Restricted Stock Unit (RSU)

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Restricted Stock Unit (RSU): How They Work, Taxation, Pros & Cons

What is an RSU?

A restricted stock unit (RSU) is an employer grant that promises company shares to an employee after certain conditions are met—most commonly, remaining with the company for a set vesting period or achieving performance milestones. RSUs have no transferable value until they vest and are converted into actual shares.

How RSUs work

  • Grant and vesting: Employers award RSUs with a vesting schedule (e.g., time-based: 25% per year for four years; or performance-based). Until vesting, the employee has no ownership rights.
  • Settlement: On vesting, the company issues shares (or sometimes cash equivalent). Employers commonly withhold a portion of shares or take other measures to cover payroll and income taxes; the employee receives the net shares.
  • Post-vesting: Once converted to shares, the employee can sell or hold them. Any later appreciation or decline is treated as a capital gain or loss relative to the value at vesting.

Tax treatment (U.S. perspective)

  • Ordinary income at vesting: The fair market value (FMV) of the shares received at the vesting date is treated as ordinary income and is subject to payroll and income tax withholding. Employers typically report this amount on the employee’s W-2.
  • Cost basis: The FMV at vesting becomes the employee’s cost basis for capital gains tax purposes.
  • Capital gains/losses: If shares are sold after vesting, the difference between the sale price and the FMV at vesting is a capital gain or loss (short- or long-term depending on holding period after vesting).
  • No 83(b) election: RSUs are generally not eligible for a Section 83(b) election because they are not considered property until shares are actually issued at vesting.
  • Dividend treatment: RSUs do not pay dividends before vesting. Some plans provide dividend equivalents, which are typically taxable when paid or when shares vest, depending on plan terms.

Key advantages

  • Retention and alignment: Encourage long-term employment and align employee incentives with company performance.
  • Guaranteed value at vesting: Unlike out-of-the-money stock options, RSUs retain value equal to the underlying share price at vesting.
  • Simpler administration: Employers don’t issue shares until vesting, which can simplify early recordkeeping and delay dilution.

Key disadvantages and limitations

  • Immediate taxation at vesting: Employees owe ordinary income tax on the full FMV at vesting even if they do not sell shares to cover taxes.
  • No voting rights or dividends until conversion: Employees typically gain shareholder rights only after shares are issued.
  • Forfeiture risk: Leaving the company before vesting usually results in forfeiture of unvested RSUs.
  • Potential cash crunch: Tax withholding can consume a meaningful portion of vested value if shares or cash are withheld to satisfy taxes.

Practical examples

  • Simple example: An employee is granted 1,000 RSUs when the stock trades at $10. If the RSUs vest one year later and the stock is $15 at vesting, the employee recognizes $15,000 as ordinary income at vesting (and receives net shares after tax withholding). If the employee later sells those shares at $20, the $5 per share difference ($20 − $15) is taxed as capital gain.
  • Real-world illustration: Large companies frequently use RSUs for executives and staff. For instance, public filings sometimes show executives receiving substantial RSU grants that convert into common stock when vesting conditions are satisfied.

RSUs vs. stock options (brief)

  • RSUs: Promise of shares at vesting; taxable as ordinary income at vesting; always have value equal to underlying shares at vest.
  • Stock options: Right to purchase shares at a set exercise price; value depends on market price exceeding the exercise price; tax treatment varies by option type and timing of exercise/sale.

Special considerations

  • Plan terms vary: Vesting schedules, treatment of dividend equivalents, and post-termination vesting (e.g., disability or retirement exceptions) depend on the employer’s plan documents.
  • Withholding methods: Employers may use net-share settlement, share withholding, sell-to-cover, or cash payment to meet tax withholding obligations.
  • Dilution: Employers defer issuing shares until vesting to manage dilution; however, eventual issuance increases outstanding shares.
  • Consult tax/professional advice: RSU taxation and planning (e.g., timing of sales to manage capital gains) can be complex—seek personalized guidance.

Bottom line

RSUs are a widely used form of equity compensation that reward employees for tenure and performance by granting shares over time. They align employee and shareholder interests and guarantee some value at vesting, but they also create immediate tax liabilities and come with forfeiture risk before vesting. Understanding your RSU plan terms and the tax implications at vesting is essential for effective financial planning.