It is common for businesses to reward employees through stock, but it is important to know the differences between restricted stock units and restricted stock. The two often get mixed up because, after all, they sound the same. But there are important differences.
What is Restricted Stock?
An employee who receives restricted stock receives a grant of actual stock. Once granted, the employee has stockholder rights with respect to the restricted stock, but it is subject to a “substantial risk of forfeiture,” which is typically until the employee completes an employment period designated by the employer, and/or the employer achieves certain performance criteria such as a designated EBITDA level. An award is said to have “vested” on the date the substantial risk of forfeiture lapses.
Once the restricted stock vests, the employee holds the stock subject only to the restrictions that apply to other stockholders such as transfer restrictions. If provided by the restricted stock agreement between the employer and the employee, at vesting, the employer may distribute any dividends that the employee would have received as a stockholder prior to vesting (but for the fact that the restricted stock had not yet vested).
For tax reasons, a grant of a restricted stock award makes the most sense at the beginning stages of a business. As a general rule, the employee must pay income tax on a restricted stock award at the time the award vests based on the fair market value of the stock at vesting. However, an employee may instead elect under Section 83(b) of the Internal Revenue Code to pay income tax on the restricted stock at the time it is granted based on the fair market value of the stock at grant. Given that the fair market value of the stock of a new business is often negligible, the employee making an “83(b) election” has little income tax liability at grant and no income tax liability at vesting.
The employee’s ability to take an 83(b) election is less beneficial if the stock has a substantial value at the time of grant. Still, the employee may end up paying less tax making an 83(b) election if the value of the stock increases between the time of grant and the time of vesting. However, there is a risk of paying more tax if the value of the stock decreases between the time of grant and time of vesting.
What is a Restricted Stock Unit?
A restricted stock unit (RSU) award is not an outright grant of stock. It is a promise to deliver stock and/or cash in the future once the vesting conditions that apply to the award lapse. The delivery of the stock or cash after the vesting conditions are satisfied is often referred to as the “settlement” of the restricted stock unit award.
An RSU award that entitles the employee to receive stock immediately on the vesting date resembles a restricted stock award in many respects. An employer may even opt to structure the RSU award to pay the employee the equivalent value of any dividends the employee would receive had the employee instead held vested restricted stock. Such rights are called dividend equivalent rights.
A key distinction between the two types of awards is that until the RSU award settles in stock, the employee does not have stockholder rights. In addition, the employee may not make an 83(b) election with respect to the RSU award. The employee must always pay income tax on the RSU award at the time RSU award settles based on the fair market value of the stock at such time. This may be a substantial tax burden for the employee.
Furthermore, cash is often delivered on settlement of an RSU award in lieu of stock, which is also known as a phantom stock award. A cash-settled RSU award never gives the employee the rights of a stockholder and will require the employer to have sufficient cash reserves to make the payment when due. On the other hand, a cash-settled RSU award may be attractive to an employer who does not want to dilute the value of their stock or extend the privileges of stock ownership to the employee, such as rights to information about the business. In addition, a cash-settled RSU may be attractive to an employee because it allows them to immediately realize the value of the award on settlement. In a private company, an employee who receives stock on settlement of the RSU award will generally not be able to sell the stock or receive any payment for the stock until the employer experiences a liquidity event such as a sale or initial public offering, or the employee terminates employment and the stock is repurchased by the employer or other stockholders.
Moreover, the settlement of an RSU award does not always occur immediately on vesting. In the case of such a delayed settlement, the employee has no income tax liability until the award settles, but the employer and employee still owe employment taxes on the earlier vesting date. In addition, if the settlement could occur outside of what is called the “short-term deferral period” (generally, later than the 15th day of the third calendar month following the year in which the award vests), the RSU award may need to comply with Code Section 409A. “Section 409A” is a draconian tax provision that restricts when nonqualified deferred compensation may be paid and imposes harsh penalties on the employee if the compensation does not comply with its mandates. The restrictions of Section 409A mean that most RSU awards vest and settle at the same time or close in time. However, in some instances, the benefit of deferring taxation on the award outweighs the burdens of Section 409A compliance, and the RSU award will have a delayed settlement date. In contrast, a restricted stock award is never subject to Section 409A.
How Do These Differ from Stock Options and SARs?
Restricted stock and RSU awards are “full value” awards. Upon vesting or settlement, they entitle the employee to receive one share (or fair market value cash equivalent of one share for cash-settled RSUs) for each share of restricted stock or each RSU granted. In contrast, stock option and stock appreciation right (SAR) awards typically entitle the grantee to receive only the number of shares (or the fair market value cash equivalent for cash-settled SARs) with a value equal to the appreciation in value of the stock between the award’s grant date and the exercise date. Restricted stock and RSU awards will always have some value. Options and SARs only have value if the stock price increases.
Restricted stock and RSUs vest or settle automatically without any action by the employee. In general, and subject to the specific design of the award, the employee must choose to exercise a vested option or SAR. If the employee does not exercise a vested option or SAR, the award will eventually terminate without any payout. This means the employee will never receive the benefit of the award. However, this also means the employee will not have to pay the exercise price or tax on the award, which might be prohibitively expensive for them.
Key Takeaways
It is important not to confuse restricted stock and RSU awards. They implicate different tax, economic, and business considerations. An employer should assess which award better suits its needs and the needs of the employee. An employer or grantee should consult their tax or legal advisors for additional information on these incentives.
Madeline Lewis is a corporate and tax attorney with experience advising businesses and individuals on compensatory, employee benefits and employment-related matters. She can be reached at madeline.lewis@mclane.com.
