A restricted stock unit (RSU) is an award of stock shares, usually given as a form of employee compensation. The recipient must meet specific conditions before the restricted stock units are transferred to the owner.
Restricted stock units are issued to employees through a vesting plan and distribution schedule after they achieve required performance milestones or upon remaining with their employer for a certain length of time.
Restricted stock units give employees an interest in their employer’s equity but have no tangible value until they are vested. The RSUs are assigned a fair market value (FMV) when they vest. Restricted stock units are considered income once vested, and a portion of the shares is withheld to pay income taxes. The employee then receives the remaining shares and has the right to sell them.
Key Takeaways
- Restricted stock units are a form of stock-based employee compensation.
- RSUs are restricted during a vesting period that may last several years, during which time they cannot be sold.
- Once they are vested, RSUs can be sold or kept like any other shares of company stock.
- Unlike stock options or warrants, RSUs always have some value based on the underlying shares.
- For tax purposes, the entire value of vested RSUs must be included as ordinary income in the year of vesting.
Understanding Restricted Stock Units (RSUs)
Restricted stock gained popularity as a form of employee compensation as an alternative to stock options after the accounting scandals of the mid-2000s. At the end of 2004, a new regulation required companies to book an accounting expense for stock options issued. This action leveled the playing field among equity types.
Given those scandals, companies began to consider other types of stock awards for attracting and retaining talent. RSUs, which had usually been reserved for higher levels of management, became more common.
The median number of stock options granted individually by major companies dropped significantly between 2003 and 2005. In contrast, the median number of RSU awards rose markedly in the same period. In certain instances, vesting may be permitted to continue if an employee becomes disabled or retires.
Special Considerations
RSUs are treated differently for tax purposes than other forms of stock options. The entire value of an employee’s vested stock is counted as ordinary income in the year of vesting.
In order to declare the amount, an employee must subtract the original purchase of the stock or its exercise price from the FMV on the date it becomes fully vested. This difference is then declared as ordinary income by the taxpayer.
If the stock is sold at a later date (and not on the exercise date), the difference between the sale price and FMV is declared as either a capital gain or loss on the date of vesting.
Advantages and Disadvantages of RSUs
Advantages
RSUs provide an incentive for employees to stay with a company for the long term and help it perform well so that their shares increase in value. If an employee decides to hold their shares until they receive the full vested allocation and the company’s stock rises, the employee receives the capital gain minus the value of the shares withheld for income taxes and the amount due in capital gains taxes.
Administration costs are minimal for employers as there aren’t actual shares to track and record. RSUs also allow a company to defer issuing shares until the vesting schedule is complete, which helps delay the dilution of its shares.
Disadvantages
RSUs don’t provide dividends before they vest. But an employer may pay dividend equivalents that can be moved into an escrow account to help offset withholding taxes or be reinvested through the purchase of additional shares. The taxation of restricted stocks is governed by specific tax rules.
Restricted stock is included in gross income for tax purposes and is recognized on the date when the stocks become transferrable. This is also known as the vesting date.
RSUs aren’t eligible for certain tax elections that allow an employee to pay tax before vesting, as the tax authorities don’t consider them to be tangible property.
RSUs don’t have voting rights until actual shares get issued to an employee at vesting. If an employee leaves before the conclusion of their vesting schedule, they forfeit the remaining shares to the company. For instance, if an employee’s vesting schedule consists of 5,000 RSUs over two years and he resigns after 12 months, he forfeits 2,500 RSUs.
Pros
- Incentivize employees to stay with the company
- Employees receive capital gain minus value of shares withheld for income taxes
- Minimal administrative costs
Cons
- Don’t provide dividends
- Aren’t considered tangible property so employees can’t pay tax before the vesting period
- Don’t come with voting rights
Examples of RSUs
Suppose Madeline receives a job offer. Because the company thinks Madeline’s skill set is valuable and hopes she remains a long-term employee, it offers her 1,000 RSUs in addition to a salary and other benefits.
The company’s stock is worth $10 per share, making the RSUs potentially worth an additional $10,000. To give Madeline an incentive to stay with the company and receive the 1,000 shares, it puts the RSUs on a five-year vesting schedule.
Madeline receives 200 shares after one year with the company, another 200 shares after the second year, and so on until she acquires all 1,000 shares at the end of the vesting period.
Depending on the company’s stock performance, Madeline may receive more or less than $10,000.
Real-World Example
As a real-world example of what a company does to issue RSUs, take a look at the actions of an electric vehicle company. This company indicated that its chief accounting officer had received 4,808 restricted stock units and was converting them into common shares.
How Do Restricted Stock Units Work?
Restricted stock units are a type of compensation in which an employee receives shares of stock that are paid out over a period of years.
Restricted stock units fluctuate in value over time. From a company’s perspective, restricted stock units can help employee retention by incentivizing employees to stay with the company long-term. For employees, restricted stock units are a stake in a company’s success and occasionally produce very substantial income.
What Is the Difference Between Restricted Stock Units and Stock Options?
Stock options provide employees with the right but not the obligation to acquire shares of the company at a specified price. If the share price rises, the employee can acquire the shares and sell them at the higher market price.
Restricted stock units are awarded outright on a set series of dates over several years. The employee then owns the shares and can sell or keep them.
Do Restricted Stock Units Carry Voting Rights?
Restricted stock units do not carry voting rights until they become vested.
Once they are vested, the units are converted into common stock shares and carry all the usual rights of stock ownership.
The same goes for dividends: restricted stock units do not pay dividends until they vest.
Related Terms: vesting period, stock options, employee compensation, fair market value, capital gains taxes.
References
- Financial Accounting Standards Board. “FASB Issues Final Statement on Accounting for Share-Based Payment”.
- Journal of Accountancy. “Restricted Stock Awards and Taxes: What Employees and Employers Should Know”.
- Internal Revenue Service. “Equity (Stock) - Based Compensation Audit Techniques Guide”.
- Internal Revenue Service. “26 CFR 1.83-2: Election to Include in Gross Income in Year of Transfer”.
- Intuit TurboTax. “How to Report RSUs or Stock Grants on Your Tax Return”.
- Charles Schwab. “RSUs: Essential Facts”.
- Govinfo.gov. "§ 1244 - Losses on Small Business Stock".
