Back to Basics: Employer Stock

A few fundamental concepts about employer stock grants will illustrate how these grants can affect the holders’ financial situations. We’ll point out potential pitfalls to help employees make informed financial decisions.


I’m a shareholder
Strings Attached
A popular choice
The taxman cometh
Where is my cash?
Parting Thoughts


I’m a shareholder

I used to work for an investment bank. Fresh out of college, I threw myself into the unexplored territory of institutional finance. Everything was exciting, and after a few years, my bonuses grew larger.

One particularly good year, the numbers exceeded my expectations. But the size of the bonus wasn’t the only surprise about it. A large chunk of it wasn’t cash. It was company stock. With a concerning qualifier—“restricted.” Is that good? I wondered. What now?

This post covers the basic concepts of how equity grants work, focusing on restricted employer stock. Often there are no right or wrong answers to the questions posed by my younger self; however, knowing the basics can help you make informed financial decisions that incorporate your specific circumstances.

In general, whether equity compensation—the term for compensating employees with company stock in various manners—is a good thing depends a great deal on what you do with it. With the right choices, it can be a powerful asset.

Receiving stock awards means that you are not just an employee; you are a shareholder, with all the associated ups and downs. Remember, one significant way stock is different from money in the bank is that company stock value changes over time, which creates a risk of losing value and the potential for a reward. There are also tax implications to consider.

Below, we’ll be discussing awards that come with terms and stipulations. As a shareholder of a “restricted” award, the award is given to you conditionally; it is not yours until the condition is satisfied. Therefore, you will have to make some choices that can affect financial outcomes several years later.

Strings Attached

When a company grants stock instead of cash, it often does so with strings attached—conditions that must be fulfilled before the shares become the grantee’s property. This is why it’s called “restricted stock.” The company places the stock in an escrow account and waits for you to satisfy the grant condition. If you do not, the shares revert to the company.

The dates and acts of giving and taking the shares back are important for many tax and investment reasons—so much so that there is a standard terminology around these terms. The date the award is given is the grant date, and the date when you fulfill the condition and gain unrestricted access to the shares is called the vesting date. If you fail to satisfy the stipulated requirements and the shares go back to the company, you are said to have forfeited the shares.

The two main types of restrictions companies place on share awards are time-based and performance-based. Time-based restrictions require the grantee to keep working for a certain period, usually three to four years, depending on the company and the industry. During this time, the company lifts the restrictions, or vests, the shares according to a vesting schedule: the employee will gradually get the shares as time passes.

The figure below shows two examples of these types of vesting schedules. A graded schedule allows incremental vesting, usually in equal portions. A cliff schedule waits until the end of the restricted period before vesting all shares at once.

Sample Graded and Cliff Vesting Schedules

Years Worked

Percent Vested

Graded

1

25%

2

50%

3

75%

4

100%

Years Worked

Percent Vested

Cliff

1

0%

2

0%

3

0%

4

100%

 

Your company will most likely choose one or the other. However, these two types are sometimes combined. An example of a combined schedule would be a four-year schedule including a one-year cliff followed by monthly graduated intervals for three years. In simple terms, you get 25% of your equity compensation after one year of service and a small portion every month after that.

Sample Combined Vesting Schedule

Month Worked

Percent Shares Vested

1-11

0.00%

12

25.00%

13

27.08%

14 – 46

2.08% vests every month

47

97.92%

48

100%

If your grant is time-based, all you have to do is stay with the company until your shares vest. That’s not the case for performance-based grants. Given to top executives, these grants depend on measurable value to shareholders, such as stock price performance or corporate earnings. We’ll get into the details of performance-based grants in another post.

The rules for how restricted stock vests and any contingency plans or exceptions are company-specific. If you are eligible for equity compensation, it’s a good idea to find out how your employer handles equity compensation to learn the rules and take full advantage of your opportunities. And the best way to find out is to ask.

Most companies set general rules for making equity grants in written plans approved by their board of directors. The documents are usually named things like “Stock Option Plan,” “Equity Insentience Plan,” or “Stock Compensation Plan.”

Another source of specific information is the Individual Grant Agreement between the company and each grantee—potentially, you. This agreement outlines the rules for your specific stock grant. In addition, your employer will often have a dedicated person whose responsibilities include helping employees understand the details of the agreement.

Even if your employer doesn’t have a dedicated person charged with helping employees understand their stock grants, there are often other employees at the company, usually in the Human Resources department, who deal with equity compensation as part of their job and have seen how these grants work.

A popular choice

Equity compensation might take different forms. Often the type depends on the age and industry of the company, the stability of profit, and whether the company’s shares are trading on an exchange or not.

Restricted stock has always been a popular form of compensation. Still, during the 80s and the 90s, it got eclipsed by stock options. This payment form gives the owner a right to purchase the company’s stock at a preset price, called a strike price, even if the stock price has risen later.

Stock options are still trendy, especially among technology companies in Silicon Valley and startup companies. Yet, in recent years, restricted stock has become a more popular form of compensation.

When a small startup with little cash to spare is trying to attract skills, their best currency is the promise of high growth, so stock options make sense. Over time, option grants grow faster than an outright stock award—one option is worth less than one share of stock, so for the same dollar amount, the grantee gets more of them.

The situation is different in a large, seasoned company. It makes more sense to give restricted shares when shares are stable and growth is limited. These grants are often substantial.

This all sounds great on paper. But the issue becomes more complicated when you account for the fact that being a part of your employee compensation restricted stock is subject to taxes.

And if you haven’t planned and accounted for what will happen when your restricted stock vests and taxes come due, you and your portfolio could be in for some unpleasant surprises.

The taxman cometh

Tax rules for equity compensation are not as straightforward as income tax rules. They often depend on what the taxpayer does with the grant and when.

Unfortunately, when these matters are left unattended until it is time to pay, the default options probably won’t be the best option for the recipient of equity compensation. At that point, it is too late to do anything about it: the stock is sold, the time to make choices has passed, and personal cash reserves are depleted.

The good news is, with proper planning, the same rules allow you certain choices that can lead to an overall reduction of taxes—if you play your cards right.

Let’s get into further detail. With a greater understanding of the situation, you’ll be able to determine which choices might create your optimal tax outcome.

By default, when restricted stock is granted, there is no tax due. That is because, by its nature, the stock is restricted; technically, it hasn’t yet been given away by the current owner. It is when the grant vests that the IRS considers the shares received, and at that point, it taxes them as ordinary income.

In this case, the usual taxes apply—federal, state, and local income tax and social security tax. It’s essential to recognize that more tax will be due if the stock price has increased since the grant date. The amount of tax is based on the stock’s value at the vesting date, not the grant date. If the stock does well, there might be a lot of tax to pay on the vesting date.

However, holders of restricted stock have another choice. This is well-known in professional circles but not heavily publicized elsewhere—an internal revenue code provision called Section 83(b).

Section 83(b) allows an election—a choice the grantee can make, in this case, by sending a letter to the IRS within 30 days of the grant — that can significantly improve tax outcomes in many cases.

A full and proper analysis of the different scenarios where this election works better warrants a separate article; we tread this at length in a previous blog. Here, I will outline the rules and illustrate one example where it works well.

Typically, the tax on equity compensation is due in the year when the shares vest, not the year they’re granted. Recall that vesting usually happens three to five years after the grant. Taxation is delayed because, of course, five years after the grant, the shares might revert to the company if the grantee leaves the company or if other grant conditions are not fulfilled—the forfeiture outcome. Since, in this scenario, no property was granted, there is also no tax.

In contrast, the Section 83(b) election allows you to choose to pay the tax at the grant time. In other words, you accelerate paying the tax, paying it now instead of later.

The obvious question is, what happens if you pay the tax now and forfeit the share later? The answer is—nothing happens. Your tax money stays with the IRS and is never returned to you.

Why pay this tax earlier when you can pay it later, or even never? One good reason is that the amount of taxes you will pay earlier could be much smaller than the potential tax burden later.

When you take the Section 83(b) election, the tax you pay will be calculated based on the value of the share at the grant date—which has the potential to be a much smaller amount.

The result is that the stock’s growth after the grant date will only be taxed at the time you sell the stock, not at the vesting date; at that point, any growth will be treated as capital gain rather than income. Capital gains are taxed at the rate of 10% – 20%, depending on your overall income, and are not subject to social security income tax.

Compare this to paying later. The gains taxed at the vesting date might not only be more significant if the stock goes up, but the stock growth since the grant date will be taxed as ordinary income, not capital gains. Ordinary income is currently taxed at rates of up to 37.5%. In addition, there will be social security income tax to pay.

With the Section 83(b) election, the award recipient pays an ordinary income tax on the potentially smaller value at the grant date. Should the stock price increase after the grant date, a smaller capital gains tax on the increase at any later time of sale.

However, it’s important to note the risk inherent in this option. Section 83(b) elections do not always work out well for the grantee. If a forfeiture event happens, the paid tax money is lost.

Despite the risk of losing tax money, many employees have high confidence in staying with their company and choose to pay early. If you’re secure in your employment, this could be a worthwhile investment.

However, there’s one more issue to keep in mind. With the Section 83(b) election, taxes will need to be paid with cash while the shares are still restricted. You cannot sell your restricted shares to pay the tax as they haven’t vested yet; the money you pay has to come from other sources, most likely your savings.

Where is my cash?

When it comes to restricted stock, cash flow is often overlooked. Whether you choose the Section 83(b) election and pay the tax at the grant date or choose to pay the tax at the vesting date, you will need to come up with that tax money somehow.

Of course, companies are required to withhold taxes. They might withhold the amount from your salary, or they might let you provide the cash yourself.
This is best not left to chance. If you’re the grantee of restricted shares, it’s important to consider whether your employer is withholding enough taxes and to have a plan for how you will be able to pay.

Make sure you have enough cash earmarked for taxes. If you have the option and plan on selling some of the stock to pay the IRS, keep an eye on the stock price. By the time you file the taxes and need the cash, there’s a chance the stock price may have fallen—but the taxes due will still be based on the stock’s value when the grant is vested.

If you do not choose Section 83(b), you might be able to “surrender” some of the stock to cover the taxes, but this option might not always be available depending on the employer.

If you are an insider—an officer, director, or a more than 10% shareholder—keep in mind, too, that the Securities and Exchange Commission (SEC) requires you to report the surrender of shares by filing Form 4. Insiders are required to report any transfers of securities to the SEC, and “surrender of shares to pay withholding taxes” counts as a transfer.

Another factor to consider when planning what to do with your restricted shares is when the vesting shares’ windfall puts the owners in a higher tax bracket. If you find yourself in this situation, whatever taxes your employer has withheld may not be not enough. You might find that more cash is needed to cover the taxes, and there may be other restrictions on selling the shares immediately after they vest, drying up that potential source of available cash.

For example, the company could be in a post-IPO lock-up period or a blackout period around its earnings release dates. Employees would be prohibited from trading the stock during these dates, which could leave you relying on savings to pay your taxes.

You can avoid these headaches by getting a robust understanding of how your restricted awards work and making plans well in advance. Planning to find a suitable time to sell your vested shares can alleviate massive amounts of stress later on. In addition, selling helps to diversify your overall investment risk away from a single position and towards a more balanced portfolio.

Whatever you do with your vested shares, you will need to think ahead to decide when and how you will deal with the tax burden of restricted stock compensation. The sooner you learn the details, the better off you’ll be.

Parting Thoughts

So does $100 equal to $100 share of the company stock?

Clearly, it doesn’t. Cash goes to your bank and needs budgeting and possibly investing.

With stock, on the other hand, you are a shareholder. You own a part of the company. However, if it’s restricted, you will have to fulfill some conditions to receive the stock, usually a time commitment of some kind.

If the company is young and full of potential, its stock could take you to the next level of wealth, but if you forget to watch your investment risks, your newfound wealth could disappear overnight.

Equity grants can present tax opportunities, but you need to plan to take advantage of them. If you haven’t looked at your employer stock account for a while, chances are you are not taking full advantage of it.

Now that you’re aware of owning company stock’s parameters, the most important thing is to start asking questions about your equity awards. You have to learn when your shares will be vesting, choose if a Section 83(b) election is right for you, and be aware of your cashflows to make sure you have enough cash to pay the tax.

Remember that you don’t need to know all the answers, and you don’t have to do everything yourself. HR, other employees at your company, or a dedicated financial planner can all be valuable resources.

Regardless of how you go about it, with careful planning and an understanding of the rules, chances are you will be able to turn equity compensation into a lucrative investment.

Jan Pevzner, CFP®, EA

I am a Gotham Block principal, an investment advisor that helps professionals balance portfolio and equity compensation risks.