The Great Benefits Of Restricted Stock And Restricted Stock Units (RSUs)
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Your company may no longer be granting you stock options, or may be granting fewer than before. Instead, you may be receiving restricted stock (or restricted stock units, commonly called RSUs). While these grants don't give you the same potentially life-altering, wealth-building upside as stock options, they have benefits you will grow to appreciate. (In this article and elsewhere on this website, the term "restricted stock" includes RSUs unless they are mentioned separately.)
Less Risk And Clearer Value
The value of stock options depends on how much (or whether) your company's stock price rises above the price on the grant date. By contrast, restricted stock has value at vesting even if the stock price has not moved since grant (or even if it has dropped).
Depending on your attitude toward risk and your experience with swings in your company's stock price, the certainty of your restricted stock's value can be appealing. By contrast, stock options have great upside potential but can be "underwater" (i.e. having a market price lower than the exercise price). This is why restricted stock is often granted to a newly hired executive. It may be awarded as a hiring bonus or to make up for compensation and benefits, including in-the-money options and nonqualified retirement benefits, forfeited by leaving a prior employer.
You also may find it easier to appreciate a restricted stock grant because its monetary value in your pocket (i.e. your company's stock price) is easier to figure out than a stock option's value, which is theoretical. A stock option grant involves more shares than a comparable restricted stock grant (an FAQ on this website discusses typical share ratios of restricted stock grants to comparable option grants). However, stock options may never be worth anything: in the worst case, they may be underwater after vesting and for the remainder of the option term.
Of course, the very essence of restricted stock is that you must remain employed until it vests to receive its value. While you may have between 30 and 90 days to exercise stock options after voluntary termination, unvested grants of restricted stock are often forfeited immediately. Thus, it is an extremely effective golden handcuff to keep you at your company.
Unlike a stock option, which requires you to decide when to exercise and what exercise method to use, restricted stock involves fewer and simpler decisions.
You receive the shares at vesting, which can be based simply on the passage of time or the achievement of performance goals. Restricted stock is considered "supplemental" wages, following the same tax rules and W-2 reporting that apply to grants of nonqualified stock options. You may have a choice of tax-withholding methods (e.g. cash, sell shares for taxes), or your company may automatically withhold enough vested shares to cover the tax withholding (see the detailed FAQ on methods of withholding).
The infographic below summarizes the basic key facts of restricted stock and RSUs.
Lower Your Potential Tax
The most meaningful decision with restricted stock grants is whether to make a Section 83(b) election to be taxed on the value of the shares (i.e. "property") at grant instead of at vesting. Whether to make this election, named after the section of the Internal Revenue Code that authorizes it, is up to you. (It is not available for RSUs, which are not "property" within the meaning of Internal Revenue Code Section 83. See the FAQ on the main differences between restricted stock and RSUs.)
If a valid 83(b) election is made within 30 days from the date of grant, you will recognize as of that date ordinary income based on the value of the stock at grant instead of recognizing income at vesting. As a result, any appreciation in the stock price above the grant date value is taxed at capital gains rates when you sell the stock after vesting.
While this can appear to provide an advantage, you face significant disadvantages should the stock never vest and you forfeit it because of job loss or other reasons (see a related article on the risks of the 83(b) election). You cannot recover the taxes you paid on the forfeited stock. For this reason, and the earlier payment date of required taxes on the grant date value, you usually do better by not making the election. However, this election does provide one of the few opportunities for compensation to be taxed at capital gains rates. In addition, if you work for a startup pre-IPO company, it can be very attractive for stock received as compensation when the stock has a very small current value and is subject to a substantial risk of forfeiture. Here, the downside risk is relatively small.
Unlike stock options, which rarely carry dividend equivalent rights, restricted stock typically entitles you to receive dividends when they are paid to shareholders. With RSUs, your company decides whether to pay dividend equivalents.
Unlike actual dividends, the dividends on restricted stock are reported on your W-2 as wages (unless you made a Section 83(b) election at grant) and are not eligible for the lower tax rate on qualified dividends until after vesting. (A related FAQ gives details on the tax treatment of dividends.)
If you receive restricted stock in place of some or all of the stock options that were granted in prior years, you should adjust your financial and tax planning. While both awards provide an exposure to the value of company stock, they do so in different amounts and in different ways. Moreover, because options give you greater leverage, they carry more risk too. Executives, especially those who are close to retirement, may need to change their stock option exercise strategy for outstanding awards. For details, see another article.
In most cases, death either fully accelerates vesting or triggers pro rata acceleration, depending on length of service through the date of death. In some cases, your company has the discretion to vest all or just a portion of the award. Many plans or grant agreements allow you to designate a beneficiary who would be entitled to receive the shares upon your death. Otherwise, the shares would pass through the decedent's estate.
The value of restricted stock shares at death may be clearer than the value of stock option shares. The IRS requires the use of a valuation formula, such as Black-Scholes, to estimate the value of the options at the date of the optionholder's death. (See the section Life Events: Death Taxes.)
Stock Ownership Requirements
A majority of large companies now have stock ownership guidelines for key executives. Typically, only your vested restricted stock counts toward ownership requirements, though unvested restricted stock can count as well (unexercised stock options are rarely counted). Check your program for details.
Some companies have in place arrangements and procedures that will let you elect to defer income taxation from the date when the restricted stock or RSU vests to a date that you choose to receive the shares on (see the detailed FAQ on deferred delivery of shares with restricted stock units). You then pay income tax on the value of the shares at the distribution date. However, FICA taxes, including the 1.45% Medicare tax (plus the 0.9% additional Medicare tax for certain high-income taxpayers), is due at the vesting date. These arrangements allowing the deferral of the date when awards are taxed must comply with the deferred compensation rules of IRC Section 409A.
Senior executives who are corporate insiders, and all directors, need to make Section 16 filings (Form 4 and/or Form 5) upon the grant of time-vesting restricted stock. Check with your corporate secretary or general counsel's office for the filing rules of restricted stock that vests only upon the meeting of performance hurdles. The SEC rules that enhanced disclosure of executive compensation (adopted in 2006) require more detailed proxy reporting for restricted stock and RSU grants than prior regulations did. Details appear under Stock Awards in the proxy tables (and footnotes) for: Summary Compensation; Grants of Plan-Based Awards; Outstanding Equity Awards at the Fiscal Year-End; and Stock Option Exercises and Stock Vested.
If you may be in possession of "material nonpublic information" about your company, you will also want to consider setting up a Rule 10b5-1 trading plan for selling shares after they become vested.
Restricted stock is no longer maligned as merely "pay for a pulse," particularly as companies add performance features that trigger grant or vesting. Although experts predict that stock options will continue as the primary long-term incentive award to attract, motivate, and retain key employees and executives, the role of RSUs in particular is growing. Surveys show that it is the primary replacement for stock options. Appreciating its benefits and understanding the details of related tax and financial planning will help you maximize its value.
Before his retirement, Richard Friedman was the Vice President of the Benefits & Compensation Group at The Ayco Company, a leading provider of financial-planning services for executives at public companies. This article was published solely for its content and quality. Neither the author nor his firm compensated us in exchange for its publication.
Got another four minutes? Watch our popular video on the essentials of restricted stock and RSUs.
People who read this article also read:
- Restricted Stock: Tax, Financial, Estate, And Retirement Planning (Part 1)
- Restricted Stock & RSU Fundamentals: What You Need To Know (Part 1)
- Decisions At Vesting With Restricted Stock (Part 1): Withholding
- How To Diversify Your Company Stock Holdings While Leveraging The Wealth In Your Stock Options & Other Equity Grants
- Decisions At Grant With Restricted Stock (Part 1): Tax Fundamentals