Definition of Restricted Stock Units
Restricted stock units (RSUs) refer to the value granted in company’s common stocks to the employees by an employer as a part of compensation through a well-defined vesting plan and a schedule of distribution based on the accomplishment of set performance milestones or based on a requirement to serve a minimum number of years with the company. The stocks units are not issued at the time of grant instead they are issued only after the completion of the vesting period.
RSUs form part of compensation plans offered by companies. In these plans, an employee is offered an interest in the fixed number of units of the common stocks of the company. However, units are not granted initially at the time of grant of interest. The units are issued only at a future date based on completion of a specified milestone or completion of a specified tenure by the employee. This means that the units vest in favor of the employees as per the company’s vesting schedule. At the vesting date, the employees can get either the units or cash based on the fair market value of the units as on the vesting date. Such compensation benefit is offered to new employees or employees who are highly skilled to incentivize them for staying with the company.
Example of Restricted Stock Units
Suppose a company appoints a new employee who is highly skilled and thus, highly valuable for the company. The company offers 500 units of restricted stock units to the employee as part of the compensation plan in addition to the regular salary. The vesting conditions suggest that the employee needs to stay for 5 years with the company to be eligible for the stock units. The units will be vested after a period of 5 years and the employee will get an option to either get 500 units of stock or an equivalent cash value based on fair market value of the stock as on the vesting date. This is an example of a restricted stock unit plan.
How to Tax Restricted Stock Units?
The stock units or cash that are awarded to the employees at the vested date as per the fair market value are considered as the ordinary income of the employee for that year. The income is calculated based on the fair market value of the stocks prevailing on the vesting date. The employer is required to withhold tax on the RSU distributions and the remaining portion of shares or cash after appropriating taxes is transferred to the employees. An employee can either hold the shares or they can sell them.
How is Stock Limited on Restricted Stock Units?
Under RSU plans, the employer promises to pay a fixed number of common stock units to employees or a cash equivalent after the completion of the vesting period. The number of units for which the company wants to entitle employees is based on the company’s assessment of their roles and capabilities. There are three ways in which stocks can be restricted in case of RSUs:
- Time-based restriction: A restriction is placed on the number of years that an employee needs to serve in the company before the right in stocks vest.
- The performance or milestone-based restriction: A restriction may be placed for completion of a particular milestone such as completion of a particular project.
- A combination of the above two restrictions
Restricted stock units are advantageous for the employer as well as the employees in the following ways:
- The company is able to retain talented employees and it saves them from the loss that they would incur on the early resignation of such employees.
- The company is deferring the payments for the future instead of making an upfront payment and hence saving its cash flows.
- The employee gets ownership interest in the company once the option vests.
- The shares are issued at the prevailing market prices on the vesting date and the employee also gets an option to get equivalent cash value.
Some limitations that employers and employees face in case of restricted stock units are as follows:
- It is not guaranteed that highly talented employees will stay with the company just because of the right of RSUs as some other company might offer to compensate them even better based on their high skills.
- The amount at which the employees are to be compensated is unknown to the company at the beginning since the fair market value as at the vesting date is considered.
- It may happen that the value of the stock doesn’t appreciate as expected by the employees.
- If for any genuine reason the employees want to leave the company before the vesting period, the employees will have to forego the rights.
Restricted stock units are a good option to retain employees with the company. A benefit that is associated with RSUs is also that the employees don’t have to bear any cost and the same form part of their compensation plan.
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