What is Restricted Stock?
Let’s break it down. What is restricted stock? Restricted stock is equity that is given to an employee by their employer as part of their compensation package. The shares are “restricted” per SEC regulations as long as the owner of the restricted stock remains an affiliate, also known as a control person. These restrictions enacted as part of the Securities Act of 1933 are meant to prevent insider trading, but in doing so, make the restricted stock highly illiquid.
Why Do Employers Offer Restricted Stock?
There are a handful of reasons why employers offer restricted stock to employees as part of their compensation.
- First and foremost, it gives employees ownership in the company and aligns their interests with those of shareholders.
- Because restricted stock typically vests over time, it also gives employees an incentive to stay with the company for the long haul.
- Offering restricted stock is a cost-effective way for companies to attract and retain top talent.
- From a tax perspective, restricted stock is often more advantageous for both employees and employers than other forms of equity compensation (such as stock options).
Can I Sell Restricted Stock?
A common question employees ask is, “Can I sell restricted stock?” The good news is—yes, you can. The not-so-great news? There are a number of steps you need to take first, you are limited in how much stock you can sell if you are an affiliate, and you will get hit with a sizable tax bill of 23.8%. You can see the steps below and we recommend reading our article about What You Need to Know About Selling Restricted Stock for more details.
- Holding Period. Before you may sell any restricted securities in the marketplace, you must hold them for a certain period of time.
- Current Public Information. There must be adequate current information about the issuing company publicly available before the sale of restricted stock can be made.
- Trading Volume Formula. If you are an affiliate, the number of shares you may sell during any three-month period cannot exceed the greater of 1% of the outstanding shares of the same class being sold. Additional trading volume restrictions may apply depending on whether the stock is listed on a stock exchange or if it’s quoted on the OTC Bulletin Board and Pink Sheets. Its best to check out the SEC website for the most accurate information.
- Ordinary Brokerage Transactions. If you are an affiliate, the sales must be handled as routine trading transactions. Brokers may not receive more than a normal commission. Neither the broker nor the seller can solicit orders to purchase the securities.
- Filing a Notice of Proposed Sale with the SEC. If you are an affiliate/control person, you must file a notice with the SEC on Form 144 if the sale is made up of 5,000 shares or the total dollar amount is greater than $50,000 in any three-month period. The sale must take place within three months of filing the notice. If the restricted stock has not been sold by then, you must file an amended notice.
Investing Restricted Stock in an Exchange Fund
Restricted stock awards are highly illiquid as an affiliate. For some, this creates a highly concentrated stock position in one single company, which also happens to be their employer. However, there is a way to leverage restricted stock and diversify your assets using exchange funds. Exchange funds, also called swap funds, take in restricted stock in exchange for shares in the fund of the same value. This allows owners of restricted stock to diversify their portfolio while also putting off tax consequences until later. While exchange funds help with diversification and defer taxes, ultimately the taxes will need to be paid. These funds have some other drawbacks as well.
- Investors Must be Accredited – In order to participate in private placements, investors must be an accredited investor.
- Exchange Funds are Illiquid – Typically an exchange fund requires that you remain part of the partnership for at least seven years. If you need access to your capital, redeeming shares early could trigger a penalty or return the same restricted stock shares you had originally tried to diversify. Assets held in the exchange fund may also be highly illiquid, such as real estate investments. That is generally why the exchange fund has a longer time horizon.
- Not All Assets Qualify – Exchange funds may not allow certain types of restricted stock shares. For example, shares that do not trade on any of the major stock exchanges or have a value less than a certain amount may not qualify. Generally exchange funds try not to hold a concentration in any single company so once the max concentration is met, other company affiliates will not be able to participate.
- May Have High Fees – Some exchange funds have higher management fees than others and/or incur an upfront sales charge. They might also choose to invest in assets with higher expense ratios eating into future profits.
There is a new type of exchange fund for accredited investors that at the time of this writing (November 2022) is being set up, called the Copper Moose Private Placement. The investment provides investors an opportunity to exchange their illiquid securities for interests in a private placement that offers many substantial benefits including:
- Multiple Payment Options – Provides for the ability of investors to pay for the investment with illiquid securities including Rule 144 Restricted Stock – a largely untapped marketplace estimated to exceed $7 trillion.
- “Preservation of Principal” – Adds a component that assures a 100% collateralized return of principal in 7-10 years, in cash, held in segregation on behalf of the investor.
- Growth Potential – Adds a separate growth component that provides upside participation in the future growth of a contributed security or the S&P 500.
- Substantial Tax Benefits – Provides a first-year cash distribution that can be used to cover the long-term capital gains tax (up to 23.8%) that may be due on the constructive sale of the securities after exchange.
- Long Term Growth – Provides a growth component in private companies that enables investors to participate in future growth of those investments in perpetuity.
Learn more about this unique offering at www.coppermoosefund.com
How is Restricted Stock Taxed?
Restricted stock is taxed differently than other kinds of stock. Because it is typically given to employees, it has a zero-cost basis meaning that you will be taxed on the entire value of the stock.
There are two options for how your restricted stock awards can be taxed.
- Normal Income Tax Treatment – Under normal federal tax laws, the employee is taxed on their restricted stock awards at the time of vesting. The entire value of the vested stock must be counted as ordinary income in the year of vesting if the stockholder doesn’t take the Special Tax 83(b) election. Once the stock vests and the taxes are paid, the cost-basis is set, meaning later if the stock is sold, the shareholder will recognize capital gains or losses.
- Special Tax 83(b) Election – Under Section 38(b) of the IRS code, employees are able to change how their Restricted Stock Awards are taxed. If any employee takes this special election, they will be taxed on the fair market value of the stock at the time it is received (less what they paid for it) instead of being taxed on the value at the time the restricted stock vests. Gains or losses from that point onward would be treated as capital gains and losses. A risk associated with a special tax 83(b) election is that if the employee were to leave the company prior to the stock vesting, they would not be entitled to any refund of tax paid or tax loss regarding the forfeited stock.
There are a lot of nuances involved with restricted stock. While it is a great benefit for executives and companies, it can present a number of challenges and uncertainty. It’s best to consult a financial advisor who understands this convoluted equity to help you properly plan for your tax liability and diversify a concentrated position.