Restricted stock units (RSUs) continue to be a popular form of equity compensation. This article covers ten things every compensation professional should know about RSUs.
1. How are RSUs different from restricted stock?
RSUs represent a contractual right to receive shares, or a cash payment of equal value, in the future. This contractual right is unfunded, meaning that it is a mere promise to pay on the part of the issuer. The contractual nature of RSUs is the primary difference between RSUs and restricted stock. An award of restricted stock, unlike RSUs, consists of currently issued and outstanding shares that are subject to a risk of forfeiture and restrictions on transferability. Ultimately, both RSUs and restricted stock represent compensation equal to the value of a share of stock, but the contractual nature of the RSUs permits greater flexibility in the areas of tax planning and capital structure. Restricted stock generally includes voting rights even prior to vesting, while RSUs never include voting rights.
2. Popularity continues to be high.
RSUs have been used for decades, but their popularity has increased dramatically in the last 10-20 years. In a recent survey of 325 companies, 72% reported using RSUs in their long-term incentive compensation programs compared to only 47% ten years earlier and 4% 21 years earlier. At the same time, the prevalence of restricted stock decreased significantly, falling to 14% of companies in 2019 from 32% ten years earlier.
3. RSUs can defer time of income taxation.
In contrast to restricted stock, the income taxation of RSUs generally can be delayed beyond vesting. Deferring the tax event can allow an employee or director to pay fewer taxes in the short-term. If the RSU recipient is given the opportunity to choose the timing of the future payment event, moreover, he or she can coordinate the timing of the tax recognition on the RSUs with his or her overall financial plan. The deferral of the tax event for the RSU recipient may be disadvantageous to the issuer, however, since it also delays the issuer’s tax deduction.
Any deferral of RSUs must comply with Section 409A of the Code, which governs all nonqualified deferred compensation, including deferred RSUs. RSUs that do not comply with Section 409A can be subject to significant adverse tax consequences to the award recipient, including immediate taxation upon vesting, a 20% additional income tax, and an interest penalty.
The two primary requirements of Section 409A relate to (1) the timing of payment and (2) the timing of the election to defer payment. With respect to the timing of payment, Section 409A requires that deferred RSUs be paid (or begin to be paid if installments are elected) on one of the following Section 409A-permitted events:
- Separation from service
- Change in control event
- Specified time or fixed schedule
- Unforeseeable emergency
The payout triggered by the permitted event may occur in a lump sum or in installments, but in general it cannot be accelerated. For publicly traded companies, there is an additional requirement of a six-month delay on payments to certain specified employees that result from a separation from service.
In addition to these restrictions on the timing of payments, Section 409A includes detailed rules on when the permissible payment event and the form of payment must be selected. The general rule (subject to many exceptions) is that the time and form of payment for any deferred compensation must be irrevocably elected in the year before the year in which the services to earn the compensation are performed. For example, for a grant of fully vested RSUs to be made in 2021 by a calendar year company, the initial deferral election rules may require the deferral election to be made by December 31, 2020. (Note that these are general rules; the actual taxability of RSUs should be assessed in the context of the particular terms of the RSU.)
A deferral election can also be made within the first 30 days following grant, but only with respect to RSUs that will vest at least 12 months after the date of the deferral election. The fact that RSUs may vest within such a 12-month period due to death, disability, or a change in control event (as defined in Section 409A) does not preclude the deferral election but, if the RSUs actually vest within the first 12 months, the deferral election cannot be honored.
Section 409A requires that any deferral election be documented in keeping with its rules. An election to defer RSUs can be documented as part of the RSU award agreement, a separate deferral election form signed by the company, and the RSU holder or a nonqualified deferred compensation plan maintained by the company. A Code Section 83(b) election, under which an award recipient may elect to have the value of restricted stock included in income at the time of grant by filing an election within 30 days, generally is not available for RSUs.
4. Recent IRS guidance on the taxation of RSUs:
Earlier this year, the IRS’s Office of Chief Counsel released a Generic Legal Advice Memorandum (Memo) that provided guidance on the timing and amount of withholding and deposits for certain equity award types, including RSUs. For RSUs, the Memo indicated that the date as of which the shares subject to RSUs should be valued and included as income and be treated as subject to withholding for tax purposes is the date on which the employer initiates payment, even if the shares issued in payment are not actually delivered until a later date.
5. FICA may be due earlier than income taxes.
The FICA tax event, in contrast to the income tax event, for employee holders of RSUs cannot be delayed beyond the date on which the RSUs are no longer subject to a substantial risk of forfeiture. FICA tax is due for RSUs upon vesting, even if payment and income taxation of the RSUs is delayed.
6. RSUs can solve retirement vesting tax issue.
RSUs can help to address one common problem encountered by issuers who accelerate vesting of restricted stock upon the award holder’s retirement. This type of retirement vesting can inadvertently trigger taxation upon retirement eligibility, rather than actual retirement. Restricted stock becomes taxable when it is vested for tax purposes, which occurs when the award is no longer subject to a substantial risk of forfeiture.
For example, if an award of restricted stock provides for accelerated vesting upon the award holder’s retirement and defines retirement as any termination of employment after reaching age 65, the IRS considers that award to be vested when the award holder reaches age 65, even if he or she continues working. Since the award holder can quit at any time and keep the award, it is no longer subject to a substantial risk of forfeiture. Thus, the restricted stock becomes taxable to the employee even though he or she has not retired, and, depending on the terms of the award, the liquidity of the shares, and any insider trading considerations, the employee may not be able to sell shares to raise the funds to cover the taxes.
RSUs can address this issue by providing that the award will not be paid until a fixed date or separation from service, even if it vests before then. Choosing separation from service as the payment date may delay income taxation of the RSUs until actual retirement.
7. RSUs can reduce state tax liability.
RSUs can be used to reduce state income tax liability in some circumstances. As a general rule, compensation is taxed by the state in which it is earned. Under the federal source tax rule, however, “retirement income” may be taxed only by the state of which the recipient is a resident or domiciliary.
RSUs that are deferred until separation from service and paid out in 10 or more annual installments are considered retirement income for purposes of this rule. This suggests some possible tax planning strategies. As an example, if a recipient of RSUs intends to reside in a low-tax state, such as Florida or Texas, after retirement, he or she may arrange for the RSUs to be taxed in the low-tax state by deferring payment of his or her RSUs until separation from service and choosing payment in 10 annual installments. (Reference should be made to specific state laws and the terms of the RSU to assess the state-taxation implications of any RSU exercise.)
8. RSUs can help executives satisfy stock ownership guidelines requirements.
RSUs can help executives to satisfy stock ownership requirements. Many publicly-traded companies have stock ownership guidelines that require their executive officers or directors to hold a number of shares representing a multiple of their compensation. These requirements are thought to encourage the alignment of the interests of the company’s management with the interests of the company’s shareholders.
Typically, when restricted stock vests, the award holder surrenders a portion of the shares subject to the award to satisfy the taxes that are due as a result of the vesting and settlement. This leaves the award holder with only the “net” amount of shares to count toward the stock ownership guidelines.
If deferred RSUs are used instead, the income taxes may not be due immediately, and the total, pre-tax number of shares subject to the RSUs can continue to count toward the award holder’s compliance with the ownership guidelines.
9. RSUs allow flexibility over dividend rights.
RSUs may include a right to receive payments similar to dividends, known as “dividend equivalent payments,” or they may include no dividend rights.
10. RSUs allow flexibility over settlement in shares or cash.
RSUs may be paid in cash or in shares, whereas restricted stock always involves the issuance of shares. Cash-settled RSUs can allow employees to participate in their employer’s equity appreciation without diluting the employer’s shareholders or giving the employees voting or other minority shareholder rights.
Whether RSUs are paid in cash or shares affects the accounting treatment of the RSUs. The details of RSU accounting are beyond the scope of this brief discussion, but, in general, RSUs that can be settled only in shares receive accounting treatment similar to restricted stock. The fair value of the award, based on the stock price at the time of the grant, is expensed over the service period. On the other hand, if the RSUs may be settled in cash, then they may be subject to liability accounting, requiring them to be marked to market periodically. (Consult your accountant to assess the details of your company’s accounting situation if you have issued RSUs.)
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