Today I am going to start with what I call a mini-series. And not like the types of mini-series we had on TV back in the 80s. Not that I was ever allowed to stay up and watch them. No, in this case I am referring to tackling one topic that isn’t super complex. Normally I would wrap it into a larger article, however, the intent with this approach is to treat it as a solo one because it is actually rather important.
This first part is What is a Restricted Stock Unit.
A Restricted Stock Units is a right to receive stock after you have satisfied any conditions imposed by the company. The conditions can be working for the company for a certain amount of time or a sales goal. If you meet the conditions you get the shares. If not, well, then you don’t get them.
That’s the simplest definition, but let’s dive into a few more details, including taxes, which is everyone’s favorite.
Restricted Stock Units and Restricted Stock, which I’ll cover in a similar type of article next week, are becoming more and more common in the world of equity compensation. Simply because employers are awarding them more frequently than nonqualified stock options now.
I know some people in my world think of RSUs as a type of cash bonus provided by an employer, but it is so much more than this. However, I get where they are coming from.
Here is a simple example of the life of an RSU. An employer awards you a set number of Restricted Stock Units on what is called a Grant Date. As part of this award, your employer will provide you with a document that lays out all the rules and guidelines for the RSUs. Please keep a copy of this in a safe place.
The document includes the requirements you need to satisfy in order to actually earn and take ownership of your RSUs. These are the vesting requirements and have vesting dates associated with them. The requirements can include hitting certain goals, most of which are time-related. Vesting time periods take one of two forms. There is the cliff vesting which all of your RSUs are fully vested once that time period is satisfied. For example, if it is a 4-year cliff vesting period all of your RSUs vest on that date, but up to a day before the vesting date no shares are vested or under your control. The other type of vesting calendar is more gradual and is a graduated vesting schedule. Following the previous example, it may be 25% of your RSUs vest every year over the next 4 years.
Until RSUs vest, there are no taxes you have to worry about as you do not own them. Because you don’t own RSUs until vesting has been met, you also do not get any dividends and you don’t have any shareholder rights, so no voting rights for you.
Now, once the RSUs vest the fun begins. Maybe fun is a strong word since the vesting means taxes come into play. The taxes can come in two forms, but at a minimum there will be compensation income for you.
Compensation income, also known as ordinary income, is calculated as the difference between the value of the RSUs when you vest and any amount you paid for them. Now, a good portion of RSUs do not have a grant price associated with them. This means your compensation income is the total fair market value of the shares once they vest. For example, if your RSU award is 1,000 shares on a 4-year cliff vesting schedule and the share price is $30, well, your RSU is worth $30,000 on the date it vests. Since you paid nothing for the shares your compensation income is that full $30,000 amount.
If you did pay something toward the shares, then your compensation income is the fair market value reduced by whatever amount you pay. Same example as before, but your RSU grant was for 1,000 shares at $20 a share 4 years ago. 4 years has passed by and the shares are now worth $30 a share. The total fair market value of the shares when you receive them at vesting is $30,000. However, your RSU agreement says you can pay $20,000 for these shares. So, the difference of $10,000 is treated by the IRS as compensation income.
A key item to point out here is although there is taxable income, there may not be any actual cash coming your way, unless you sell the shares that are now vested. If you have not sold the shares, you still have to report income and pay taxes. Don’t fret too much about how to pay this bill as my experience is employers will dispose of the necessary number of shares to pay the associated taxes. Just be careful that if your RSU compensation income numbers are large you could get pushed up into a higher tax bracket and your employer is withholding based on a lower bracket. This could easily come into play with two income families and the RSU holder’s employer is only calculating withholdings based on the RSU holder’s income. So, double check withholdings and do the proper tax planning.
Another important item to mention with RSUs. You do not have the ability to say when shares will be vested. Meaning once they vest the shares will automatically become yours and any gain will be additional compensation income. This is where people say it is like a cash bonus. This is easy for planning purposes, but doesn’t provide you any flexibility in those years where your income may be higher or lower. You know, so you could do some tax planning with them.
Now, the second tax form may or may not come into play. This deals with capital gains. If you sell all the shares once they vest, then there is no issue with capital gains. However, if you hold onto the shares for some period of time after they vest, then capital gains will come into play once you dispose of those shares down the road.
Following the earlier example, let’s say you held onto those 1,000 shares that had a fair market value of $30 a share once they vested. You wait 10 more years to dispose of them and they had a great run. The value is now $100 a share. The $70 difference between the $30 a share and $100 a share is treated as long-term capital gains. This is nice because capital gains are often taxed at a lower rate than compensation income. So, you now have a capital gain of $70,000, but hopefully paying a much lower rate than $70,000 of compensation income.
I think that is enough to answer the question of what is a Restricted Stock Unit. Come back next week for what is a restricted stock. To quote a favorite annoying expression – they are the same, but different.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.