What are Restricted Stock Units, how do they work

Here is a primer on Restricted Stock Units (RSU) what they are, how they work and the tax impact of receiving RSUs from your employer
resTricTed stock units - rsu taxes and how to calculate them

While not quite as common in India as they are in the western countries, Restricted Stock units (RSUs) are still in use and a norm in startup companies. Let’s look at how they work and what is in it for you if your employer is to allot some RSUs to you.

What Are Restricted Stock Units?

Also known as “letter stock” “restricted stock awards” and “Section 1244 stock” (in United States), RSU’s are stock-based compensation. There may be slight differences in these terms. They are offered to employees as a right to receive stock in the company when certain conditions (known as “vesting”) are met. Once the vesting period is over, they are shares of the company’s common stock.

The term “restricted” means that the stock units are subject to forfeiture if the conditions are not met. The restrictions are designed to prevent the holder from premature selling as this might affect the company. However, the terms under which they are issued give the schedule under which the vesting takes place.

Restrictions can be lifted if the company is acquired by another one and in case the employee is dismissed in the restructuring process that may happen as a result.

In US, it is common for firms to offer between one-third to one-fifth of the number of RSU’s as compared to the number of regular stock options they can offer. This is because RSU’s have a greater protection down the line and they cannot become completely worthless even if the company goes bust.

Facts about RSUs

Restricted stock units are:

  • issued at no cost acquisition upfront
  • without voting rights, unless they are restricted stock awards in which case there are voting rights
  • lower in value than unrestricted stocks
  • used to motivate employees and promote loyalty and performance
  • non-transferable
  • subject to conditions and timing of sale
  • subject to vesting period restrictions that could last many years/retirement
  • given based on employment of a certain number of years
  • offered subject to your working in this firm for a certain number of years

Employees may have to forfeit their RSU’s if they leave their employment with the company or don’t meet specified performance targets. They may also have to give up their RSU’s if they violate any norms laid down by government or regulatory bodies.

Who can get Restricted Stock Units?

  • Employees who are being considered for a higher position or are joining from a different firm. In this case, it will be part of the compensation package in the form of restricted stock units (RSU)
  • Employees who have been working in the firm for a while may be given the choice of whether they’d like the equity part of their compensation in the form of RSU or as stock options
  • Your recent appraisals entitle you to RSU
  • Directors in your company are entitled to receive a certain number of RSU

In all these situations, it’s crucial that you know exactly what RSU’s are and how they can impact your present and future finances, taxes and financial plans.

How it all started

RSU’s became popular in the 1990’s and early 2000’s when executive compensation began to come under increasing scrutiny by the US Congress. This was a result of the abuse of the prevailing systems of awarding stocks by firms such as Enron. Changes to the GAAP (generally accepted accounting principles) in 2006 made RSU’s a more acceptable and safer option.

Microsoft transitioned to restricted stock offers in 2003 as part of its employee compensation packages, and in a year’s time, more than 60% of companies surveyed reported similar patterns. Between 2004-2010, this was reflected in more than 80% of employees’ compensation packages.

Comparing RSU’s and Stock Options

There are several points of similarity and difference between regular stock options and RSU’s

  • Stock options and RSU’s are both provided with a grant date on issuance
  • There is no exercise price on RSU’s while stock option price is set based on their underlying security’s entire current market-value
  • Vesting milestones can be set according to company policy for both stock options and RSU’s
  • With RSU’s you have the option of taking cash payments in lieu, while this is not available for stock options where the payment is made only in stock
  • Vesting makes RSU’s subject to taxes, and the income is treated as regular income with capital gains liability in case you have held them for more than one year
  • In the case of regular stock, non-qualified stock options are taxed based on the difference between market and grant prices

RSU’s and Taxation

This is a highly complex area and you would certainly need the advice and assistance of a professional taxation expert who has experience and knowledge of this sector.

In India, Short Term and Long term capital gains tax is applicable on RSUs depending on how long the stocks were held, in addition to the individual’s tax slab. On the other hand, in the US, RSU’s are governed by Section 1244 of the US Internal Revenue Code.  So the normal income tax regimes come into play when your RSU’s are vested. You will have to pay taxes on the full market value of your shares when the vesting period is fulfilled.

The stock’s value on the vesting date has to be declared as your income, but this is minus the original price. You will have to pay the tax at an earlier date in case you leave the company and the stocks are forfeited.

During vesting, the company will usually withhold the legal requirements such as TDS or for federal income tax. If you fall in the higher tax bracket, you may have to sell more stocks to meet this tax obligation.

Are They Worth Holding or Selling?

When the vesting period comes to a close, RSU’s are converted to regular stocks. You then have the option of holding on to them for greater appreciation as part of your portfolio, or you can encash them by selling them.

The strategy you choose has to be based on your immediate and long-term financial plans and goals.

Your financial expert can analyze whether you need to sell them for diversifying out of a concentrated stock-position. You may also want to sell for better investment prospects, based on the performance of your company. This means you need thorough knowledge of the financial outlook of the company and its future.

If it looks bright, obviously you would want to hang in there, otherwise, selling is the better strategy. Another aspect to consider is whether there are any conditions on which the stock was given to you as a senior executive. Typically, companies may want executives at the highest level to retain their stocks so as not to upset the apple-cart.

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