Stock options have long been a “carrot” for attracting, motivating and retaining executives. But other incentives — notably restricted stock and restricted stock units (RSUs) — have gained popularity in recent years.
With restricted stock, the company awards executives nontransferable shares up front, and those shares are forfeitable until they have vested. The company typically bases vesting on continued employment, achievement of performance goals, or both. With RSUs, however, the company awards the stock, or sometimes its cash value, after the executive meets vesting conditions.
Stock options remain attractive
For employers, stock options used to have a big advantage over other incentive compensation tools: They enabled companies to provide executives and other employees with valuable benefits without recording compensation expense on their financial statements. This advantage disappeared after the Financial Accounting Standards Board (FASB) amended its standards for “share-based payments” in 2004, requiring companies to estimate the fair value of stock options on the grant date and report that value as compensation expense.
Options remain attractive, offering significant upside potential for employees. But restricted stock and RSUs also have some advantages. For example, they generally retain value despite market volatility, whereas options can become worthless in a down market. Also, from the employer’s perspective, restricted stock and RSUs generally involve fewer shares, so they cause less ownership dilution.
Restricted stock can be risky
Restricted stock provides an appealing — but risky — opportunity for employees. If they make what’s known as an “83(b) election” to pay tax on the stock’s market value when they receive it, they can convert any future appreciation in value into long-term capital gains, which enjoy more favorable tax treatment. But it can be risky because, if they ultimately forfeit the stock, they’ll have paid tax on income they never receive.
Without an 83(b) election, employees are taxed at ordinary-income rates on the stock’s market value when it vests. If the stock appreciates in value, their tax bills will potentially be higher than they would have been under the 83(b) election — but if they forfeit the stock, they’re not taxed.
RSUs, on the other hand, aren’t eligible for the 83(b) election, so there’s no opportunity to convert ordinary income into capital gains. But they do offer a limited ability to defer income taxes. Unlike restricted stock awards, which become taxable immediately upon vesting, RSUs aren’t taxable until the employee actually receives the stock. So rather than having the stock delivered immediately upon vesting, the employer and employee can agree to delay delivery, which will defer the employee’s income tax. Any income deferral, however, must satisfy strict tax code requirements.
From the employer’s perspective, RSUs offer several benefits:
Employer-controlled timing. With RSUs, the employer controls the timing of its compensation expense deduction because the expense is deductible when the stock is delivered. With restricted stock, the expense is deductible either when the stock is awarded or when it vests, depending on whether the employee makes an 83(b) election.
Possibly larger deductions. RSUs may generate larger compensation expense deductions. If the stock price goes up between the time RSUs are awarded and delivery of the stock, the employer enjoys a larger deduction. With restricted stock, if an employee files an 83(b) election, the employer’s deduction is limited to the stock’s value at the time of the award. (On the down side, with RSUs, if the stock price falls, the employer’s deduction may shrink.)
Other benefits. The employer avoids the administrative expense of issuing stock unless and until RSUs vest. Also, employees don’t have voting rights or receive dividends until they receive stock (although some RSU plans pay dividend equivalents).
For public companies, it’s also important to consider IRC Sec. 162(m), which places a $1 million limit on deductions for compensation paid to certain top executives. Some types of compensation are excluded from the limit, including “qualified performance-based compensation.”
A close look is warranted
As you can see, restricted stock and RSUs are similar — but different. If you’re considering either of these compensation tools, be sure to weigh their pros and cons as well as the tax implications before locking in.