Compensation is one of the most important aspects of a company’s strategic plan. Employees care not only about their immediate compensation, but also about their potential to grow with the success of the company. Offering company stock as compensation has been commonplace in corporate America over the past 50 years, but in today’s changing business world, equity compensation is increasing in importance.
This article will explore two types of equity compensation: restricted stock units (RSU) and restricted stock awards (RSA). RSUs and RSAs will first be explained, followed by a discussion of the accounting implications and a comparison of the two. For more detailed information on stock options, see our Stock Options 101 (For Employees) article.
Restricted Stock Units
RSUs represent an interest in company stock, but they have no tangible value until the shares vest and restrictions for the employee lapse. In other words, RSUs are an unfunded promise to issue a specific number of shares at a future time once vesting conditions for the employee have been satisfied. The “vesting period” for RSUs represents the time until the shares are unconditionally owned. RSUs cannot be sold or otherwise treated as owned by employees until they have the legal right on the vesting date. The restrictions often include a time-based requirement and/or performance metric(s) to be met before the RSUs vest. RSUs also provide an option to receive the cash value of the RSU in lieu of shares once vested. This option to receive cash value does not exist for restricted stock awards. Another difference is that stock is not issued for an RSU until restrictions lapse, so RSUs do not count as outstanding shares.
RSUs are considered “full value” awards since employees never have to pay for them. This represents one of the major appeals of RSUs to employees, because RSUs always have value once vested, even if the stock price plummets. They have also become increasingly popular since they are useful in retaining key management. According to The Ayco Company’s October 2019 study of 325 companies, “Performance-based awards have become the most common long-term incentives granted to executives at large companies, while stock option utilization has declined.”1
A common restriction for RSUs is a time-based component, which makes the award dependent upon the employee or executive spending a certain length of time with the company. This can help incentivize management teams to focus on the long-term success of the company; however, time-vested awards have also been criticized as “pay for pulse,” because the executive or employee can receive significant value even without stock price appreciation. Thus, in the past few years we have increasingly seen the addition of performance vesting features in RSU awards.
RSUs are used in many industries and have become more widely used over the last few decades. Notable publicly-traded tech companies such as Facebook, Microsoft, and Google all use RSUs. The Ayco study shows the use of RSUs in companies’ long-term incentive compensation programs went from 47 percent to 72 percent over a 10-year period. Some companies, such as Microsoft, denote RSUs with performance vesting requirements as performance stock units (PSU). PSUs may use a different valuation model to measure fair value and may have different methods for recognizing compensation expense, but they are still categorized under the RSU umbrella.2
Restricted Stock Awards
RSAs, aka “restricted stock,” is a form of compensation like an RSU, but with some notable key differences. Restricted stock is an actual share of stock that the recipient receives, but the rights to sell or transfer the shares are restricted until the vesting period passes. Like RSUs, a certain vesting period or service level must be met in order to obtain full value from the stock. However, in contrast, the value of restricted stock cannot be given as cash once the vesting period passes—the value received must be in stock. After vesting, the owner may sell the shares received. Another major difference is that restricted stock entitles the owner to dividend and voting rights; although RSUs could include dividend equivalents, this is optional for the company and not very common. Restricted stock is treated like any other issued and outstanding stock when it comes to entitlement to voting and dividend rights—the major difference is the existence of restrictions on sale or transfer until the stocks vest. The dividends from restricted stock may be distributed as cash when paid or may be accrued and paid only after the award vests completely. Like an RSU, restricted stock is a “full value” award, meaning the recipient receives value from the reward even if the stock price plummets.
RSU and RSA Accounting Implications
Before selecting RSUs or RSAs to be a part of your company’s equity compensation packages, it is important to be aware of the accounting implications on the financial statements. For private companies, when the employee is initially granted the RSU or RSA, the company should reasonably estimate the fair value of the stock. This is often done by getting a valuation of the company and dividing by the number of outstanding shares to get share value. For a detailed explanation of the valuation process for stock compensation, read our Valuation article. Valuation is a critical step for companies preparing to IPO in the future, since recording compensation expense based on bad calculations could be challenged by auditors when attempting to go public. In addition, “cheap stock” can draw scrutiny from the SEC if restricted stock is severely undervalued before an IPO. For public companies, valuation is unnecessary since the fair value of an RSU or RSA is just the current stock price. Compensation expense will be recorded over the vesting period for RSUs, RSAs, and Options, with no initial financial statement impact on the grant date.
Additionally, the company must make certain required disclosures. These include key information such as the nature and terms of the arrangements, the effect of compensation expense on the income statement, how the initial fair value measurement was made on grant date (for private companies), and the cash flow effects arising from the agreement.
If the employee leaves the company before the vesting date or does anything that would forfeit his or her right to the shares, no compensation expense is required to be recognized. Any previously recorded compensation expense and deferred compensation would be reversed. For more detailed accounting implications about vesting methods, conditions, and classification please see our Accounting for Stock Compensation article.
Individual and Employer Tax Implications
In addition to the financial statement impacts, it is important to be aware of the tax impacts resulting from different types of equity compensation. The timing of the company’s tax deduction corresponds to when the employee recognizes income. This next section will explain the tax implications of RSUs and RSAs and share some unique options to private companies.
The taxation of RSUs differs from RSAs because no shares are transferred on the grant date of RSUs. Employees generally have no voting or dividend rights connected with the stock, so the employee will not recognize any taxable income until the shares are transferred. Once the shares vest (restrictions lapse) they are transferred, and the recipient will include the full stock or cash value as ordinary income. Employers will receive a deduction equal to the fair market value of the RSUs in the year the vested shares are transferred to the employee.
Private companies have a unique problem with RSUs. When the RSUs vest and the recipient owes taxes on the income recognized, it is much more difficult to sell some shares to pay the taxes because the company is privately held. To alleviate this issue, companies can use a “double trigger” vesting requirement or offer the new 83(i) tax election to employees. A “double trigger” is essentially an additional restriction on the shares becoming fully vested until the company goes public or has another liquidity event. This defers the recognition of income and duty to pay taxes until the company can turn the shares into cash, allowing the recipient to bear the tax burden. This method is commonly used by private companies. The new 83(i) tax election comes from the Tax Cuts and Jobs Act of 2017 and enables RSU recipients to defer paying taxes up to 5 years if several requirements are met. Although this election provides some clear benefits by deferring income, small employers should understand the administrative burdens and requirements before offering this election to employees. Some of the stringent requirements include the following:
- 80% of the domestic employees must be granted the same rights and privileges in the calendar year in which Section 83(i) is to apply
- Qualified stock (NQO or RSU) must be issued to qualified employees
- Excluded employees include those who own one percent of the stock of the corporation at any time in the past 10 years or a covered employee3
- For more extensive application to your company, please consult a tax professional.
Employee recipients of restricted stock will exclude the value of the stock from taxable income during the vesting period, unless they elect otherwise. This exclusion exists because the employee is at risk of losing the RSA if the vesting requirements are not met, even though the employee may be considered an owner for purposes of state law. If the RSA never vests, the right to the stock cannot be transferred and will never be recognized. Therefore, the receiver will not include the RSA in taxable income until the shares are vested and no longer at risk of loss. Once the vesting period is over, the employee will recognize the stock received in its taxable income at an amount equal to the fair value.
Owners of RSAs also have the right to make a special tax election known as the IRC Section 83(b) election. Owners must make this election within 30 days of the granting of the shares, and it is irrevocable. This election allows an employee to include the RSA in taxable income on the grant date based on the fair market value on that day less any costs paid. If the employee believes the stock value will appreciate from the grant date to the vesting date, and believes they will meet the vesting requirements, this election is desirable because it changes the stock appreciation tax character from ordinary rates to capital gain tax rates, which are lower.
The employer will take a deduction equal to the same amount the employee recognized in his or her income. The timing of the employer deduction matches when the employee recognizes the income, and thus depends on whether the employee takes the 83(b) election. If the employee does not make the election, the employer deduction is taken in the same tax year in which the shares vest. If the election is made, the employer takes the tax deduction on the RSA grant date instead of on the vesting date in order to match when the employee recognizes income.
RSU and RSA Comparison
In addition to considering the tax and financial statement consequences of both RSAs and RSUs, considering other factors may help you determine which option is best for your company.
The table below highlights some of the major differences described in this article:
If your company desires flexibility, RSUs are the better choice. Since RSUs represent an unfunded promise to a share of stock rather than an actual share of stock, companies have more flexibility in how they choose to settle that right. For example, a company could choose to settle the RSU in cash rather than shares, thus giving the employee value while avoiding diluting the current shareholders. RSUs can be particularly valuable to an executive who is taking over in a turnaround situation and is requiring a minimum value for his or her equity compensation.
On the other hand, although RSAs lack flexibility in how the right is settled, they provide flexibility in the tax implications for the recipient. The recipient may take the IRC section 83(b) election and recognize all income up front on grant date in an amount equal to the fair market value on that day. This election is particularly valuable if the employee believes the company’s stock value will increase over the vesting period. The flexibility in tax treatment allows for tax planning strategies to be considered by the employee.
Another point to consider is that RSAs and RSUs do not require any cash outlay for the employee, and thus may be more desirable than options. Options require employees to spend cash to exercise their option, whereas RSUs and RSAs require no cash outlay to receive the benefit once shares vest and restrictions lapse. In addition, options can expire worthless if the market price drops below the exercise price, but RSUs and RSAs are “full value” awards that have value even if the stock value declines.
Although RSUs and RSAs have many similarities, they also have some key differences. Your company should be aware of the different effects that these equity awards will have as you seek to build competitive compensation packages for your employees.
- The Ayco Company – Compensation and Benefits Digest Archives
- Springmeyer Law – Restricted Stock in Startups
- Restricted Stock and Restricted Stock Units: What’s the Difference and How/Why They’re Used in Startups
- Flow Financial Planning
- Fidelity – Restricted Stock Awards
- National Center for Employee Ownership – Stock Options, Restricted Stock, Phantom Stock, Stock Appreciation Rights, and Employee Stock Purchase Plans
- CEO World Magazine – The Advantage of RSUs in Your CEO Compensation Package
- Equity Compensation and the Rise of Restricted Stock Units by Joshua A. Agen
- The Ayco Company – Compensation and Benefits Digest Archives
- 2019 10-K Filing for Microsoft under Accounting Policies “We measure the fair value of PSUs using a Monte Carlo valuation model. Compensation cost for RSUs is recognized using the straight-line method and for PSUs is recognized using the accelerated method.”
- IRS Guidance on the Application of Section 83(i)