It is common in a discussion of restricted stock units (“RSUs”) or restricted stock to get the two mixed up. After all, they sound the same. But an employer who offers restricted stock or RSUs should understand the fundamental differences between the two forms of award.
What is Restricted Stock?
A person who receives restricted stock receives a grant of actual stock. At grant, the grantee has stockholder rights with respect to the restricted stock, but it is subject to a “substantial risk of forfeiture.” Typically, the substantial risk of forfeiture exists with respect to the award until the grantee completes a period designated by the employer of employment or service, 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 grantee 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 grantee, at vesting, the employer may distribute any dividends that the grantee 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 grantee 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, a grantee may instead elect under Section 83(b) of the Internal Revenue Code (the “Code”) to pay income tax on the restricted stock at the time of grant 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 grantee making an “83(b) election” has little income tax liability at grant and no income tax liability at vesting.
The grantee’s ability to take an 83(b) election is less beneficial if the stock has a substantial value at the time of grant. In that case, the grantee may end up paying less tax if he makes an 83(b) election and the value of the stock increases between the time of grant and the time of vesting, but he risks 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?
An 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 RSU award.
An RSU award that entitles the grantee 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 grantee the equivalent value of any dividends the grantee would receive had the grantee 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 grantee does not have stockholder rights. In addition, the grantee may not make an 83(b) election with respect to the RSU award. The grantee 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 grantee.
Furthermore, cash is often delivered on settlement of an RSU award in lieu of stock. Another name for a cash-settled RSUs is a phantom stock award. A cash-settled RSU award never gives the grantee 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 the employer’s stock or extend the privileges of stock ownership to the grantee such as rights to information about the business. In addition, a cash-settled RSU may be attractive to a grantee because it allows the grantee to immediately realize the value of the award on settlement. In the private company context, a grantee 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 grantee 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 grantee has no income tax liability until the award settles, but still the employe and grantee 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”, as it is called, is a draconian tax provision that restricts when nonqualified deferred compensation may be paid and imposes harsh penalties on the grantee 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 RSUs and Restricted Stock Differ from Stock Options and SARs?
Restricted stock and RSU awards are “full value” awards. Upon vesting or settlement, they entitle the grantee 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 have value only if the stock price increases.
Restricted stock and RSUs vest or settle automatically without an action by the grantee. In general and subject to the specific design of the award, the grantee must choose to exercise a vested option or SAR. If the grantee does not exercise a vested option or SAR, the award will eventually terminate without any payout. This means the grantee will never receive the benefit of the award. However, this also means the grantee will not have to pay the exercise price or tax on the award, which might be prohibitively expensive for the grantee.
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 grantee.
Note, this is a high-level overview of various forms of equity incentives and individual circumstances may vary. An employer or grantee should consult their tax or legal advisors for additional information on these incentives.