Restricted stocks, also known as restricted securities, refers to those unregistered shares whose ownership cannot be transferred by the shareholder until certain conditions are met. This means a stockholder can exercise the right to transfer a stock only after the fulfilment of certain conditions. These conditions usually include:
Usually, restricted stocks are awarded to employees of a company as equity compensation. Restricted stocks are profitable for a company in the sense that until these stocks are earned and issued, they do not give any ownership rights to the employees. The employees are granted the shares either on the condition that they will stay in an organisation for a pre-defined number of years or until the organisation achieves a particular milestone.
These conditions are imposed to prevent their premature selling, as this can impact a company negatively. Typically, restricted stocks are subject to a graded vesting schedule, which has a longer duration. Another word for restricted stock is “letter stock.” Restricted stocks are more common in established or reputed organisation to keep their employees motivated.
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With restricted shares, an employee gets a claim in the company; however, that is not valuable until an employee vest. Vesting gives an employee the right over the assets provided by the employer and motivates him to stay in the company. The vesting schedule of a company decides when an employee will have complete ownership over an asset. Restricted stocks became more popular when companies were required to pay for stock option grants. This happened in mid the 2000s. The two conditions which must be fulfilled for these stocks to become transferable are i) Continuous employment for a predetermined period ii) Fulfillment of preplanned performance objectives and earning per share (EPS) goals.
These stocks are unrestricted if the company merges with some other corporation or if there is an acquisition. Furthermore, if an executive is laid off during merger/acquisition, he is likely to forfeit the restricted stock. Other reasons for an executive to lose his shares in a public-traded company can be a failure to meet the performance goals and non-compliance with the Securities and Exchange Commission (SEC) regulations. This means that an executive will lose his restricted stock if they fail to meet the performance targets or violate SEC rules in the US.
1) Restricted stock unit (RSU)
A restricted stock unit or RSU is an assurance or a promise by an employer to an employee to grant a certain number of shares of the company’s stocks at a predetermined future date. Holders of RSUs carry no voting rights because they are not actual stocks. To receive stock, an employee must exercise RSU.
2) Restricted stocks award
Restricted stock awards are more or less similar to restricted stock units. However, the only difference between the restricted stocks unit and the restricted stocks award is that the latter comes with voting rights. Thus, as soon as these stocks are awarded, an employee can exercise voting rights. Besides, in RSU, an employee is allowed to receive the cash value of the restricted stock unit in exchange for a stock award; however, in restricted stock awards, employees are not allowed to redeem the cash value of restricted stock awards.
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The Internal Revenue Code (IRC) governs the taxation on restricted stocks. It is usually considered a complex process. Capital gains or loss on restricted stock is equal to the gap between the stock’s price on the date when it is sold and the date when it vests. When it comes to taxation, a restricted stockholder will pay tax on these capital gains or losses. Section 1244 of the IRC regulates the taxation of restricted stock. Besides, restricted stocks are taxed as ordinary income for the year they vest. This is contrary to stock options, as they are not taxed when they are vested.
For taxation purpose, the amount of restricted stock that must be considered is the gap between fair market value of the stock on the vesting date and the initial/original exercise price of the stock.
However, section 83(b) election of the IRC allows the restricted stockholder to recognise the income from the restricted stock on grant date rather than the vesting date to calculate the ordinary income tax.
This is mainly done to minimise income tax liability. However, this is risky because if the restricted stockholder joins another company before the shares vest, then the taxes paid are non-refundable.
Advantages of Restricted Stocks
Disadvantages of Restricted Stocks