If you receive part of your compensation as RSUs, you should understand how sell-to-cover and other tax withholding strategies work.
If you receive restricted stock units (RSUs) as part of your compensation at a public company, you’ll pay taxes twice: ordinary income taxes at vesting and capital gains taxes when you sell your shares.
Companies will often withhold taxes from your RSUs, or they may let you decide on the withholding method. We’ll focus on one tax withholding method in particular called the sell-to-cover method as it’s the most widely used. We’ll also discuss two alternative methods called same-day sale and cash transfer.
Throughout this article, we will be using examples to show you how sell-to-cover and alternative methods work. For the sake of simplicity, we’ll suppose that your tax withholding rate is 25%, the value of one share is $10, and you receive 100 shares.
This method allows the employer to sell just enough of your vested RSUs to cover the tax burden and distribute the remaining shares to the employee. In this method, the employee is left with stock.
Example: Since the price of the vested stock is $10 and you own 100 shares, the total value of your stock is $1000. However, since your tax withholding rate is 25%, you owe $250 of your compensation to the government. In the sell-to-cover method, your employer will choose to sell 25 shares of the total 100 to pay off the tax withholding fees of $250. Therefore, you’re left with 75 shares of the stock and no tax obligations.
The following example will explain how the sell-to-cover method will impact your tax obligations.
For this example, we will begin by indicating some baseline metrics. The employee in question, Mr. Jones, earns $50,000 a year with $5,000 allocated to other taxes withheld.
Mr. Jones is given 100 units of company stock priced at $10 per share as part of his compensation package, so his vested RSUs are valued at $1,000. The tax withholding rate in this example is also 25%.
The company Mr. Jones works for went ahead and sold the 25 shares he owes in tax withholding on his behalf. If the company uses a broker as an intermediary in this process, Mr. Jones will report those $250 as a forced sale.
However, if the company does not use a broker, then the 75 shares will be distributed as a net issuance, and Mr. Jones will not have to do anything else on his tax forms until he sells those remaining shares.
As mentioned above, Mr. Jones already had $5,000 of taxes withheld. He will have an additional $250 withheld from his RSUs to get a new total of $5,250. His employer will pay these taxes to the government.
Mr. Jones will have no further obligation. However, if the shares begin to rise in value, they will incur capital gains tax. This form of taxation is due after a sale on the units. Therefore, Mr. Jones will not have to pay for the positive performance of the stock unless he actualizes the profits by selling them for a net gain.
If the stock decreases in value, it will be considered a capital loss, and will be deducted from Mr. Jones’ total income at the time of due taxation. Let us consider each of these possibilities in the following two examples:
After a year, the price of one share in the company stock increases from $10 to $20. Since Mr. Jones owns 75 shares, he now has $1500 worth of stock as opposed to the original $750 he owned when the units initially vested. If Mr. Jones decides to sell that stock, he will have been said to earn $750 in capital gains. In this situation, let’s assume that capital gains are taxed at 15%. This means that Mr. Jones owes $112.50 worth of taxes and is left with $637.50 leftover as capital gains.
Instead, assume that the stock drops from $10 to $5 a share, so Mr. Jones finds himself with a capital loss. With 75 shares equating to $375 instead of $750, Mr. Jones has lost $375 when he decides to sell at a loss. Since his taxable income was previously listed at $51,000- he will be allowed to subtract the $375 he lost for a new value of $50,625.
Mr. Jones receives a W-2 form from his employer at the end of the year which indicates his income and taxes withheld. If his employer withheld shares through a net issuance, then he has nothing to report, but if it used a forced sale, he’ll have to report it.
If Mr. Jones sold his remaining shares, he’d have to report the capital gains or losses on his tax return.
In this method, your employer will sell all of your shares on the day they vest. After the sale, your employer will allocate the appropriate amount of tax withholding and deduct that from the total profits of the sale. In this method, you’re left with cash.
Example: So, the total value of your stock is $1000, you owe $250 of your compensation to cover your 25% tax withholding. In this method, your employer sells your vested stock immediately, using $250 to pay your impending taxation. Upon completion of this payment, they distribute the remaining $750 to you.
This method places the obligation of employer tax payments onto you, the employee. You’ll use your own cash to pay these taxes in order to keep all of your stock units. In this method, you’re left with stock.
Example: In this method, you pay the $250 owed to the government directly out of your pocket, in hopes that the value of the stock will continue to increase. Compared to the previous method, cash transfers allow you to continue generating capital gains by owning the stock. This situation leaves you with 100 units of the stock and $250 less in your pocket.
The information provided herein is for general informational purposes only and is not intended to provide tax, legal, or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation of any security by Candor, its employees and affiliates, or any third-party. Any expressions of opinion or assumptions are for illustrative purposes only and are subject to change without notice. Past performance is not a guarantee of future results and the opinions presented herein should not be viewed as an indicator of future performance. Investing in securities involves risk. Loss of principal is possible.
Third-party data has been obtained from sources we believe to be reliable; however, its accuracy, completeness, or reliability cannot be guaranteed. Candor does not receive compensation to promote or discuss any particular Company; however, Candor, its employees and affiliates, and/or its clients may hold positions in securities of the Companies discussed.