Perhaps the most common form of equity compensation is what's known as "Restricted Stock Units" or RSUs. Restricted Stock Units are called "units" because they aren't technically shares of the company but they will convert into shares of a company with one unit as one share.
The mechanics of when a RSU converts into the underlying equity depends on if the RSU is "single trigger" or "double trigger"
Note that this post will be using the following common terms.
Terms
- 409a - A formal report that appraises the fair market value (FMV) of a private company's common stock.
- Cost Basis - How much you paid to acquire the equity (Price * Quantity at the point of ownership).
- Cliff - a period that an employee must work before any of their equity or stock options vest.
- Dispose - To sell
- Long Term Capital Gains - If you hold on to an equity for over a year you are taxed as long term capital gains and taxed at a flat 15%.
- Proceeds - How much you got when you sold the equity.
- Sell to Cover - selling a portion of the equity to cover taxes.
- Spread - The difference between how much you sold something for vs. how much you bought it for. (i.e: Proceeds - CostBasis).
- Short Term Capital Gains - If you hold on to an equity for less than a you are taxed as short term capital gains and taxed at your income tax rate.
- Supplemental Income - A type of taxable income separate from their regular wages or salary.
- Vest - vesting is a process used by companies to grant ownership stakes or stock options to employees or partners over a set period of time.
Single Trigger
Single trigger is often seen in publicly traded companies. Restricted Stock Units that are single trigger will convert into the underlying equity on vest.
Double Trigger
Double trigger Restricted Stock Units can only be offered by private companies. Private companies will typically prefer to use double trigger simply because it's a way for the board, founders, and other principles to prevent voting dilution.
As the name implies; with double trigger RSUs there are two triggers. The first trigger is when the equity vests. The second trigger is a liquidity event (the shares are able to be sold).
Tax Considerations
Restricted Stock Units are considered Supplemental Income from a tax perspective.
RSUs are taxable at the moment that they convert into underlying shares of the company. For single trigger this means at vest and for double trigger it means on the second trigger (IPO, acquisition, tender offer, etc.).
Since RSUs are considered a type of wage income, tax withholding is often done by your payroll provider (you'll see the withholding on your paystub).
Example
Let's say we work at a publicly traded company and as part of our compensation we have a single trigger RSU grant with a vesting schedule of 100 shares on the first of every month.
On the first of the month we get our 100 shares, the share price is $10 which means our cost basis is $1000 (100 * 10). This means that we owe taxes on the $1000 of additional income we just made. Typically the payroll company will "sell to cover" meaning they sell some of the shares that just vested and withhold them to cover the taxes. So while your vest may be for 100 shares you may have retained 80 of them after covering for taxes.
Thus far we've talked about the taxes you pay when you acquire the shares of stock. There is a second tax event when you dispose (sell) the stock.
When you acquire the shares it is considered Supplemental Income and is taxed similarly to your wage income (salary, bonus, etc).
When you dispose (sell) the shares it is taxed as Capital Income. Capital income is split into being "long term" (more than a year) and "short term" (less than a year). Long term has a flat tax rate of 15% and short term has the same tax rate as your personal income tax.
Example (cont)
Continuing with our example we have acquired (after taxes) 80 shares at $10 per share.
(Short Term Example)
Let's say the next day we see the share price go up to $15 and we get excited and sell half of our shares. We sell 40 shares at $15 and get $600, this is called our "proceeds". Of course we didn't get this for "free" we got these shares when they were $10 so the "CostBasis" is ($10 * 40).
Proceeds = ($15 * 40) = $600
CostBasis =($10 * 40) = $400
Profit = Proceeds - CostBasis = $600 - $400 = $200
We owe taxes on the profit. Because we sold this within a year of owning it (when it vested) we'll need to pay short term capital gains. Let's say our current income tax bracket is 30%. That means we'll need to pay $60 in taxes
Taxes = Profit * TaxBracket = $200 * 0.3 = $60
(Long Term Example)
Let's say we wait a year and a day to sell the remaining 40 shares of stock. Let's also say the share price of $15 has remained the same. In that case our Proceeds, CostBasis, and Profit all remain the same.
Proceeds = ($15 * 40) = $600
CostBasis =($10 * 40) = $400
Profit = Proceeds - CostBasis = $600 - $400 = $200
However because we waited over a year we'll be taxed at long term capital gains, a flat rate of 15%.
Taxes = Profit * 15% = $200 * 0.15 = $30
Deciding to sell the oldest first (known as FIFO) can have a large impact on taxes while deciding to sell the newest first (LIFO) will be the quickest path to diversification.
Summary:
- RSUs become shares of a company when they vest (single trigger) or when they vest AND have a liquidity event (double trigger)
- When RSUs convert from units into shares of the company it is considered "Supplemental Income" and is taxed similar to wage income (e.g. salary)
- You get taxed when you get the shares AND when you dispose (sell) the shares
- How long you hold on to shares before selling them has large tax implications.
- If you hold on to the shares for longer than a year the tax is a flat 15%
- If you hold on to the shares for less than a year then the tax is the same as your income tax bracket.
