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Tax time can be stressful enough, but when you sell stocks during that year, they can be even more complicated. For example, if any of the stocks you sell are restricted stock units (RSUs), you could risk getting taxed twice if you don't know what you're doing.
Whether you work with a professional tax advisor or do your taxes yourself, knowing how to avoid double taxation on RSU sales is essential.
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What Are Restricted Stock Units (RSUs)
Restricted stock units are employer-paid benefits to compensate employees for their loyalty. They are shares of the company stock, provided with a vesting date and distribution schedule. You don't pay taxes on the RSUs on the grant date. Instead, you pay taxes on the shares given on the vesting date.
Most employers give RSUs with a long vesting period, with the first payout at least one year from your start date. From there, the RSUs usually vest in increments, so you can spread out when you receive your stock compensation and the taxes owed.
When the RSUs vest, you receive shares of common stock in your brokerage account, and the income becomes a part of your ordinary income using the fair market value of the shares. The income is reported on your paystub and W-2 at the end of the year, so you pay applicable income taxes on it. Therefore, your employer should withhold taxes when the shares vest.
However, that's not the end of the tax liability for the equity compensation. You must still pay capital gains tax on any profits earned when you sell the stocks. But, of course, you aren't obligated to sell the stocks; you are free to hold onto them as long as you wish or sell them at any time.
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RSU Taxation - Are RSUs Taxed Twice?
Here's the problem. If you file your taxes incorrectly, you may mistakenly pay double the taxes on RSUs when selling them.
It all boils down to the cost basis on the stocks and reporting the equity compensation properly. If the cost basis is misreported, or you overlook the ordinary income taxes already paid, you could accidentally pay taxes twice.
What Is Double Taxation?
Double taxation means you pay tax twice on the same income. This often happens when Form 1099-B isn't properly completed, and the tax advisor doesn't know the shares were a form of equity compensation.
If overlooked, you might pay ordinary income taxes on the vesting date and again when you sell the shares.
How Do RSUs Get Taxed?
So how do RSUs get taxed?
You'll owe taxes on your equity compensation twice, at vesting and when you sell.
- Vesting - On your vesting date, you automatically own shares of the company stock. The stock has a fair market value which is your cost basis. This amount is added to your pay, much like a bonus, and taxed when your shares vest.
- Selling - When you sell your shares, you'll pay capital gains tax, just like any other profits you earn on assets. Capital gains tax rates are lower than most ordinary income tax rates and range from 0% to 20%.
When Are RSUs Taxed?
It sounds crazy, but you will pay taxes on RSUs twice, first when they vest and second when you sell them. You have a tax liability initially because the restricted stock units are compensation, so you pay ordinary income tax.
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Signs You're Being Taxed Twice
It's essential to work with a tax professional if you get paid in RSUs to ensure you aren't taxed twice on the RSU income.
The most significant warning sign that you're being taxed twice on your restricted stock units, RSUs, is what appears in Box 1e on your 1099-B when you sell the shares. If the box says $0, then when you prepare your tax returns, you'll likely pay taxes on the entire difference between the sale price and cost basis, when instead, you should only pay it on the profits earned.
How to Avoid Double Taxation
To avoid double taxation and to ensure your tax return is correct, there are a few steps you should take.
Locate Supplemental Tax Documentation
Don't rely only on the 1099-B form. Instead, supply proof of the true cost basis of the restricted stock unit so you only pay taxes on what you owe.
Some documentation may include the following:
- Records from your company supporting the vesting date and number of shares
- Supplemental data on the 1099-B stating the cost basis
Accurately Report RSU Sales
When you sell your RSUs, you must report the RSU income. Your income is the difference between the cost basis on which you already paid taxes and the stock price when you sell it.
Accurately reporting the sales will ensure you pay the correct capital gains tax rate.
Do RSUs Count as Income?
RSUs are equity compensation and count as income. You pay income tax on the amount vested when you receive it. Think of it like receiving a bonus. You'd pay tax on the compensation received when you receive it, which is true of RSU income.
Understanding Cost Basis and Proceeds
Again, understanding the difference between the cost basis and proceeds is essential because you must cover your tax liability when your shares vest. Because you may have a long vesting schedule, you may pay taxes on the shares over time.
The cost basis is the stock price on the vesting date. You'll see the income reported on your W-2 and pay stub. The proceeds are any money you earn from selling the vested shares.
If you sell the shares after holding them one year or longer, you'll pay long-term capital gains tax. However, if you sell them immediately or within one year of becoming vested, you'll pay short-term capital gains tax, which has the same rates as the ordinary income tax rate.
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Double Taxation Impacts on RSUs
Double taxation is like paying as much as 70% on your RSUs, which is unnecessary. You'll lose most of your income from the compensation by not following the taxation rules.
Addressing and Rectifying Double Taxation
If you determine you paid double tax on your RSUs within the last three years, you can file an Amended tax return, 1040-X. This allows you to rectify the issue, report the right cost basis and get a refund of your tax overpayment.
RSU Taxation Example
Here's a quick example to explain RSU taxation.
Let's say you receive 500 shares at $10 a share on your vesting date. Your employer reports the income on your paystub and collects the necessary taxes for the $5,000 cost basis. You then decide to sell the shares at $13 a share, making $3 a share, for a gain of $1,500.
You owe capital gains taxes on the $1,500 capital gain, but because you kept the shares for three years, you'll pay long-term capital gains tax on the proceeds.
Here's the problem. When you receive your 1099-B for selling the shares, your brokerage firm didn't realize you receive restricted stock units, so they entered $0 because they don't know the cost basis.
This could have led to double taxation. Fortunately, you worked with a reputable tax advisor who was savvy enough to ask questions about the shares and discovered they were restricted stock units.
So now you'll pay capital gains tax on only $1,500. If your advisor didn't figure that out, you'd pay taxes on $6,500, even though you've already paid ordinary income tax on the $5,000 cost basis.
Your tax advisor was able to help you avoid double taxation. If he didn't, you could have filed an amended tax return in the future, but that's like giving the IRS free money, so it's best to avoid it in the first place.
How to Avoid Double Taxation on RSU Sales - The Bottom Line
You must pay taxes on your RSU sales, but that doesn't mean you should overpay. Therefore, it's essential to know how to avoid double taxation on RSU sales or to use a tax professional that understands employee compensation and how it affects your taxes when you sell shares of your company stock.
If your RSU income isn't appropriately reported, be sure to have the necessary documentation to avoid double taxation of RSUs.