This article is the fourth in our series on equity-based compensation intended to assist employers with answering a common question: What type of equity compensation award is best for our company and our employees? The first article is available here, the second article is available here, and the third article is available here.

This article will provide an overview of restricted stock, stock-settled restricted stock units (RSUs), and performance stock units (PSUs). As an overview, this article will address only certain key aspects of restricted stock, RSUs, and PSUs. It is not intended to be a comprehensive discussion of every issue or consideration that applies to these types of awards. The article focuses on privately-held companies and does not address the additional or different securities law, accounting, and governance considerations that apply to publicly-traded companies. In addition, all discussion of taxes is limited to U.S. Federal income tax.

Description

What is Restricted Stock?

Restricted stock is an award of stock that is subject to restrictions, meaning it is both non-transferable and subject to a substantial risk of forfeiture, until it vests (i.e., until the restrictions lapse). The recipient of restricted stock is the record owner of the stock at the time of the grant, meaning the recipient holds voting, dividend, and other shareholder rights unless limited by the company.

What are Stock-Settled RSUs and PSUs?

A stock-settled RSU represents a right to receive a share of the company’s stock in the future upon a specified vesting date or a later payment date. Unlike restricted stock, no shares of stock are actually issued at the time the award is granted; rather, a grant of an RSU is viewed as an unfunded and unsecured promise to award stock in the future. The recipient of an RSU is not the record owner of the stock unless and until the award is settled. A PSU works the same as an RSU, except that the award vests upon achievement of certain specified performance goals, rather than based on continued service through a specified date.

Tax Treatment

Restricted Stock

A restricted stock grant is not automatically subject to ordinary income tax at grant. Rather, the recipient of restricted stock will be taxed and subject to withholding when the stock becomes transferable or is no longer subject to forfeiture, whichever occurs first.

A recipient may, however, make an election, as permitted under Internal Revenue Code § 83(b), to pay taxes on the value of the stock when awarded (an “83(b) election”). The 83(b) election may be attractive to a recipient, especially if the shares have a very low value on the grant date, as all post-grant appreciation will be eligible to be taxed as a capital gain once the stock is sold (and no taxes are due on the value of the stock at the time it vests).

The company will be eligible to take a deduction when the recipient recognizes ordinary income, if any.

RSUs and PSUs

There are no tax consequences at the time an RSU or PSU is granted; rather, the value of the units is taxed as ordinary income and subject to income tax withholding, if applicable, when the award is settled. A recipient may not make an 83(b) election related to an award of RSUs or PSUs.

The company will be eligible to take a deduction when the recipient recognizes ordinary income.

Note: If the RSU or PSU is subject to Internal Revenue Code Section 409A (Section 409A), then a special tax rule will apply for FICA tax purposes. Specifically, the value of the award will be subject to FICA taxes when it vests, rather than when it is settled. The application of Section 409A and the special FICA rule is complex and outside the scope of this article.

Advantages

Restricted Stock

An award of restricted stock has several potential advantages:

• Notwithstanding the restrictions, the recipient of restricted stock immediately owns the granted shares, so restricted stock awards convey a stronger sense of ownership than an award of RSUs or PSUs, especially if the awarded stock includes voting and/or dividend rights.
• Restricted stock enjoys flexible taxation, as recipients can delay taxation or elect taxation at grant via an 83(b) election if desired.
• Restricted stock requires no personal investment from recipients.
• From the company’s perspective, the potential for forfeiture if the recipient leaves before the restrictions lapse can significantly aid retention, especially if the recipient filed an 83(b) election and paid associated income taxes.

RSUs and PSUs

RSUs and PSUs also have potential advantages as an incentive compensation vehicle:

• RSUs and PSUs generally require no personal investment from recipients.
• From the company’s perspective, granting a recipient an RSU or PSU does not give the recipient any rights as a shareholder.

Disadvantages

Restricted Stock

Some potential disadvantages to restricted stock include the following:

• Unless a recipient elects early taxation through an 83(b) election, the value of the shares when the restrictions lapse is taxed as ordinary income, rather than as a capital gain.
• Early taxation does not protect the shares from forfeiture. If the shares are forfeited after an 83(b) election, the taxes may not be recovered.
• Other than the possibility of an 83(b) election, the tax event cannot be timed. Any tax withholdings will need to be taken from other compensation paid to the individual since withholdings cannot be taken from the restricted stock itself.
• From the company’s perspective, a gain in market value is not required for an award of restricted stock to provide incentive or value to the recipient.
• Shareholders may view restricted stock negatively due to the appearance that recipients are getting “something for nothing.”

RSUs and PSUs carry similar and additional disadvantages, such as the following:

• RSUs provide no opportunity for capital gains until after the awards are settled.
• RSUs and PSUs may be subject to Section 409A, as discussed above, which limits the flexibility in design and complicates timing for FICA taxation.
• RSUs raise concerns under ERISA if the payout occurs only upon termination of employment or after a period of more than 10 years.
• PSUs may not incentivize retention as much as other equity awards if it appears unlikely that the company will meet the specified performance goals during the performance period.
• From the company’s perspective, a gain in market value is not required for an award of RSUs or PSUs to provide incentive or value to the recipient.

Other Considerations

Securities Laws

Restricted stock and stock-settled RSUs and PSUs are considered “securities” for purposes of U.S. Federal and state securities laws. This means that any grant of restricted stock or stock-settled RSUs or PSUs must comply with the requirements of the Securities Act of 1933. The Securities Act generally requires that any time a security is offered and sold, it must either be registered with the Securities and Exchange Commission or qualify for an exemption. 

An exemption frequently used for restricted stock, RSUs, and PSUs in the private company context is known as Rule 701, which generally exempts from registration securities that are offered and sold to employees, consultants, or advisors of the issuer or its subsidiaries under a written compensatory benefit plan if certain requirements are met. Companies should review Rule 701 and other available exemptions to determine what exemption, if any, is available for the particular grant.

In addition to the U.S. Federal securities laws, any grant of restricted stock, RSUs, or PSUs in the U.S. must qualify for an exemption under, or comply with state “blue sky” laws. The state “blue sky” laws where the employee or consultant resides at the time the award is granted will generally apply. Certain states may require a notice filing or payment of a fee when these awards are granted to service providers in those states. Companies should review the applicable state “blue sky” laws before making any grants to an employee or consultant in that particular state.

Documentation and Stockholders’ Agreements

Restricted stock, RSUs, and PSUs are generally documented using a written plan that contains the main terms and conditions applicable to the restricted stock, RSU, or PSU, with individual award agreements given to each recipient setting forth the particular terms and conditions of their award, such as the number of shares or units granted, the exercise price, if applicable, and their vesting period or performance criteria. The board of directors of the company normally adopts the plan and approves each grant, although delegation of such authority to an officer may be available.

When restricted stock, RSUs, or PSUs are to be granted in or settled for private-company stock, it is often prudent from the employer’s perspective to require the employee to enter into a stockholders’ agreement or similar agreement that will govern the employee’s ownership of the stock following exercise. A stockholders’ agreement can provide valuable protections for the employer and its other stockholders by, for example, limiting the transfer of stock (often by making it subject to a right of first refusal), ensuring that the employer has the ability to repurchase the stock if the employee leaves employment, and requiring the employer to participate in a merger or other sale transaction that is supported by the other stockholders.

Samantha M. Adams also contributed to this article.