What Is a Restricted Stock Lapse & How Does It Work?

Equity compensation is a common employee benefit, offering individuals a stake in their company’s future success. This non-cash compensation often includes restricted stock and restricted stock units (RSUs). Understanding “lapse” is important for employees, as it signifies a key event in the lifecycle of restricted stock, impacting ownership rights and financial obligations.

Understanding Restricted Stock and Vesting

Restricted stock and restricted stock units (RSUs) are equity compensation providing employees with company shares or the right to receive them. These awards are “restricted” by conditions that must be met before full ownership is granted. Restricted stock awards (RSAs) transfer shares at grant, but are subject to forfeiture until conditions are satisfied. RSUs represent an employer’s promise to deliver shares once criteria are fulfilled.

The primary conditions for these awards to convert into full ownership usually involve either time-based or performance-based vesting. Time-based vesting requires an employee to remain with the company for a specified period, with ownership often accruing gradually. Performance-based vesting depends on achieving specific company or individual goals, such as revenue targets or project completion.

Vesting is the process by which an employee gains full ownership rights to their equity awards by meeting predetermined conditions. Until shares are vested, they cannot be freely sold or transferred. Unvested equity may be forfeited if an employee leaves the company prematurely.

The Mechanics of a Restricted Stock Lapse

A “lapse” in the context of restricted stock and restricted stock units occurs at the precise moment the restrictions on these awards are removed. This event typically coincides with the fulfillment of the vesting conditions, such as the completion of a required employment period or the achievement of specific performance targets. When these conditions are met, the shares are no longer subject to forfeiture and the employee gains full legal ownership.

The terms “lapse” and “vesting” are often used interchangeably to describe this critical point in the equity award’s lifecycle. For restricted stock, the shares previously held under restriction become entirely the employee’s property. For RSUs, which represent a right to receive shares, actual company shares are issued and transferred to the employee’s brokerage account at the time of lapse.

This transition signifies that the employee now possesses unrestricted shares, which can be held or sold at their discretion. The fair market value of the shares at this moment is important for subsequent financial considerations.

Tax Implications of a Restricted Stock Lapse

When restricted stock or restricted stock units lapse, the fair market value (FMV) of the shares at that time is generally considered ordinary income to the employee. The amount of taxable income is determined by the FMV of the shares on the vesting date, minus any amount the employee paid for the grant.

This ordinary income is subject to federal income tax, state income tax (if applicable), Social Security tax (FICA), and Medicare tax. Employers typically handle tax withholding at the time of lapse, often by withholding a portion of the shares or allowing the employee to sell shares to cover the liability.

The income recognized from the lapse of restricted stock or RSUs is reported on the employee’s Form W-2 for the year in which the lapse occurs. This ensures the income is properly included in total annual compensation.

Post-Lapse Considerations

Once restricted stock or restricted stock units have lapsed, the employee gains full ownership of the shares and has several options. The shares can be held for potential future appreciation or sold immediately for liquidity.

When shares lapse, their fair market value on that date establishes the employee’s cost basis for tax purposes. This cost basis is crucial because it determines any capital gain or loss when the shares are eventually sold. If the employee holds the shares and their value increases beyond this initial cost basis, selling them will result in a capital gain. Conversely, a decrease in value would result in a capital loss.

The tax treatment of any subsequent capital gain or loss depends on the holding period after the lapse date. If the shares are sold within one year of the lapse, any gain is considered a short-term capital gain and is taxed at ordinary income tax rates. If the shares are held for more than one year after the lapse, any gain is classified as a long-term capital gain, which typically benefits from lower tax rates.