Restricted Stock Unit (RSU): How It Works and Pros and Cons

What Is a Restricted Stock Unit (RSU)?

A restricted stock unit (RSU) is an award of stock shares, usually given as a form of employee compensation. The recipient must meet certain 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 particular length of time.

Restricted stock units give employees 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.

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 involving companies like Enron and WorldCom. 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.

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 Fortune 1000 companies dropped by 40% between 2003 and 2005. The median number of RSU awards rose by nearly 41% in the same period.

Special Considerations

RSUs are treated differently for tax purposes than other forms of stock options. That is, 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 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 an employee's vesting schedule consists of 5,000 RSUs over two years and he resigns after 12 months, he forfeits 2,500 RSUs.

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 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, had received 4,808 restricted stock units and was converting them into common shares.

Source: SEC EDGAR