Restricted Stock: What It Is, How It Works, Selling & Taxation

What Is Restricted Stock?

Restricted stocks are unregistered shares of ownership in a corporation that are issued to company executives, directors, and other employees as part of their compensation. Restricted stocks are nontransferable and must be traded according to the relevant Securities and Exchange Commission (SEC) regulations. The restrictions of these stocks usually relate to their vesting period, which is when they can't be sold or transferred.

The restrictions are intended to discourage premature selling that might negatively affect the company and to provide stability at the firm by providing a benefit to employees who stay on for a certain amount of time.

Restricted stock typically becomes available for sale under a graded vesting schedule that lasts several years. Restricted stock is called “letter stock” or “section 1244 stock” (the part of the Internal Revenue Code [IRC] that covers them).

How Restricted Stock Works

Restricted shares provide employees with a stake in their companies. However, they have no value until they vest, that is until a waiting period is over or a company milestone is met. Vesting gives employees an incentive to perform well and remain with a company. The vesting schedule a company sets up determines when employees acquire full ownership of the asset, in this case, restricted stock units (RSUs).

The RSUs are assigned a fair market value at the time of their investing. Restricted stocks became more popular in the mid-2000s as companies were required to expense stock option grants. Restricted stocks are a form of employee compensation and typically become transferable after satisfying certain conditions, such as continued employment for a period of time or the achievement of particular product development, earnings, or other financial goals.

Insiders are often given restricted stock after mergers and acquisitions, underwriting activity, or changes in ownership to prevent premature selling that might negatively affect the company. Employees might forfeit restricted stock if they leave the company, fail to meet corporate or individual performance goals, or run afoul of SEC trading restrictions.

The SEC regulations that govern the trading of restricted stock are outlined under SEC Rule 144, which describes the registration and public trading of restricted stock and the limits on holding periods and volume.

These shares can have a double-trigger provision. That means that an employee's shares become unrestricted if the company is acquired by another and the employee is let go in the restructuring that follows.

Restricted Stock Units vs. Restricted Stock Awards

Two variations on restricted stock are restricted stock units (RSUs) and restricted stock awards. A restricted stock unit is granted to an employee and represents the promise to give a certain number of shares of the company's stock at a predetermined time in the future.

Since RSUs are not actually stocks but only a right to the promised stock, they carry no voting rights. An RSU must be exercised to receive the stock. Once converted, the stock carries the standard voting rights for the class of stock issued.

A restricted stock award is like an RSU. However, it comes with voting rights because the employee owns the stock immediately once it is awarded. In addition, though an RSU represents a right to stock, in some cases, an employee can elect to receive the cash value of the RSU instead. This is not the case for restricted stock awards, which cannot be redeemed for cash.

Restricted Stock vs. Employee Stock Options

Restricted stock and employee stock options are forms of equity compensation furnishing employees with shares in their company. However, restricted stocks are different from stock options, which are derivatives that outside investors can trade.

The key difference between restricted stock and employee stock options is that restricted stocks do not have an exercise price. Instead, employees automatically receive shares when the restricted stock vests. With employee stock options, the employee must pay the exercise price of the option to receive the shares.

Another difference is that stock options are typically awarded on a set schedule, while restricted stocks can use a fixed schedule as well or vest if the employee makes specific performance benchmarks. Restricted stocks and employee stock options are also taxed differently: restricted stocks are taxed after vesting, while stock options are taxed when exercised.

Advantages and Disadvantages of Restricted Stock

Advantages

• Restricted stock is easier for employees to understand than other forms of equity compensation. Employees receive stock when a certain date or condition is met.
• Employees don't have to pay to exercise an option to receive preferred stock, meaning they benefit even if they lack the resources to pay for stock options.
• They offer flexibility. Employees can retain the shares they earn or sell them immediately for cash.
• Since the value of restricted stock depends on the company's stock price, offering restricted stock gives an incentive to employees to help increase the value of the company.
• A longer vesting schedule can encourage employee loyalty.

Disadvantages

• Restricted stocks are taxed when vested, giving owners little flexibility in when they pay taxes on them.
• The recipients of restricted stock don't have voting rights or receive dividends until the shares vest.
• If you leave a company before the restricted stock vests, you forfeit your shares.

How Restricted Stocks Are Taxed

The taxing of restricted stock is governed by section 1244 of the IRC. Generally, restricted stocks are taxable once the vesting schedule is over. In addition, restricted stocks are taxed as ordinary income in the year they vest. This differs from stock options, which are taxed when employees exercise their options, not when vested.

The amount of declared income for the restricted stock for the Internal Revenue Service is the stock’s fair market value on the vesting date minus its original exercise price. However, the restricted stockholder can elect to use IRC section 83(b), which permits using the price on the grant date, not the vesting date, for calculating ordinary income tax.

The tax bill must be paid sooner in this case, but it can be substantially lower if the stock had appreciated between the grant date and the vesting date. The risk is that if the restricted stockholder leaves the company before the shares vest, the shares are forfeited, and taxes that were already paid are nonrefundable.

The Bottom Line

Employers use restricted stocks to provide an incentive to employees to remain in their jobs and to work to better the company's stock price by giving them shares in the business.

The vesting of restricted stock can be based on basic timelines or performance-based goals, making them highly flexible. The recipients of restricted stock should take steps to ensure they understand how their restricted stock is taxed and consider how long they plan to hold the stock once it vests.