Money Matters

RSU Sell-To-Cover: Tax Tricks Explained

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.

The Sell-To-Cover Method Explained

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.

When is sell-to-cover a good method?
The sell-to-cover method is tax-efficient in many situations, especially when selling all of your shares would push you into a higher tax bracket. Additionally, this method effectively allows you to eliminate your tax obligation while also maintaining your position in the company by holding onto the remaining stock.

The following example will explain how the sell-to-cover method will impact your tax obligations.

In-Depth Analysis of The Sell-To-Cover Strategy

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 sells shares through either a forced sale or net issuance

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.

The company will pay the withheld taxes to the government

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.

The eventual sale of vested stock

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:

Capital gains tax

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.

Capital loss deduction

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.

Filing tax returns

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.

Alternative Withholding Tax Tricks

Same-day sale

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.

When is same-day sale a good method?
This method is tax-efficient in that you’ll have no capital gains to tax. If you believe that your company’s stock will decline in value, then the same-day sale method allows you to cash out while its price is certain. You can use the cash to invest in a diversified fund, or even to buy more company stock later on if you wish to.

Cash transfer

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.

When is cash transfer a good method?
This method is tax-efficient when you believe the stock will rise in value and want to hold it to make a profit later on. If you hold the stock for at least a year, you’ll pay the lower long-term capital gains tax rate if you eventually sell.

Key Takeaways

  1. If you receive RSUs at a public company, you may be able to choose how your taxes are withheld. 3 possible methods are sell-to-cover, same-day sale, and cash transfer.
  2. Each method has its own unique efficacy, but the sell-to-cover method is often regarded as the most complex of the three.
  3. Note that the sale of the company stock will incur capital gains tax if sold at a profit, or capital loss deduction if sold while down.

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