/>iFor banks seeking to attract and retain the best talent, restricted stock has become a popular alternative for providing incentive compensation to bank executives. Restricted stock may take the form of either a restricted stock award (RSA) or a restricted stock unit (RSU). Both have significant retentive value, but they have important differences that affect the interest of the executive.
Restricted Stock Awards
A RSA is an actual grant of stock that is subject to certain restrictions, as determined by the employer, until it vests. On the grant date, the executive receiving the RSA becomes the record owner of the shares of stock subject to the award. During the vesting or restricted period, the shares remain subject to the restrictions, the executive may not transfer the shares, and the shares are typically held in escrow by the employer. RSAs may, but are not required to, have a purchase or strike price. If so, such price would likely be far below the stock’s fair market value. However, most RSAs are typically granted with no purchase price.
RSAs may provide for dividends on the restricted shares to be paid to the executive during the vesting period or, alternatively, may provide that such dividends be accumulated and paid at the time the award vests. In addition, a RSA may, but is not required to, grant voting rights to the executive during the restricted period. This shareholder rights feature provides the employer flexibility in designing the RSA for each executive.
Restricted Stock Units
A RSU is a similar award but does not include the actual issuance of shares at the time the award is granted. Instead, it is an award to an executive of the right to receive shares of stock after the restrictions imposed during the vesting or restricted period lapse and the RSU vests. It is an unfunded and unsecured promise by the employer to deliver the shares in the future. Since no shares are issued at the time of the grant of a RSU, RSUs are more flexible than RSAs. Specifically, there are no voting, dividend, or other shareholder rights to address during the vesting or restricted period; however, dividend equivalent rights may be granted under a RSU as an optional feature. Additionally, an award of a RSU may provide that it will be settled in either stock or cash equal to the value of the stock.
Another distinguishing feature of RSUs that may provide an attractive advantage to executives is that RSUs may be structured with a deferral feature. A deferred RSU may be designed by the employer with a settlement date that is automatically deferred beyond vesting, for example, upon retirement or other separation from service. Alternatively, it may be designed to allow an executive to elect to defer settlement of the award beyond the vesting date to some future date or to retirement, thus giving the executive control over the timing of the settlement and, therefore, the taxation of the award. In either case, caution must be exercised to ensure compliance with the deferred compensation provisions of the Internal Revenue Code of 1986, as amended (the Code), both in designing such a deferral feature under a RSU and in the executive’s election for such deferral. Generally, any such election by an executive must be made at the time the award is granted.
Vesting
During the vesting or restricted period, the shares subject to a RSA or RSU are subject to forfeiture (typically upon the executive’s termination of employment) if the restrictions or vesting criteria are not met. Further, shares issued under a RSA, although owned by the executive, are non-transferable, meaning that the executive generally may not sell, assign, or encumber the shares in any manner.
Vesting of RSAs and RSUs is, generally, time based, requiring the executive to remain employed through the vesting date or dates in order to vest in the shares subject to the award. The employer determines the vesting or restricted period, which may be cliff vesting (providing full vesting of all shares after a set number of years, such as three full years of service) or incremental vesting (providing vesting over a number of years, such as 20% per year for five years). Vesting can also be tied to the attainment of certain performance metrics during a set performance period, although this is not a common feature with a RSA or RSU. In addition, RSAs and RSUs may, but are not required to, provide for acceleration of vesting upon the occurrence of one or more certain events that may occur prior to the end of the vesting or restricted period. Common events that may be included as a vesting acceleration feature are the retirement, death, or disability of the executive or a change in control of the employer.
Tax Considerations
There are no tax consequences to either the executive or the employer at the time of the grant of a RSA or RSU. Upon vesting of a RSA, the executive has compensation income taxed at ordinary income rates in an amount equal to the fair market value of the shares on the vesting date less the amount paid for such vested shares, if any. Likewise, the executive has compensation income at the then fair market value taxed at ordinary income rates on the vesting date of a RSU or, if a later settlement date is elected or otherwise applicable under the terms of such RSU, on such later settlement date. The executive will have a basis in the shares equal to the amount included in income, and his or her capital gains holding period begins on the date of vesting or, if applicable, on a later settlement date for a RSU.
Alternative tax treatment is available with respect to a RSA for an executive who chooses to make an election under §83(b) of the Code. This election is not available for RSUs. Under a §83(b) election, the executive is taxed on the fair market value of the shares (less any amount paid for the restricted shares) at the time of the grant. The election is made by the executive’s filing a written document (no specific form is required) with the Internal Revenue Service identifying the executive and the property to which the election applies and providing a copy to the employer within 30 days after the date of the grant. If the §83(b) election is made, there are no additional income tax consequences to the executive at the time the RSA vests. The advantages of the §83(b) election are that compensation income will hopefully be lower at the time of election than on the vesting date and that the grant date will start the executive’s capital gains holding period. There are also some risks to the executive in making the §83(b) election, resulting from the fact that the election cannot, generally, be rescinded or the taxes recovered. Therefore, if the stock price declines during the vesting period, there is the risk that more taxes would be paid based on the fair market value on the grant date than would have been paid at vesting. Likewise, if the RSA is forfeited, the executive cannot claim a refund for taxes paid on the RSA shares not received. Some technical considerations arise with respect to a §83(b) election in connection with RSAs granted to an executive of an S corporation. Under Treasury Regulations, for tax purposes, including the tax provisions governing S corporations, stock issued under a RSA is not treated as outstanding until the shares vest. However, if the executive makes an election under §83(b) with respect to a RSA, the stock is treated as outstanding and the executive is treated as a shareholder for all tax and S corporation purposes. The shares the executive holds subject to the RSA must have the same rights as to distributions and liquidation proceeds, as well as for sharing in the profits and losses of the employer, as all other shareholders. If not, the S corporation could be deemed to have a second class of stock outstanding in violation of S corporation requirements, resulting in a loss of its S corporation status. As a consequence, the profit or loss of the S corporation allocated to the stock subject to the RSA will be passed through to the executive during the restricted period even though the executive is not yet vested in the shares.
Regardless of when the executive recognizes the income with respect to a RSA or RSU, whether at vesting, a deferred settlement date under a RSU, or the grant date pursuant to a §83(b) election for a RSA, the income is compensation income subject to all income and employment tax withholding by the employer. The employer is entitled to a compensation deduction at the time the executive recognizes the income.
As noted above, dividends may be paid on a RSA during the restricted period. In the event dividends are paid during this period, they are treated as compensation income, subject to all withholding taxes, and are reported on IRS Form W-2 the same as any other compensation. However, in the event an executive makes a §83(b) election with respect to the RSA, the dividends paid during the restricted period, if any, will instead be treated as dividends, the same as those paid to any shareholder, and reported on IRS Form 1099-DIV.
Summary
While there are several options available to provide equity and other incentive awards to bank executives, RSAs and RSUs offer advantages that may prove beneficial to both the bank and the executive. They have significant retentive value in that they are full-value awards that will provide the executive with some value even if the stock subject to the award declines in value after the date of the grant. In addition, since the stock typically is issued without a purchase price, the executive is not required to make a cash outlay in order to realize the value of the award. Both RSAs and RSUs provide the employer flexibility in designing the grant in a manner that best fits its current needs and operates most effectively to benefit its current executives, and such design is not required to be identical for the grants made to each executive. As noted, for example, with RSAs, the employer has the option of providing immediate dividend rights and/or voting rights; with RSUs, the employer may provide the executive the right to defer settlement, and therefore taxation, beyond the vesting date; and these features, among others, may vary from executive to executive. There can be some disadvantages, including that there may be a liquidity issue for the executive in meeting the tax liability upon the vesting or other settlement of the shares. Further, large grants can have a dilutive effect on other shareholders. Overall, however, RSAs and RSUs are effective incentive alternatives with significant retentive effect that provide tangible value easily understood by the executive.
