With news of big IPOs like Lyft hitting the headlines, the value of your own equity compensation is likely top of mind. A common type of equity that companies offer their employees as part of their compensation package are Restricted Stock Units, or RSUs.
Restricted Stock Units are a type of restricted stock (which may also be known as “letter stock” or “restricted securities”). Restricted stock is company stock that cannot be fully transferable until certain restrictions have been met.
These can be performance or timing restrictions, similar to restrictions for options. You can think of restricted stock as a bonus awarded as stock instead of cash; however, like cash, it is taxed as if it was paid in cash (i.e., as ordinary income).
Restricted stock can be a popular alternative to stock options, particularly for executives, due to their favorable accounting rules and income tax treatment. There are two basic types of restricted stock: Restricted Stock Awards (RSAs) and Restricted Stock Units (RSUs). We’ll focus mainly on Restricted Stock Units in this article.
Want to know more about employee equity compensation? Do you have a question about your employee equity that wasn’t answered here? Read our free Guide to Employee Equity Compensation.
What Are Restricted Stock Units?
Restricted Stock Units (RSUs) represent an employer’s promise to grant the difference in price (stock price minus strike price) to employees based on vesting requirements, performance benchmarks and/or transferability restrictions.
The key difference is that RSUs are issued in the form of units – not stock – that correspond in number and value to a specified number of shares of employer stock. Upon vesting, you’ll get your equivalent shares. The result of this difference is that you are not deemed to be the holder of the shares until vesting and do not have voting rights (unlike with RSAs).
This makes it a particularly popular mechanism for pre-IPO companies: RSU holders are not technically shareholders and increasing ownership does not trigger SEC filing rules.
Tax Treatment of Restricted Stock Units
Restricted Stock Units can be awarded on regular vesting schedules or performance benchmarks, which means that the value of the RSUs on the day of vesting is subject to payroll and ordinary income taxation.
Similar to the concept of a cashless exercise, some employers allow stock to be withheld to cover the statutory minimum for taxes in the form of shares, since RSUs are taxed on vesting. This provides for a net stock amount to the employee, adjusted for taxes, upon vesting. The disposition method is not restricted after vesting, unless the company is subject to “open window” trading policies.
Purchase Strategies for Restricted Stock
When you’re offered equity by your company, you need to decide how you exercise the shares. But note, if the grant is restricted stock with par value, accepting the grant means you’ll eventually be required to pay for those options when they vest.
There are typically three standard methods that you can choose within 30 days of the settlement date (the date and time that your transfer of shares is made, which establishes the legal transfer of ownership).
- Pay Cash. You receive all your shares and cover your income tax burden with your own cash. So, if you believe your company’s share price is going up, this might be an attractive strategy; however, it’s riskier as you end up with equity and will deplete your cash reserves to cover the income tax burden.
- Cashless: Exercise and sell to cover. You receive only the portion of shares after covering the cost of your income taxes with shares. For example, if you were entitled to 100,000 shares and pay a 35% marginal tax rate, you’d get 65,000 shares. Because market price doesn’t impact your tax rate, this is likely the least risky strategy.
- Cashless: Exercise and sell. You sell your shares immediately and cover the purchase price, commissions, fees, and taxes. This is like paying cash, since you assume the risk of the share price (for the period of time before you sell), but it may make sense because you don’t have to raise the cash to pay your tax obligations.
Make sure to talk to your employer to see what options are available to you.
Should You Sell Your Restricted Stock Units?
RSUs are taxed at the time they are vested. So in essence, you have purchased your company’s stock at the current market price. This means you should make the decision to sell them based on the stock price at the time of vesting and how large your investment is in your company’s stock. Holding your vested shares instead of selling them is similar to purchasing your company stock with your bonus check – unless you have a strong reason for keeping your company’s stock, it’s generally recommended that you sell as soon as your shares vest and add the proceeds to your well-diversified investment portfolio. However, every person’s circumstance is unique, so be sure you consult a financial advisor when deciding what to do with your vested shares.
Did you know? Personal Capital offers free, no-obligation introductory consultations to evaluate your portfolio. Have a question about your RSUs or your employee equity holdings? Contact a Personal Capital financial advisor for a free portfolio review.
Understanding the value of your restricted stock, its vesting requirements, and your purchasing strategy are crucial elements of a successful financial plan around employee equity. Personal Capital’s dedicated financial advisors can help sort through the oftentimes complex circumstances surrounding employee equity compensation.