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Why RSUs Are Edging out Restricted Stock

A plethora of advantages for employers and executives alike are making restricted stock units increasingly more popular than ordinary restricted stock. Don't get caught unaware of RSUs' complexities, though.
Andrew Liazos, CFO.com | US
September 20, 2011

Public companies increasingly are using so-called "restricted stock units" when compensating executives. In fact, recent surveys suggest they are now twice as prevalent as restricted stock for equity grants that are in the form of full-value shares (as opposed to stock options). What exactly is a restricted stock unit (RSU), and what should CFOs know about them?

An RSU represents a contractual right for the holder to receive a share of stock at one or more times in the future upon meeting certain vesting conditions as specified in an award agreement. In contrast, restricted stock involves up-front issuance of shares to an executive before any vesting conditions have been satisfied.

RSUs have become the more popular award for several reasons. First, they provide greater flexibility than restricted stock by allowing the employer (and in some cases the employee) to choose when shares will actually be issued, irrespective of the vesting date. That lets companies avoid the administrative cost and burden of issuing shares of stock (which usually include voting rights) and processing payments of dividends on shares that may never be earned and vested. That is particularly at issue when RSUs are awarded to a broad class of employees and/or when RSUs are subject to performance-based vesting conditions. It is also easier to do tax withholding with RSUs.

Plus, RSUs allow executives to accumulate larger vested equity positions faster than is possible with restricted stock, which is taxable upon vesting (unless an executive elects to be taxed earlier on unvested amounts by filing a Section 83(b) election). In order to pay taxes on vesting, some of the vested shares are typically sold into the market. In contrast, the shares underlying RSUs are not, if designed properly, subject to income tax until received by the employee, which may occur several years after the vesting date. RSUs are often developed in connection with executives accumulating equity stakes sufficient to meet share ownership guidelines.

There can also be special tax considerations. Restricted stock is difficult to use when a company allows for accelerated vesting of compensation upon retirement. While the employee must actually retire in order to sell the stock under most company policies, the IRS will typically consider restricted stock to be vested upon the employee first becoming eligible to retire by meeting an age and/or service requirement. RSUs can be used to tie the date of income tax to actual retirement or a later date. In addition, if tax-deduction limitations under IRS Section 162(m) are an issue for the employer for awards that are not performance-based, the issuance of shares can be delayed until a time when that limitation no longer applies to the employee.

There is a corporate governance angle to this as well. RSUs allow an employer to more easily enforce clawback policies that require recovery of certain types of incentive compensation that would not have been paid had the actual financial results been known at the time of payment. Once shares are already issued to the executive, it can be difficult to recover them (or their value if the shares have already been sold). The Dodd-Frank Act eventually will require that all public companies adopt clawback policies.

On the other hand, there are complexities when using RSUs that do not apply to restricted stock. RSUs will be subject to deferred compensation payment restrictions under IRS Section 409A if payment of shares may be delayed beyond March 15 of the year immediately following vesting. Specifically, Section 409A restricts when deferred amounts may be paid - in general, payment must be tied to a fixed date, separation from service, death, disability or change in control - and when the payment date must be designated in writing. Violating Section 409A triggers immediate income tax on vested amounts, a 20% addition to tax, and a premium interest tax.

This can be more complicated than one might think. In the case of an RSU with a retirement acceleration provision mentioned above, recall that the IRS will consider vesting to occur upon first becoming eligible to retire. So, this RSU would likely be subject to Section 409A, as the payment on retirement could occur after March 15 of the year after become retirement eligible. As such, the payment event in the RSU award agreement must comply with Section 409A in order to avoid adverse tax consequences. Unfortunately, we've seen too many situations where employers did not know the RSUs were subject to Section 409A, and it has been difficult to correct these RSUs in order to avoid adverse tax consequences.

Another example of when Section 409A can be a problem is when the employee's signature is required for the RSUs, as might be desired because of clawback conditions or employee covenants in the award agreement. What happens if the executive has not signed the award agreement? Does the company delay the issuance of shares until the agreement is signed? Doing so could result in a Section 409A election, as it could be considered a payment other than on a designated payment event. To avoid such a problem, it is typically best to have a provision providing for forfeiture of the award if the employee has not signed the agreement within a stated period of time (e.g., 30 to 60 days).


From a tax perspective, it is also important to keep in mind that there is no deferral of FICA taxes with RSUs. Just like restricted stock, RSUs are subject to FICA tax upon vesting regardless of when shares are issued. If FICA taxation is not planned for in advance, such as prior authorization of withholding for these taxes from another source of compensation, the company may have administrative burdens recovering these amounts from employees.

When granting RSUs to a broad-based group of employees, CFOs will also want to keep in mind when shares should be paid to avoid ERISA coverage. Stock compensation can trigger ERISA when payment of shares on RSUs is systematically deferred until termination of employment or a later date. This will not be a problem if these types of RSUs are granted only to a select group of highly paid employees or management; plans covering just these types of employees (referred to as top hat plans) are not subject to ERISA's vesting and funding protections. Using these types of RSUs outside of a top hat plan, however, exposes the employer to the risk of claims by a former employee to vesting and funding of RSUs that had previously been forfeited.

So, while there is much to say about the advantages for RSUs, care is needed in structuring them to avoid unintended consequences.

Andrew Liazos heads the executive-compensation practice at law firm McDermott Will & Emery.




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