Restricted Stock Units Require Strategic Planning
Equity compensation like RSUs are an exciting employee benefit that can supercharge the process of wealth accumulation. However, many equity recipients are unaware of the tax triggers and risks of letting company stock accumulate unchecked.
RSUs are the simplest form of equity compensation, but they still have layers of complexity. This blog will teach you how to reap the benefits of Restricted Stock Units and navigate the potential tax and concentration hazards.
If you need a refresher on equity compensation terminology, check out our other blog post, The Executive's Guide to Equity Compensation.
What are RSUs?
Like other forms of equity comp, RSUs are part of an executive or key employee's compensation package.
When you receive an RSU grant, your employer is saying, “Hey, these shares of company stock are free and they're for you. You can't have them right now, but when you meet these requirements, they're all yours.”
You naturally say, “Great! What do I need to do?”
The answer: Meet the vesting criteria.
The exact vesting criteria will depend on your company's plan agreement, but there are three common structures.
1. Single trigger RSUs
2. Double trigger RSUs
3. Performance Share Units (PSUs)
Single-trigger RSUs are common at publicly traded companies. The typical vesting "trigger" is continued employment during a 3-4-year vesting period where the grant vests in equal parts. In some cases, grants vest more frequently or all at once, known as cliff vesting.
Single-Trigger RSU Example
On July 1st, ABC company grants you 2,000 RSUs that vest equally over 4 years. If you stay with ABC, 500 shares will vest on July 1st for the next 4 years.
If ABC uses cliff vesting, they could say all 2,000 shares vest on July 1st of the 4th year.
Double-trigger RSUs are common at private companies to give employees a source of liquidity to pay the tax liability created from the vesting event.
Trigger #1 of a double-trigger RSU is the vesting period
Trigger #2 is a liquidity event (IPO, tender offer, acquisition)
Since RSUs are taxed at vesting, the second trigger delays vesting until you have liquidity to pay the taxes.
Double-Trigger RSU Example
It's been 4 years since you received the RSU grant, but there's been no company liquidity event, so the grant hasn't vested.
2 years later, your company goes through an IPO. Trigger #2 is met, the grant vests, and you can sell shares when they settle, barring any blackout/lock-up period.
Performance Share Units (PSUs)
PSUs add a slight twist by making vesting contingent on performance metrics (EBITDA, revenue, etc.) within a specified time period.
Don't hit the metrics, the grant expires worthless. Meet/exceed the metrics, you could receive bonus shares from a performance multiplier.
On January 1st, ABC grants you 2,000 PSUs that vest if the company reaches $15M in annual revenue by January 1st, 4 years from now.
Say company revenue reaches $26.25M (175% of the target). You could receive 3,500 shares (2,000 x 175%).
RSU Taxes at Vesting
When shares of an RSU grant vest, you're taxed on the Fair Market Value (FMV).
FMV = # of shares x share price
Public company shares are valued by looking at the market price at vesting. For private companies, the share price is determined by the current 409A valuation.
RSUs and other equity comp are considered "supplemental income."Supplemental income is taxed the same as ordinary income, but federal tax withholding is different.
The IRS requires the first $1M of supplemental income be withheld at 22% and any supplemental income over $1M be withheld at 37%. In addition, income recognized from RSU vesting is also subject to state, local, Social Security, and Medicare taxes. If you earn >$200k, you'll be charged the 0.9% Medicare surtax. SS taxes aren't withheld if you already reached the SS wage limit of $160,200 (2023).
What Happens When RSUs Vest?
When shares vest, your company will calculate the required tax withholding and sell the number of shares necessary to cover the required withholding.
The remaining shares are officially yours. You can either:
• Sell at vesting
• Hold and sell in the future
Before deciding, here are a few things you should consider.
Tax Planning for RSUs
If your total income puts you in a high tax bracket, but tax on your RSUs was only withheld at 22%, you could have a substantial liability when you file taxes the following year.
Executives and key employees typically receive substantial base pay before their equity comp, making the following scenario perfectly reasonable. Consider a married couple with taxable income of $700,000. In 2023, this puts them in the 37% marginal tax bracket. If one spouse has $500,000 of RSUs vest, their supplemental income (not wages) is below $1M. By default, federal taxes will be withheld at 22%.
However, the $500,000 of income will be taxed at 37%, so the RSU tax liability comes to $185,000, but the RSU tax withholding was only $110,000.
The potential disparity in tax withholding and liability requires careful planning to avoid being blindsided by a hefty tax bill at filing. Your tax or financial professional can help you determine your outstanding liability.
Capital Gains Tax on RSUs
When shares vest, your cost basis becomes the FMV at vesting. So, selling at vesting prevents you from participating in the potential growth of the shares, but it puts cash in your pocket without an extra tax liability or future tax considerations.
If you decide to hold the shares, your holding period will determine the future tax impact.
If you sell for a gain within a year of vesting, the gain will be taxed at your ordinary income tax rate. If you wait at least a year from vesting to sell, the gain will be taxed at long-term capital gains rates.
If the price falls, you can sell and take a short or long-term capital loss, but this ends up with you getting less cash than what you paid ordinary income tax on.
Left unmanaged, your company stock can quickly comprise most of your net worth if you have various forms of equity comp vesting at multiple points throughout the year.
Concentration can expedite the wealth accumulation process, but it can also wipe away your wealth just as quickly. Not only does your company stock comprise the majority of your net worth, but your income, benefits, and future livelihood are all tied to the performance of a single company.
It can be difficult to accept the idea that what made you wealthy may not keep you wealthy, and it can be even more difficult to watch the share price climb after you sell. However, if you received equity grants once, you'll typically receive them in the future. So, shares from future grants can replace the shares you sell now, and you can continue to participate in the potential growth and upside of your company.
Selling at vesting isn't as exciting as holding and seeing where the stock price goes, but it does allow you to:
• Diversify investments
• Fund big ticket expenses
• Lock in tax consequences
• Allocate to other savings goals
Diversification may not have the upside or excitement of a single stock, but it does provide a more predictable path for living the life you want to live.
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