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What You Need To Know About Restricted Stocks

2 mins read

“Restricted stock” is normally common stock that is subject to regular transfer limitations for private company stock as well as buyback or forfeiture depending on a vesting schedule. Vesting is typically done over a four-year period (with an optional one-year cliff, meaning the first vesting event occurs at 12 months) and is contingent on the shareholder continuing to be an employee or officer of the company. In other words, if you own restricted stock, you probably have the same ownership rights as the company’s founders. It is called “restricted” because it may be subject to certain restrictions and vesting provisions, such as the company’s right to repurchase certain unvested shares if the employee stops working for the company.

The usage of restricted stock by founders ensures that each of the other founders continues to contribute to the firm.

Example:

Consider the case of a firm whose stock is divided among five founders. Six months into the enterprise, one of the founders decides he’s had enough of surviving on Top Ramen money. He chooses to quit the company and the other founders in order to get a better paid position. Three years later, the company has raised many rounds of venture capital funding, and the other four founders have increased its value to the tens of millions of dollars. The founder who bailed early on is today a billionaire thanks to the risk-taking and efforts of the other four founders on whom he bailed. Rather of enabling this outcome, founders will limit each other’s stock and subject themselves to a vesting schedule, allowing the company to buy a leaving founder’s unvested shares.

Particular Points to Consider

For tax reasons, restricted stocks units are considered differently from other types of stock options. That is, in the year of vesting, the whole value of an employee’s vested stock is reported as ordinary income.

To calculate the amount, an employee must deduct the stock’s original purchase price or exercise price from the FMV on the day it becomes fully vested. The taxpayer then declares the difference as regular income.

If the stock is sold at a later date (rather than on the exercise date), the difference is reported as a capital gain or loss on the date of vesting.

 Advantages and Disadvantages

Restricted stocks units incentivize employees to remain with a company for the long term and contribute to its success so that their shares grow in value. If an employee chooses to keep their shares until they have received their full vested allocation and the company’s stock grows in value, the employee gets the capital gain less the value of the shares withheld for income taxes and the amount owing in capital gains taxes.

Employers incur little administrative expenses since there are no physical shares to maintain and register. Restricted stocks units also enable a company to postpone issuing shares until the vesting schedule is completed, which helps to postpone share dilution.

Advantages

  • Encourage employees to remain with the company.
  • Employees get capital gain less share value deducted for income taxes.
  • Minimum administrative expenses

Cons: There are no dividends.

  • Because they are not considered physical property, employees cannot pay taxes on them prior to the vesting period.
  • Voting rights are not included.

Because they are not considered physical property, employees cannot pay taxes on them prior to the vesting period.

Disadvantages

Before they vest, Restricted stocks units do not pay dividends.

However, an employer may pay dividend equivalents, which may be deposited into an escrow account to offset withholding taxes or reinvested in the form of more shares. Section 1244 of the Internal Revenue Code governs restricted stock taxation (IRC).

  • For tax reasons, restricted stock is included in gross income and is realized on the day the stocks become transferable. The vesting date is another term for this.
  • Because Restricted stocks units are not considered tangible property by the Internal Revenue Service (IRS), they are ineligible for the IRC 83(b) Election, which permits an employee to pay tax before vesting.
  • Restricted stocks units do not have voting rights until the employee receives real shares upon vesting.
  • If an employee departs before the end of their vesting period, the remaining shares are forfeited to the company. For example, if an employee has a vesting schedule of 5,000 Restricted stocks units over two years and resigns after 12 months, he forfeits 2,500 Restricted stocks units.

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