What Is Restricted Stock?
Restricted stock refers to unregistered shares of ownership in a corporation that are issued to corporate affiliates, such as executives and directors. Restricted stock is non-transferable and must be traded in compliance with special Securities and Exchange Commission (SEC) regulations. The restrictions are intended to deter premature selling that might adversely affect the company. It typically becomes available for sale under a graded vesting schedule that lasts several years. Restricted stock is also referred to as "letter stock" and "section 1244 stock."
Types Of Shares: Authorized, Outstanding, Float And Restricted Shares
- Restricted stock is one form of executive compensation offered by select corporations.
- The use of restricted stock is most common in established companies that want to motivate employees by giving them a share of the equity.
- Restricted stock represents the actual ownership of shares but comes with conditions on the timing of the sale.
- The restrictions are intended to deter premature selling that might hurt the company, as well as to motivate managers to align their interests with the future of the company.
How Restricted Stock Works
Restricted stock became more popular in the mid-2000s as companies were required to expense stock option grants. It is often used as a form of employee compensation, in which case, it typically becomes transferrable, that is, vests, upon the satisfaction of certain conditions, such as continued employment for a period of time or the achievement of particular product-development milestones, earnings per share (EPS) goals, or other financial targets.
Insiders are given restricted stock after merger and acquisition activity, underwriting activity, and affiliate ownership in order to prevent premature selling that might adversely affect the company. An executive may have to forfeit restricted stock if he leaves the company, fails to meet corporate or personal performance goals, or runs 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.
An executive may have to give up restricted stock should they leave the company, miss certain pre-specified performance targets, or get in trouble with the Securities and Exchange Commission.
These shares may be restricted by a double-trigger provision. That means that an employee's shares become unrestricted if the company is acquired by another and the employee is fired in the restructuring that follows.
Restricted Stock Units vs. Restricted Stock Awards
Two variations of restricted stock are restricted stock units (RSUs) and restricted stock awards. A restricted stock unit is a promise made to an employee by an employer to grant a given number of shares of the company's stock to the employee 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 in order to receive the stock. An RSU that is converted to a stock carries the standard voting rights for the class of stock issued.
A restricted stock award is similar to an RSU in a number of ways, except for the fact that the award also comes with voting rights. This is because the employee owns the stock immediately once it is awarded. Generally, an RSU represents stock, but in some cases, an employee can elect to receive the cash value of the RSU in lieu of a stock award. This is not the case for restricted stock awards, which cannot be redeemed for cash.
Taxation of Restricted Stock
The taxation of restricted stock is complex and is governed by Section 1244 of the Internal Revenue Code (IRC). Restricted stockholders pay tax on the capital gain or loss represented by the difference between the stock’s price on the date it vests and the date it is sold. In addition, restricted stock is taxable as ordinary income in the year it vests. This is converse to stock options which are taxed when the employee exercises his or her option, not when they are vested.
The amount on restricted stock that must be declared as income is the stock’s fair market value on the vesting date minus its original exercise price. However, the restricted stockholder may do a Section 83(b) election, which lets him or her use the price on the grant date, not the vesting date, for the purposes of calculating ordinary income tax. The tax bill must be paid sooner in this case, but it may be substantially lower if the stock appreciates between the grant date and the vesting date. The risk of taking this election is that if the restricted stockholder leaves the company before the shares vest, the shares are forfeited, and taxes already paid are non-refundable.