Restricted Stock Unit (RSU)

What Is a Restricted Stock Unit (RSU)?

The term restricted stock unit (RSU) refers to a form of compensation issued by an employer to an employee in the form of company shares. 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 particular length of time. RSUs give employees interest in company stock but no tangible value until vesting is complete. The RSUs are assigned a fair market value (FMV) when they vest. They are considered income once vested, and a portion of the shares is withheld to pay income taxes. The employee receives the remaining shares and can sell them at their discretion.

Understanding Restricted Stock Units (RSUs)

Restricted stock gained popularity as a form of employee compensation as a better alternative to stock options after accounting scandals in the mid-2000s involving companies like Enron and WorldCom came to light. At the end of 2004, the Financial Accounting Standards Board (FASB) issued a statement requiring companies to book an accounting expense for stock options issued. This action leveled the playing field among equity types.

Stock options were previously the vehicle of choice, but with scandals, malpractice, and issues of tax evasion, companies were able to consider other types of stock awards that might be more effective in attracting and retaining talent. RSUs, which were typically reserved for higher levels of management, were being granted to all levels of employees around the world.

Accordingly, the median number of stock options granted individually by Fortune 1000 companies dropped by 40% between 2003 and 2005. The median number of RSU awards rose by nearly 41% between that two-year period.

There are certain instances when vesting may be permitted (depending on the plan) to continue if an employee cannot continue working, such as a disability or retirement.

Special Considerations

RSUs are treated differently than other forms of stock options when it comes to how they are taxed. Unlike these other plans, the entire value of an employee's vested stock is counted as ordinary income in the same 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 Restricted Stock Units (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 because actual shares aren't allocated. 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 Section 1244 of the Internal Revenue Code (IRC).

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 the IRC 83(b) Election, which allows an employee to pay tax before vesting, as the Internal Revenue Service (IRS) doesn'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 John's vesting schedule consists of 5,000 RSUs over two years and he resigns after 12 months, he forfeits 2,500 RSUs.

Examples of Restricted Stock Units (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 December 2017 SEC Form 4 filed by the electric vehicle company Tesla (TSLA). This form indicates that the company's chief accounting officer, Eric Branderiz, wished to convert 4,808 restricted stock units he received into common shares.

Source: SEC EDGAR

How Do Restricted Stock Units Work?

Restricted stock units are a type of compensation in which a company gradually transfers shares to an employee. Depending on the performance of the company, restricted stock units can fluctuate in value. 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 can help to share in some of the upside associated with a company’s success, occasionally producing 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 at a specified price, which is typically higher than the market price prevalent at the time the options are given. This typically means that the employee benefits only if the company’s share price rises within a specified period of time. Restricted stock units, on the other hand, are often structured so that the employee receives a certain number of shares after remaining with the company for a set period of time.

Do Restricted Stock Units Carry Voting Rights?

No, restricted stock units do not carry voting rights. In order to vote, the employee would need to wait until their restricted stock units are actually paid out and converted into common shares. Similarly, prior to this conversion into common shares, restricted stock units do not pay dividends.