If you are a small business owner who has received restricted stock units (RSUs) as part of your compensation, you need to ensure that you are withholding taxes appropriately, or else you could end up owing money to the IRS at the end of the year. In this article, we’ll break down why, and what you can do about it proactively to avoid the situation.
First, let’s define what an RSU is: Essentially, it is a substitute for an actual stock grant. This means that when a company gives you an RSU, it is in lieu of company stock, but it will be exchanged for actual stock in the future. The vesting date for these assets is the time at which you take ownership of the actual shares, which is often at a specific time or based on specific performance parameters.
There is no immediate tax liability incurred when you first receive an RSU,it is when your RSU vests that you have a tax obligation, based on the payout of stock shares.This is the income you need to report on your taxes, based on the fair market value of the stock.
A potential problem can arise if your tax withholding (or estimated tax payments) are not adequate when your RSUs are vested and you have to pay income tax on it. This situation can really mess with your marginal tax rate, considering that typical Federal withholding is a flat 22% (or 37% if an individual’s income is over $1million). However, for many people who are below $1 million in income, this rate for tax withholding is inadequate and can lead to an unexpected tax bill.
The solution to a potential tax obligation related to RSUs is to withhold taxes at your marginal tax rate. The marginal tax rate is the tax you pay on an additional dollar of income. In the United States, the federal marginal tax rate for individuals increases as income rises. This means that your marginal tax rate will likely be lower than your actual tax bracket. You will also owe payroll taxes on your RSU, which will add to the amount of tax you should set aside.
Another consideration are any capital gains or losses based on when you sell your vested RSUs. For example, if you sell the stock at a higher price than its fair value at the time of vesting you will need to report a capital gain. If you have held the RSU for less than a year, you will be on the hook for your regular tax rate. After a year or more the gains will be taxed at a lower tax rate.
If you pay estimated taxes on a regular basis and your RSU becomes vested you will be expected to include this as part of your income and pay income tax accordingly during the next quarter.
Beware of the differing RSU tax triggers. RSUs can be offered with different restrictions such as being subject to only a vesting schedule; these are called single-trigger RSUs. For some RSUs, called double-trigger RSUs, additional conditions must also be met along with vesting.
Another way to reduce taxes on RSUs is to invoke the IRS regulation related to Section 83(b) Elections which allows holders of RSUs to report the fair market value of their shares as ordinary income on the date that they are granted, rather than when they become vested. Any capital gains are still taxed, but they are taxed at the time of grant. This can help you pay tax on usually a lower value stock since it is often expected that RSUs will appreciate over time.
This also means that you may want to sell RSU shares at tax time, especially if you believe the stock price will increase. However, there are no guarantees that this will be the case, so you may want to keep tabs on the value of your RSUs throughout the year and check with a tax professional to ensure that you won’t be charged tax penalties for underpaying your taxes.