The stock incentives you have been awarded over the course of your career have met the required corporate and personal performance hurdles and have now fully vested. This accumulated shareholding could very well represent the bulk of your personal wealth. A concentrated stock holding of any kind carries risk, and your overall risk is further compounded when it is a concentrated holding in the company for which you work. Anticipating your vesting schedule and understanding your tax options are important factors in managing this risk.
You might not be thinking completely clearly about what this concentrated shareholding from stock awards means for your portfolio, for several reasons. The shares might, understandably, carry an emotional component because of the effort you expended to earn them, particularly in a start-up company in which you shouldered a considerable amount of personal risk along the way. Furthermore, you might believe that they didn’t cost you anything, so there is no downside in continuing to hold them.
To be clear, the shares represent cash: they were your compensation in lieu of cash, and they at last have cash value. It is important for you to step away from their “meaning” and assess whether they continue to be the best investment option for you. Should you divest all or part of your holdings? Is the stock overvalued or fully valued at current levels? Under other circumstances, would you be a buyer or a seller here? And what are the tax implications of exercise?
The tax consequences of concentrated stock holdings vary depending on what type of stock incentive you are holding:
Restricted stock (RS) usually becomes taxable when vesting is complete, and in that year the entire amount must be declared as ordinary income. The amount to be declared is the fair value of the stock on the vesting date minus the original exercise price of the stock (which may be zero). If the stock is not immediately sold after vesting, any difference between the sale price and the fair market value on the vesting date will be subject to capital gains treatment on disposal.
Holders of RS can opt to report the fair market value of their shares as ordinary income on the date the stock is granted, instead of when the shares vest. In this case, the capital gains calculation begins at the time of the grant. This move, known as a Section 83(b) election, can significantly reduce the amount of taxes owed because the share price at the time of the grant is often much lower than the price at the time of vesting.
A simple example demonstrates the power of Section 83(b) election. Bob and Hope are each awarded 10,000 shares in WWW Corp for zero dollars, valued at $25/share on the grant date. Bob decides to declare his stock at vesting. Hope elects Section 83(b) treatment, and therefore must report $250,000 as ordinary income this year. Bob and Hope’s WWW Corp stock becomes fully vested five years later, when it is trading at $100/share. Bob will have to report $1 million in ordinary income. Hope reports nothing unless she sells her shares; when she does, they will receive capital gains treatment. Thanks to Section 83(b) election, Hope will pay a lower rate overall, whereas Bob is paying the highest possible rate overall.
All restricted stock plans are subject to the risk of forfeiture – if you leave the company before your stock vests, you will lose it all. Section 83(b) election brings an additional element of risk to the equation: if you leave the company before your stock vests, you will lose it all as well as the taxes you already paid on its value as ordinary income in the grant year. Infrequently, some companies require the employee to pay for a portion of the stock on the grant date – which would be treated as a capital loss in the event of departure.
Restricted Stock Units (RSU) represent an employer’s unsecured promise to grant a certain number of shares (infrequently, cash) to you when vesting requirements have been met. RSUs have no value when issued. Because no physical shares are awarded on the grant date, Section 83(b) election is not allowed in the case of RSUs. Therefore, only the fair market value of the shares on the vesting date matters, and this amount is reported as ordinary income. Each RSU scheme is different; some give the employee some flexibility with tax planning by allowing them to decide when to receive their shares. If the stock is held past its vesting date, normal capital gains treatment applies to subsequent appreciation or losses.