Restricted Stock Unit: Works, Taxation, Advantages & Examples

What is a Restricted Stock Unit?

A Restricted Stock Unit (RSU) is a form of equity compensation typically granted by companies to employees as part of their overall compensation package. RSUs represent a promise by the employer to issue shares of company stock to the employee at a future date, subject to certain vesting conditions being met. RSUs are commonly used by companies, particularly in the technology and finance sectors, as a way to attract and retain talent, align employee interests with shareholder interests, and provide employees with a stake in the company’s performance and success over time.

Key Takeaways:

• RSUs are a form of equity compensation commonly used by companies to reward and incentivize employees.
• RSUs are a valuable component of employee compensation packages, providing employees with a stake in the company’s performance and aligning their interests with shareholder interests over time.
• RSUs are subject to taxation.

How do Restricted Stock Units work?

Restricted Stock Units (RSUs) are a form of equity compensation commonly used by companies to reward employees.

1. Grant: When an employee is awarded RSUs, they receive a specified number of units, which represent the right to receive shares of company stock in the future. The grant typically outlines the vesting schedule and any performance or time-based conditions that must be met for the RSUs to vest.

2. Vesting: RSUs are subject to a vesting schedule, which determines when the units become “unrestricted” and the employee gains ownership rights to the shares. Vesting schedules can be based on time (e.g., three years with one-third vesting each year) or performance milestones.

3. Settlement: Once RSUs vest, the employee is entitled to receive shares of company stock or the cash equivalent, depending on the company’s policy. The shares are typically delivered directly to the employee’s brokerage account or held in a separate RSU account until the settlement date.

4. Taxation: RSUs are subject to taxation upon vesting. When RSUs vest, the fair market value of the shares is included in the employee’s income as ordinary income, and taxes are withheld accordingly. Subsequent gains or losses from the sale of the shares are treated as capital gains or losses.

5. Rights and Restrictions: While RSUs represent the right to receive company stock, they do not grant any voting rights or dividends until the shares are actually delivered. Additionally, RSUs may be subject to forfeiture if the employee leaves the company before the units vest or other conditions are met.

How are Restricted Stock Units Taxed?

Restricted Stock Units (RSUs) are subject to taxation at two main points: upon vesting and upon sale of the shares received.

1. Taxation Upon Vesting

• When RSUs vest, the fair market value (FMV) of the shares is included in the employee’s income as ordinary income.
• The FMV of the shares is typically determined based on the stock price on the vesting date.
• The value of the vested RSUs is added to the employee’s W-2 or other applicable tax forms as taxable compensation.
• Taxes, including federal income tax, state income tax (if applicable), and FICA taxes (Social Security and Medicare), are withheld from the employee’s paycheck at the time of vesting.

2. Taxation Upon Sale

• When the employee sells the shares received from vested RSUs, any gains or losses are subject to capital gains tax treatment.
• The cost basis for determining capital gains or losses is typically the FMV of the shares at the time of vesting.
• If the employee holds the shares for more than one year after the vesting date, any gains from the sale are considered long-term capital gains and taxed at the applicable long-term capital gains tax rates, which are generally lower than ordinary income tax rates.
• If the employee sells the shares within one year of the vesting date, any gains are considered short-term capital gains and taxed at the applicable short-term capital gains tax rates, which are the same as ordinary income tax rates.

Advantages of Restricted Stock Units

1. Alignment of Interests: RSUs align the interests of employees with those of shareholders, as employees benefit directly from increases in the company’s stock price. This can motivate employees to work towards the company’s long-term success and performance.

2. Retention Tool: RSUs can serve as a powerful tool for attracting and retaining top talent. By offering RSUs as part of an employee’s compensation package, companies can incentivize employees to stay with the organization over the long term, as the RSUs typically vest over a multi-year period.

3. Simplicity and Transparency: RSUs are often simpler and more transparent than other forms of equity compensation, such as stock options. Since RSUs represent actual shares of company stock, employees do not need to worry about exercising options or understanding complex option pricing models.

4. No Out-of-Pocket Cost: Unlike stock options, which may require employees to purchase shares at a predetermined price, RSUs are typically granted to employees at no out-of-pocket cost. This makes RSUs particularly attractive for employees who may not have the financial resources to exercise options.

5. Immediate Value: RSUs have immediate value from the moment they vest, as employees become owners of company stock. This can provide employees with a sense of ownership and pride in the company’s success, even before they sell the shares and realize a financial gain.

Disadvantages of Restricted Stock Units

1. Tax Implications Upon Vesting: RSUs are subject to taxation upon vesting, as the fair market value of the shares is included in the employee’s income as ordinary income. This can result in a significant tax liability for employees, particularly if the stock price has appreciated since the grant date.

2. Lack of Control: Until RSUs vest and the shares are received, employees have limited control over their equity compensation. They cannot sell or transfer RSUs, and they may forfeit the units if they leave the company before the vesting conditions are met.

3. Risk of Forfeiture: RSUs may be subject to forfeiture if the employee leaves the company before the units vest or other conditions are met. This can occur due to voluntary resignation, termination, or other reasons, resulting in the loss of potential equity compensation.

4. No Dividend Rights: While RSUs represent the right to receive company stock, they typically do not grant any voting rights or dividend rights until the shares are actually delivered. This means that employees do not benefit from dividends or have a voice in corporate governance until the RSUs vest and the shares are received.

5. Market Risk: The value of RSUs is tied to the performance of the company’s stock price. If the stock price declines between the grant date and the vesting date, the value of the RSUs may decrease, resulting in a lower payout for employees.

Examples of Restricted Stock Units

1. Technology Company RSUs: A technology company might grant RSUs to its employees as part of their compensation package. For example, a software engineer might receive a grant of 1,000 RSUs with a four-year vesting period and a one-year cliff. This means that the engineer would receive 25% of the RSUs (250 units) after the first year of employment, with the remaining units vesting evenly over the following three years.

2. Finance Industry RSUs: A financial services firm might award RSUs to its executives as an incentive to drive performance and align their interests with shareholders. For instance, a senior executive might receive a grant of RSUs tied to the company’s financial performance metrics, such as revenue growth or earnings per share (EPS). The RSUs could have a multi-year performance period, with vesting contingent upon achieving specified performance targets.

Restricted Stock Unit vs. Stock Options

Basis	Restricted Stock Units (RSUs)	Stock Options
Nature of Grant	Grants of company stock	Grants the right to purchase company stock at a predetermined price
Purchase Price	Typically no purchase price required	Often has an exercise price that must be paid to acquire shares
Tax Treatment	Taxed as ordinary income when vested	Tax treatment varies based on whether they are non-qualified or incentive stock options
Tax Timing	Taxed upon vesting	Taxed upon exercise (for non-qualified options) or sale (for incentive options)
Value Retention	Have value even if the stock price does not increase	Have value only if the stock price exceeds the exercise price
Risk	Employees bear no financial risk	Employees risk losing the exercise price if the stock price does not exceed it
Alignment of Interests	Directly aligns employee interests with those of shareholders	Indirectly aligns employee interests through potential stock price appreciation
Flexibility	Employees do not have the option to choose when to be taxed	Employees have more control over the timing of taxation

Restricted Stock Unit – FAQs

Can I sell my RSUs before they vest?

Generally, you cannot sell RSUs before they vest, as you do not yet own the shares. Once RSUs vest, you can sell the shares if you choose to do so.

What happens to my RSUs if I leave the company before they vest?

Depending on the terms of your RSU agreement, you may forfeit any unvested RSUs when you leave the company. Some companies have provisions for partial or full vesting of RSUs upon certain events such as retirement or termination without cause.

Are RSUs better than stock options?

It depends on your individual circumstances and preferences. RSUs have value even if the company’s stock price does not increase, but they are taxed as ordinary income when they vest. Stock options may offer potentially higher returns if the company’s stock price increases, but they come with the risk of becoming worthless if the stock price decreases below the exercise price.

Can I receive dividends on my RSUs?

Dividends are typically not paid on RSUs until the shares underlying the RSUs vest and are delivered to you. Once vested, you become the shareholder of record and are eligible to receive dividends, subject to the company’s dividend policy.

What happens to my RSUs in the event of a merger or acquisition?

When companie­s combine through a merger or acquisition, the­ outcome for restricted stock units (RSUs) hinge­s on deal terms and agree­ment details. At times, RSUs transform into share­s of the new firm’s stock or cash payments pe­r set values. To grasp how your RSUs fare in such sce­narios, studying your RSU contract and related documentation prove­s crucial.