What Are Vested Shares & How Are They Taxed?
Demystify vested shares and their tax treatment. Understand how employee stock ownership impacts your financial future.
Vested shares represent a common form of employee compensation, granting individuals full ownership of company stock over time or upon meeting specific conditions. This article explores the concept of vesting and its tax implications.
Understanding Vesting
Vested shares are company stock an individual gains full ownership rights to over a specified period or after achieving certain milestones. Companies utilize vesting to encourage employee retention, align employee interests with company success, and incentivize long-term performance.
One common method is time-based vesting, where ownership is granted by remaining employed for a set period. Cliff vesting involves a waiting period, such as one year, before any shares vest, followed by gradual vesting over subsequent months or quarters. An employee might receive 25% of their granted shares after the first year, with the remaining 75% vesting monthly over the next three years.
Graded vesting distributes ownership incrementally over several years from the start. An employee might receive 25% of their shares each year over a four-year period, with portions vesting annually on the grant date anniversary. This method provides a steady flow of ownership, rewarding continued service.
Beyond time, vesting can also be tied to the achievement of specific performance metrics. Performance-based vesting schedules require individuals or the company to meet predefined goals before shares become fully owned. These metrics might include reaching sales targets, completing significant projects, or achieving specific company revenue or profitability benchmarks.
This type of vesting directly links an employee’s compensation to their contributions to the company’s success. A sales executive’s shares might vest only if they exceed a certain revenue quota, or a team’s shares could vest upon the successful launch of a new product. Some companies may also employ hybrid approaches, combining elements of both time-based and performance-based vesting. Once shares become vested, the individual gains full legal ownership and control, allowing them to sell, hold, or transfer the shares, subject to company policies or trading windows.
Taxation of Vested Shares
When shares vest, it constitutes a taxable event for the recipient. The Internal Revenue Service (IRS) views the value of these shares as a form of compensation. The fair market value (FMV) of the shares at the time of vesting is subject to ordinary income tax.
The income recognized is the fair market value of the shares on the vesting date. This value is added to the employee’s regular wages and is subject to federal income tax, Social Security, Medicare, state, and local income taxes. Many companies withhold a portion of the vested shares or cash to cover these tax obligations.
If vested shares are held after vesting and then sold, any appreciation in their value from the vesting date to the sale date will be subject to capital gains tax. The cost basis for calculating capital gains is the fair market value of the shares on their vesting date.
Capital gains are categorized as either short-term or long-term, depending on how long the shares were held after vesting. Shares held for one year or less after vesting are subject to short-term capital gains rates, which are typically the same as ordinary income tax rates. Conversely, shares held for more than one year after vesting qualify for potentially lower long-term capital gains rates, offering a tax advantage for longer holding periods.
Restricted Stock Units (RSUs) are a common form of equity compensation taxed as ordinary income upon vesting. When RSUs vest, the fair market value of the shares is included in the employee’s gross income for that tax year. This amount is reported on the employee’s Form W-2, similar to regular salary or bonus income.
Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs)
Non-Qualified Stock Options (NSOs) have different tax implications. When an employee exercises NSOs, the difference between the fair market value of the stock on the exercise date and the exercise price is taxed as ordinary income. Any subsequent appreciation in value from the exercise date until the sale of the shares is then subject to capital gains tax. Incentive Stock Options (ISOs) offer potentially more favorable tax treatment but come with complex rules, including possible exposure to the Alternative Minimum Tax (AMT).
Reporting Vested Shares
For most vested shares, the ordinary income component will be reported on a Form W-2, while the sale of shares and any resulting capital gains or losses will be reported on a Form 1099-B, which is provided by the brokerage firm. This information is then used to complete Schedule D and Form 8949 when filing federal income taxes.