Restricted stock units (RSUs) are a form of equity compensation given to employees once they meet specific conditions. Equity compensation is more appealing than cash because it gives employees a portion of ownership of the company. It’s like a stock investment but given to employees as compensation for their work, loyalty, and dedication.
In this article, we’ll talk about RSUs, how RSUs work, the vesting conditions of RSUs, and some advantages and disadvantages of RSUs. And more importantly, we’ll talk about the tax implications of RSUs. Let’s get started.
How RSUs Work?
When companies give RSUs as compensation, employees don’t need to pay anything to own the stocks. Since it is compensation, the issuing company gives RSUs to employees in a way similar to how you receive a paycheck during payday. The only difference with RSUs is that it’s a bit more complicated than your paycheck. To receive RSUs, employees must first meet the vesting conditions.
Vesting is the process of giving full ownership of RSUs to an employee. However, there’s a catch. Employees need to meet the vesting conditions in order for the RSUs to vest. The vesting condition is only valid during the vesting period. Think of the vesting period as the deadline. Even if you meet the condition after the deadline, the RSUs won’t vest because it already past the deadline.
For example, let’s assume that Company A will give 200 stock units to the Vice President of Sales if it meets 90% of its sales goals for Fiscal Year 2024. However, if the vice president exceeds the sales goal, they receive 400 stock units. At the end of FY 2024, the VP’s sales reached 120%.
- Vesting Condition: Achieve 90% of the sales goal to get 200 stock units. Exceed 90% to receive 400 stock units.
- Vesting Period: Fiscal Year 2024. This means that the VP of Sales needs to meet the conditions in 2024 only. The condition will no longer be valid in 2025.
RSU vs. Stock Options
RSUs and stock options have similar characteristics. Both have vesting conditions and vesting periods but the main difference lies in how RSUs and stock options are given. RSUs are part of compensation, while stock options are only rights to purchase shares of stock at a predetermined price. Simply put, RSUs don’t require employees to pay upfront once vested. In the case of stock options, you’re only given the right to purchase stocks. It’s either you take it or leave it.
Effect on Taxes
When a company gives RSUs, you don’t need to worry about its tax implications immediately. There will only be tax consequences once the RSUs are vested, i.e., vesting conditions are met. For employees, taxes on vested RSUs are often included on their W-2s and taxed as ordinary income. Employees need not worry about anything because the employer will handle the withholding and payment of tax.
Employers can withhold taxes from vested RSUs using any of the following methods:
- Sell-to-cover: The employer will sell a portion of the RSU and use the proceeds for tax.
- Cash withholding: The employer will reduce your paycheck to pay for the tax due of vested RSUs
- Share withholding: The employer will give all the RSUs to you upon investing. Some of it will be withheld for tax payments.
Once vested, employees can sell these stocks. Selling stocks may or may not result in a capital gain, and when there’s a capital gain, employees need to pay capital gains tax on the transaction.
Examples of Vesting Conditions
The vesting condition is an important factor for RSUs because it will be basis on how RSUs are vested. Below, we discuss common examples of vesting conditions:
- Time-based conditions: When vesting is time-based, the employees only need to meet the time requirement. For example, a company may give 500 stock units to employees who will remain in the company’s employ within the next three years. Alternatively, the vesting condition can be gradual. For instance, a company will give 100 stock units every year as long as the employee remains in the company’s employ for the next five years.
- Performance-based conditions: When vesting is performance-based, employees must meet a specific key performance indicator. Performance-based conditions include revenue targets, return on investment, and other relevant KPIs.
- Milestone-based conditions: When vesting is milestone-based, RSUs only vest when an employee or department achieves a milestone (e.g., launching a new product line or opening a new branch).
Advantages and Disadvantages of RSUs
The most significant advantage of RSUs is that they give employees a portion of company ownership just by meeting certain conditions. Receiving RSUs also means that employees can own stocks that generate another income source through dividend payments. Employees also don’t need to pay anything once the RSUs vest.
However, its most significant disadvantage is the vesting condition. For RSUs to vest, employees need to work hard or stay in the company’s employ. Otherwise, RSUs will be forfeited if the vesting condition isn’t met. Moreover, unvested RSUs don’t give voting rights or dividend payments.
Conclusion
RSUs can be a good compensation plan for employees. It encourages employees to work harder and exceed their goals. While RSUs are good at boosting morale in the company, it has a lot of complications, especially with taxation.
At TL;DR Accounting, we can help you implement an RSU compensation plan for employees and guide you in taxation and financial reporting complexities. Let’s chat and let our team of CPAs help you in solving your business problems.
Until next time!
