Financial Insights

Equity Compensation: Income Tax Planning for Restricted Stock Grants

Spring time is typically when publicly traded companies will confirm the equity compensation employees should expected as part of their total compensation. We provided an overview of the different types of equity compensation that could be available to employees and the considerations when incorporating these benefits into our overall plan.

Restricted Stock Units (RSUs) and Awards (RSAs) are one of those most common forms of equity compensation and often one of the most overlooked when it comes to planning opportunities. They can be a promising perk but lurking beneath the surface is a potential tax nightmare if you’re not prepared.

Understanding RSUs

Let’s cover the basics again to confirm what exactly are RSUs?
When your employer grants you RSUs, they’re essentially saying, “Here are some shares of company stock. They’re yours, but not quite yet. You’ll get them once you meet certain conditions.”
These conditions, known as vesting criteria, vary depending on your company’s plan agreement. There are three common structures:
1. Single-Trigger RSUs: These are typical in where vesting is usually contingent on continued employment over a 3–4-year period.
2. Double-Trigger RSUs: Vesting here requires both the passage of time and an event defined within the specific compensation package.
3. Performance Share Units (PSUs): Vesting is tied to the company or the employee meeting specific performance metrics within a set timeframe.

Tax Implications at Vesting

When your RSUs vest, the value of the company shares they represent is considered earned income, which is subject to income taxes in the year that they vest. For federal purposes, income taxes due on the first $1 million of vested RSUs (supplemental income) are withheld at 22%, and any value in excess of $1 million is withheld at 37%. State, local, Social Security, and Medicare taxes also apply.

Managing Tax Withholding

Public companies typically handle tax withholding by automatically selling a portion of your shares to cover taxes before distributing the remainder of your company shares to you. This is where the biggest tax planning mistakes typically occur. Most employees assume that when stock is withheld as part of the vesting transaction, they are done and will not have any additional income tax obligations to consider.

Let’s look at a real example that illustrates the default income tax withholding issue with an employee who has base cash compensation of $400,000. They are married and their spouse does not work. They were awarded $1 million of RSUs that vest over a 4-year period. The first tranche of shares vests this year for a total of $250,000. After a 22% default federal income tax withholding, shares are sold off and they are left with $195,000 worth of shares.

Strategic Decision Making

In our example, an employee with $400,000 of base compensation is already subject to the 24% ordinary income tax bracket as a married person. The additional $250,000 of compensation from the RSUs would be subject to ordinary income tax rates of 32% and 35% per the 2024 Federal Tax Brackets (below). If no action is taken when these shares vest, then the 22% default withholding will not account for the total taxes due and the employee will face a larger tax bill to pay and a potential penalty for underpayment when the employee goes to file their return.

With your “net shares” in hand (the amount of shares left over after some have been sold to cover the tax withholding when they vest), you have options: sell immediately, hold for the future, or a combination of both. Your decision on what t do should consider factors like your tax bracket, capital gains tax implications, concentration risk, and your outlook for additional/future RSUs grants.

One option could be to sell additional some of these shares (or previously vested shares) to cover the potential taxes (where the 22% is not enough withholding) when future RSUs vest.

The cost basis of vested RSUs is the price on the stock the day they vest. Selling older shares that vested previously but held for at least a year could trigger preferential capital gains treatment on any gains realized. Selling more shares from the newly vested shares would trigger no additional income tax obligations assuming they are sold at the same price as the newly established cost basis and do not result in a realized gain.

Diversification and Risk Management

While holding onto RSUs can be tempting, it’s essential to diversify your investments to avoid overexposure to a single stock. Diversification may not offer the thrill of a skyrocketing stock price, but it provides stability and mitigates risk in the long run. As new shares are awarded and vested, depending on your income tax situation, it may make sense to sell older shares and realize a capital gain.

Plan for the Future

In managing your exposure to this single stock position, holding onto shares that recently vested and potentially have a higher cost basis could help manage your future income tax obligations when those shares are sold in the future. Equity compensation is often granted annually, meaning you’ll likely receive more RSUs down the road.

Selling shares at vesting can free up capital for other investments or expenses, or to cover anticipated income tax obligations while still allowing you to participate in your company’s growth. You can also optimize your total tax obligations by selling some newly vesting shares in combination with shares from older tax lots, if that makes the most sense in your specific distribution plan.

In conclusion, navigating the world of RSUs and taxes requires careful planning and consideration. While it’s tempting (and often easier from a practical standpoint) to simply hold onto RSUs for potential future gains, it’s essential to understand and consider the tax implications of your RSUs and to diversify your investment portfolio accordingly.

By understanding the ins and outs of RSUs and implementing a strategic tax plan for the same, you can maximize the benefits of your equity compensation while minimizing tax surprises. Seeking guidance from a financial professional can provide invaluable support in making informed decisions about your RSUs.

 

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

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