Restricted Stock Units and Performance Stock Units: Understanding Your Equity Compensation
Companies that want to recruit and retain the best and most talented executives will often employ some form of equity compensation. By making employees, and especially executive leadership, part-owners in the company, they intend to give the executive a personal incentive for better performance that also aligns with company and shareholder interests.
As we mentioned in a previous article, such executive compensation can take several different forms, depending on the goals of the company. In this article, we want to focus on two particular forms of equity compensation that many companies are turning toward: restricted stock units (RSUs) and performance stock units (PSUs). Though the names sound similar, there are some important differences that executives need to understand. It’s also important to know the optimal time to sell these units, once they’ve been received. We’ll look at each of these topics in turn.
What Is a Restricted Stock Unit?
An RSU is basically a commitment by the employer to give company stock to an employee at some point in the future (the vesting date), but only when certain conditions are met. For RSUs, these conditions typically involve a minimum required period of continuous employment with the company, and they may also include certain individual performance goals. Especially for private companies that anticipate a buyout or an IPO, the vesting date may also be tied to one of these events. Vesting may occur as either a series of “graded” events—portions of the total grant are awarded in a series of transactions over time—or as a “cliff” vesting, in which all of the units are awarded at the same time, when the vesting conditions are met.
When the RSU is issued to the employee, no stock actually changes hands; it is merely a commitment for that to happen at a specified point in the future. Thus, there is no taxable event associated with the grant of RSUs.
When the stock vests, it is taxed as ordinary income for the employee, based on the fair market value at the time of vesting. Typically, companies will withhold the taxes from the vested amount, just as they do with a regular salary. If the stock increases in value between the time the employee is vested and they sell the stock, they would also owe capital gains tax on the increase. If they hold the stock less than a year before selling, they would owe short-term capital gains on any increase, which is taxed at the employee’s marginal rate for ordinary income. If they hold the stock a year or more, the gain would be taxed at the long-term rate, which is usually less than the ordinary income rate.
What Is a Performance Stock Unit?
Many of the basic attributes of RSUs also apply to PSUs, with one important difference: PSUs are vested, not based on employment tenure or individual goals, but rather on the achievement of certain performance goals for the company. These will usually be specified on certain key metrics like total shareholder return, return on capital, or earnings per share, and may also include benchmarking related to competitor companies. Typically, the more performance exceeds the stated goal, the more PSUs will be vested. In other words, plan participants are incentivized to not merely reach the minimum goals for vesting, but to exceed them as much as possible, since they would then be awarded additional stock.
As with RSUs, there is no tax associated with the award of PSUs; when they are vested they are taxed as ordinary income, and gains between the time of vesting and sale are subject to capital gains tax.
RSUs, PSUs, Taxation, and Timing the Sale of Your Shares
While recipients of RSUs and PSUs have little control over the initial taxation of vested shares, they have total control over when any capital gains become taxable. For a couple of reasons, though, it may make more sense to sell the vested shares as soon as they become available.
First, in many cases the newly vested shares may have experienced little increase in value, if any, from the time of vesting. Even though holding the shares for at least a year would qualify for more favorable long-term capital gains treatment, a quicker sale could mean that little, if any, capital gain would have been experienced. This is one way that recipients may be able to minimize the total tax due on their shares. It can also create a much simpler tax management situation.
Second, liquidating the shares sooner, rather than later, gives the recipient an opportunity for greater diversification of their asset base. After all, most equity compensation packages provide for recurring awards of RSUs or PSUs, either annually or at some other interval, so the executive can likely look forward to more opportunities to receive vested shares in the future. Continuing to hold vested shares over time can result in a greater percentage of the recipient’s net worth being represented by the value of the company stock (i.e., a concentrated position). If the company experiences hard times, it will have negative consequences for the recipient’s net worth. On the other hand, systematically liquidating shares and re-deploying the funds in a well-diversified portfolio can help the executive build a more durable base of personal wealth that is also less subject to the price swings of a single asset.
Of course, any discussion of selling vested shares should include careful consideration of the recipient’s tax situation, the company’s underlying financial health and future prospects, and the employee’s individual goals. Terms of the company’s compensation package should also be consulted, since some plans may require minimum holding periods for vested shares.0.
GEM Asset Management, as a fiduciary financial and wealth advisor, works with successful executives and others to create durable financial plans for securing retirement and achieving other important financial goals. If we can assist you, we would enjoy the opportunity to have a conversation.
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