stock. However, an RSU can also be a unit of several stocks. The amount of stocks a RSU is worth will be defined by the employer’s compensation agreement with their employees.
In simpler terms, an RSU is a grant of a right to receive stocks from the employer to an employee as a form of income. The stocks are typically bound by a vesting schedule, and they may be bound by other restrictions. In the beginning the stocks will be inaccessible to the employee, meaning they cannot be transferred or cashed in until all requirements in their employment contract are met. Unlike some stocks, RSUs typically do not pay dividends or provide voting rights to the holder.
The vesting schedule and other RSU documents provide a timeline for when stocks become available to the employee. This is often based on if or when the employee obtains specific performance goals or stays at the company for a certain length of time. Once the restriction(s) are met, the RSUs will become available to the employee. At that point, the RSUs will be exchanged for the stocks promised and due.
While many RSUs bear similar qualities, each RSU is different based on the restrictions in the vesting schedule and other RSU documents. For example, some RSUs may only require that the employee meet a certain number of years for the RSU to fully vest, whereas another agreement may require the same number of years and a host of performance metrics be met. Taxpayers and employees should review their specific RSU vesting schedule and any other documents provided to see what restrictions are on their specific RSU(s).
When RSUs are first received, they trigger no tax consequences because they are not fully vested yet. Until the vesting requirements of the RSU are met, the employee will not have any tax on them. Once the RSUs have vested they will be treated as earned income and the employee will be subject to tax. Sometimes an employer may withhold the taxes for the RSUs. If not, the employee will be responsible for calculating and paying the tax due at the end of the year. The value of the RSUs will be subject to the taxpayer’s ordinary income tax rate.
Once the RSUs have vested, they are the same as any other stock. The holder of the stock can choose to hold onto the stocks, or they can choose to sell the stocks. When the shares are later sold, the taxpayer will owe capital gains taxes on any gain acquired from the sale of the stock.
Income in the form of RSUs will typically be listed on the taxpayer’s W-2 in the “Other” category (Box 14). Taxpayers will simply translate the figure listed in Box 14 to their federal tax return and, if applicable, state tax return(s). After reviewing the W-2, employees may determine that the employer did not withhold enough funds to cover the taxes owed. At that time, the employee will need to adjust their taxes due accordingly.
Once the stocks are vested, if the taxpayer sells the stocks attained by the RSU, they will need to determine the basis for the stocks then record any gain or loss from the sale by subtracting the amount earned by the sale from the basis of the stock. This information will then be reported on Schedule D and Form 8949 of their federal tax return.
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When an employee receives the stock directly as a form of compensation, rather than the previously discussed RSU compensation, it is known as a stock grant. Similar to RSUs, stock grants are often subject to vesting requirements. The vesting requirement can be a time period, a performance metric, or some other agreed upon vesting criteria.
For example, a company may grant an employee 1,000 shares of stock with a vesting period of two years. This means that the employee will receive those 1,000 shares only once they have vested at the end of the two-year period.
Stock grants do not trigger any tax consequences when they are first received. Rather, they must be fully vested. At the time the stocks are fully vested, the employee will be liable to pay taxes on the stock. The stocks received will be considered income and thus taxed at the employee’s applicable federal ordinary income tax rate. While some employers may withhold the amount of tax due on the stock grant, some may not, leaving it to the employee to calculate and pay the tax due.Additionally, just as with any other stock sale, if the stock from the stock grant is sold it will be subject to capital gains tax for any gains received from the sale.
Similar to RSUs, stock grants will typically be reported on your W-2 form. You will likely see the stock grant listed under Box 14 as “Other” income. If the employer withheld sufficient funds to cover the taxes owed, no other action should be required. However, if the withholding amount does not cover the taxes due, the employee will need to adjust accordingly and pay the remaining taxes.
RSUs and stock grants offer companies—both start-ups and established businesses—an opportunity to provide a source of income that provides less cash up front while still providing employees with significant income. Additionally, the vesting period of both RSUs and stock grants can function as a motivator for employees to stay with the company or meet certain performance standards. Ensure your stock strategy is tax-advantaged.
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