RSU Tax 101: How Restricted Stock Units Are Taxed
Restricted Stock Units (RSUs) are taxed when they reach a vested and settled status, which coincides with the occurrence of a liquidity event.
Startup founders and employees face uncertainty on a regular basis. So maybe you’ll find some strange sense of comfort in knowing that the tax man comes every year, right on schedule. Of course, your taxes can look a lot different in a year when you receive a substantial amount of equity compensation in the form of company stock.
Such is often the case with restricted stock units (RSUs), which are typically taxed twice—first when they vest and convert into shares of common stock, and then when you sell them at a share price higher than the price when you acquired them.
If you’re a founder, it pays to understand how your employees might be taxed on RSUs, as it can help you (and them) better navigate communications around a potential equity windfall. Ideally, you should be fully aware of how RSUs are taxed when you’re calculating the value of the shares you offer in an equity grant, as this can give you more insight into the actual value of the grant.
In this guide, we’ll take a long look at RSU taxes so you and your employees will be ready to celebrate (not dread) an equity windfall when the time comes.
- What is a restricted stock unit (RSU)?
- How are RSUs taxed?
- Understanding RSU tax rates
- Are the taxes on RSUs different from the taxes on options?
- Are the taxes on RSUs different from the taxes on RSAs?
- Get more out of your equity with Pulley
What is a restricted stock unit (RSU)?
A restricted stock unit, otherwise known as an RSU, is an award of company stock that’s typically granted to employees as a form of equity compensation. RSUs convert into shares of common stock when certain performance and/or time milestones are met—a process called vesting.
How do RSUs vest?
How RSUs vest may look different from company to company.
Many startups use a time-based vesting schedule based on a prescribed period of time from the grant date (i.e. if you stay at the company for X years, you receive X number of vested RSUs).
Other times, a company may use a milestone-based vesting schedule in which vesting is conditional upon certain benchmarks in job or company performance. If this schedule applies to you, it should be spelled out clearly in your equity grant.
If you’re employed at a startup or private company, your RSUs may not be considered fully vested until after a liquidity event, such as an initial public offering (IPO) or a tender offer. This is important to keep in mind for tax purposes. If there’s a single liquidity event that triggers vesting for all of your held RSUs, you’ll suddenly owe taxes on all of those RSUs!
Keep in mind that RSUs are typically subject to what’s called double-trigger vesting. This means that two events must take place before you’re able to sell your stock:
- First, your shares must reach their vesting date.
- Second, a liquidity event (e.g. an IPO) must occur.
Note that this second trigger may occur before you can freely sell your shares. In the case of a typical IPO, the company may have a lock-up period after the liquidity event in which stockholders can’t freely sell their shares. You’ll still owe taxes on your RSUs from the date of the liquidity event (the second trigger), but you won’t be able to sell them until you’ve cleared the lock-up period. In most cases, this period doesn’t last more than a few weeks or months.
What happens to RSUs after they fully vest?
Once they meet vesting requirements, RSUs are assigned a fair market value (FMV) and converted into company shares. This is the form of stock you’re probably familiar with if you have a brokerage account you use for trading. Just like any other stock you own, you’ll be able to either hold or sell your shares of common stock.
It’s pretty exciting when RSUs fully vest, and we won’t blame you for casually googling “used yachts” on the day your RSUs vest and become liquid. But before you cash in your shares and rush off to the Caribbean, you should probably understand how RSUs are taxed.
How are RSUs taxed?
The short answer is that RSUs are taxed as soon as they become vested and settled (i.e. a liquidity event has occured).
Some employees mistakenly believe that they are taxed on their RSUs from the moment they receive their grant. This is not the case. You do not have to pay any taxes on your RSUs at the time of the grant.
If you have double-trigger RSUs, however, you must pay taxes when each tranche of RSUs is settled and delivered to you. This normally happens when your RSUs vest. But remember—a liquidity event is also a pre-condition for RSUs to be taxed. If you work at a pre-IPO startup and you pass the time-based milestones for your RSUs to vest, you won’t be taxed on your RSUs until an IPO or some other type of liquidity event.
Once your RSUs become vested and fully liquid, they will be taxed at ordinary income tax rates. These rates may vary by state, so it’s a good idea to familiarize yourself with the ordinary income tax rate in your state.
Unfortunately, you may still owe taxes on your profits from RSUs in the years after they vest. Let’s dig into that some more.
Do RSUs get taxed twice?
It is true that you may have to pay taxes on your RSUs twice. Here’s a breakdown of how this works:
- You’ll pay taxes at ordinary income tax rates when your RSUs vest and become fully liquid. This is because your RSUs count as taxable income in the year they vest and become fully liquid. Are RSUs income? As far as the IRS is concerned, yes. It might be helpful to think of any fully vested RSUs you receive as no different than your salary compensation, at least for tax purposes. Just as you must pay ordinary income taxes on your salary, you must also pay ordinary income tax on your RSUs.
- You will pay taxes at the capital gains tax rate on any appreciation in the stock price from the time the stock was acquired to the time you sold it. Once your RSUs convert into shares of common stock, you can choose to either hold or sell them. Should you sell them, you will owe taxes on the difference in value from the time you acquired them to the date on which you sell them. The capital gains tax rate you’ll pay will depend on how long you’ve held the stock—more on that in a minute.
All of this is well and good. But you might still be wondering how much you’ll actually owe in taxes. To answer that question, let’s briefly review the different tax rates that apply to RSUs.
Understanding RSU tax rates
Two different tax rates may apply to RSUs: ordinary income tax rates and capital gains tax rates.
Which rate applies at a specific time depends on the circumstances. As we reviewed above, ordinary income tax rates apply when you receive your fully vested and liquid shares. Capital gains tax then applies on any profit you make from selling your shares.
Ordinary income tax rates
You will need to pay ordinary income tax on your RSUs when they vest and become fully liquid. Income tax rates apply at the federal and state levels.
The maximum federal ordinary income tax rate in 2022 is 37%, which applies to individual single taxpayers with incomes greater than $539,900 ($647,850 for married couples filing jointly). Those income numbers may seem a bit gaudy to you, but beware that an RSU windfall plus your normal salary plus any other income you receive might put you in that range. (Of course, this is the top marginal rate. It doesn’t mean you pay 37% on your entire income; just the amount over $539,900.)
You’ll want to check your state government’s site for details on the state ordinary income tax that may apply to your RSUs. Many states (California, for example) have equity-specific compensation guidelines to help you understand when and how stock compensation is taxed.
Capital gains tax rates
Capital gains tax rates apply to profits you make on assets you already own. Here’s an example of when capital gains tax might apply to RSUs:
- Your RSUs convert into shares of common stock at a stock price of $20 per share.
- You wait two years to sell all of your shares. On the date you sell your shares, the price per share is $30.
- The $10 difference between the stock price when you received the shares ($20) and the stock price when you sold ($30) will be taxed as capital gains.
Short-term capital gains tax vs. long-term capital gains tax
Be aware that there are two types of capital gains tax: short-term capital gains and long-term capital gains.
Short-term capital gains usually apply to profits you earn from selling assets you’ve held for a year or less. Short-term capital gains tax rates generally align with ordinary or regular income tax rate, so you don’t get any tax rate discount if you sell your shares within the first year.
Long-term capital gains, on the other hand, apply to profits you earn from selling assets you’ve held for longer than a year. Long-term capital gains tax rates can be significantly lower than ordinary income and short-term capital gains rates, which means there’s a tax benefit to holding onto your shares for longer. In the example above, you’d benefit from the long-term capital gains tax rate because you waited a year to sell your shares.
Are the taxes on RSUs different from the taxes on options?
Yes! Taxes are one of several key differences between RSUs and stock options.
As a general rule, stock options are only taxed after they are exercised and not when they vest. This differs from RSUs, which are taxed upon vesting.
Taxes are a bit more complicated with stock options, as your specific tax liability pay may differ based on the type of options granted in your stock plan.
Check out our guide to how stock options are taxed for a full rundown of how it works.
Are the taxes on RSUs different from the taxes on RSAs?
Yep, RSU taxes also work differently than taxes with restricted stock awards (RSAs).
The major difference between these two types of restricted stock is that RSAs are eligible for an 83(b) election and may solely be subject to capital gains tax if the 83(b) election is filed on time.
RSUs, on the other hand, are not eligible for an 83(b) election and are taxed as ordinary income at their full fair market value when they vest.
For more on this, check out our guide to the key differences between RSAs and RSUs.
Get more out of your equity with Pulley
An equity windfall can make tax planning seem like a much more daunting task—especially for employees who’ve never dealt with it before. Pulley understands this, which is why we’ve built out tools to help employees visualize their total equity compensation and understand what it all means.
Once you onboard with Pulley, all of your employees will get their own personal dashboard, complete with important vesting dates, signed documents, and other tools to help them better understand their stock compensation.
Pulley also offers a complete package of equity tools for founders. We can help with everything from cap table management and fundraiser modeling to creating your first audit-ready 409A valuation.
Set up a call with us today to learn more.
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