Your Restricted Stock Unit Questions, Answered

Posted by Cory M. Evans on September 18, 2014

Restricted stock units are an increasingly common form of compensation in the Bay Area.

Living in the San Francisco Bay Area means great weather and a high cost of living, but it also entails living in what is arguably the worlds hub for technological innovation and concentrated wealth. The concentrated wealth can be derived from various types of employee compensation, including restricted stock units (RSUs), which are growing in popularity.

An Alternative to Stock Options

From Silicon Valley to San Francisco, tech companies are now favoring restricted stock units (RSUs) as an alternative to incentive stock options (ISOs) due to favorable accounting rules and income tax treatment. Stock options used to be favored by companies because they could offer employees and executives compensation benefits without the company having to record compensation costs.

This changed in 2004 when the Financial Account Standards Board revised the share-based compensation transactions so that the fair value of stock options is estimated on the grant, which is then reported as a compensation expense. While beautiful and diverse, life in the Bay Area comes with complexities, such as the high expenses and a complex real estate market for those looking to buy or sell a home. However, one less burden of complexity can be dealing with RSUs, as they do not necessitate a complex options pricing model, whereas ISOs can.

What Are RSUs?

RSUs are essentially a deferred cash bonus that is paid in shares of phantom stock at the time of vesting rather than cash. Its a contractual obligation by an employer to grant restricted stock on specified dates and is often used as a source of employee compensation. RSUs do not fully transfer to the owner of the granted RSUs until certain conditions have been met, such as continued employment or performance-related goals. For example, an employee is granted 1,000 RSUs vesting 25% per year over a four-year period. The employee would then have 250 vested RSUs each year and on the fourth year would have 1,000 RSUs. All unvested shares are forfeited once the employee leaves the company.

Unlike stock options, an RSU grant is the full value at the time of vesting, which means that RSUs can never be out of the money. For example, if your company grants you 1,000 RSUs and the share price on the first vesting date is $10, then you will have $10,000 in income. If the shares price of the RSU is $8 on the second date of vesting, then you will still have $8,000 in income.

We generally dont recommend holding more than 4–5% in a concentrated stock. Tweet

How Are RSUs Taxed?

Employees are not taxed on the RSUs at the time of the grant. They are, however, taxed when the RSUs vest. The IRS considers RSUs to be compensation; therefore, the difference between the fair market value of the grant at the vesting date and the original purchase price, which could be zero, is taxed as ordinary income at your marginal income tax rate and reported on your W-2 in the year the vested shares are delivered to you. Because you pay income taxes when the shares vest, tax planning for RSUs tends to be easier and more straightforward than financial planning for stock options.

Most companies will withhold the required minimum amount for federal supplemental income tax: 25% for federal taxes and 35% for total annual amounts over $1 million; if you fall between those brackets you will have to pay more tax. Some companies allow for the surrender of shares equivalent to the value of the tax owed, which is less burdensome than writing a check for the tax owed.

Should You Sell Your Vested Shares?

You do have the option of holding or selling the vested shares. The appreciation will then be subject to short-term or long-term gains or losses based on the cost basis of the market value of the stock on the day of vesting. In the Bay Area, we see a lot of employees at firms such as Facebook, Apple and Google who hold on to their vested shares in the hope that their shares will go through the roof. Does this make sense?

First of all, there is no tax advantage in holding on to vested shares. If you were given a cash bonus instead of RSUs, would you buy your companys stock with your bonus money? Probably not. We recommend working with your financial advisor to plan for the sale of the vested RSUs. Your financial situation may necessitate the selling of all RSUs. We generally dont recommend holding more than 4–5% in a concentrated stock. Having a highly concentrated position can expose you to excess volatility and risk. When that company is also your employer, a lot of your financial well-being is already concentrated in the success of the company in the form of your job, compensation, benefits, etc.

Here are some key financial planning points to keep in mind when it comes to RSUs:

• Be aware of vesting dates—you will pay income taxes when the shares are delivered, which is usually at the vesting date.
• If youre planning to retire and have units that are vesting soon after retirement, you may want to consider postponing retirement.
• Work with your financial advisor to reallocate dollars from vested and sold RSUs across a diversified portfolio .
• If you have other types of stock options (NSOs/ISOs) in addition to RSUs it is important be aware of vesting and expiration dates. You will also want to work with your financial advisor and tax advisor to run models of your tax return prior to the year end in order to be aware of any Alternative Minimum Tax (AMT) planning issues.