Tax Treatment Of Restricted Stock Units

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					    The Executive Comp Insider
Considering Granting Restricted Stock or Restricted
Stock Units? Remember the Tax Differences
                                                     By James D.C. Barrall

   Financial Accounting Standard 123(R) is leveling the          and is subject to tax under Code Section 83 at the time the
playing field for the accounting treatment of various forms      award is made, while RSUs are promises to deliver stock
of equity compensation and is eliminating variable ac-           in the future, which may constitute nonqualified deferred
counting for performance-based awards that are settled           compensation subject to Section 409A – and which don’t
in stock. Simultaneously, public companies are trying to         result in a transfer of property subject to Section 83 until
conserve shares under their equity plans and create reten-       the stock is delivered. This is more than a theoretical dis-
tion incentives that may not be provided by stock options        tinction and can create problems for the unwary.
(which have been known to go underwater). Accordingly,               Restricted Stock. A holder of RS is taxable on the
more public companies are granting restricted stock (RS)         fair market value (FMV) of the stock when it vests, unless
and/or restricted stock units (RSUs) that are settled in         the holder elects to be taxed on the FMV of the stock as of
stock and are starting to experiment with performance            the date of grant under Code Section 83(b). At most public
vesting conditions.                                              companies, holders don’t make such elections in order to
   While RS and RSUs have much in common, there are              avoid the risk of being taxed on compensation they never
very important tax differences between the two that have         realize, either because they forfeit the RS or the value of
surprised more than a few companies and should be con-           the RS drops prior to vesting. This means that RS holders
sidered when making RS or RSU grants.                            generally are taxable when the shares vest, which has two
   The essence of RS is that it constitutes an up-front          important implications for designing RS awards. First,
transfer of shares of a company’s stock at the time the          provision needs to be made for income taxes that must
RS award is made, subject to a vesting schedule based            be withheld from the holder at the time the shares vest.
on either the holder’s continued employment (time vest-          Second, “vesting” for tax purposes means the first date on
ing) or the attainment of specified company or individual        which the RS is no longer subject to a “substantial risk of
performance goals (performance vesting). RSUs, on the            forfeiture” (SROF), not when restrictions are removed
other hand, constitute a promise to transfer shares of a         from the shares or the shares are delivered. For example, if
company’s stock at a later date, after the applicable vesting    an RS holder can retire after a stated date (such as age 65
conditions on the promise have been satisfied.                   or age 55 with at least 10 years of service), the holder will
                                                                 be taxable on the FMV of the stock the instant the condi-
Similarities Between RS and RSUs                                 tions are satisfied, even if the stock isn’t delivered to the
   The similarities between RS and RSUs are: (1) they are        holder until termination of employment.
“full value” awards in today’s parlance and both provide             Restricted Stock Units. Because RSUs don’t result
the same economics; (2) under FAS 123(R) they have the           in a transfer of property until the stock is actually delivered
same accounting expense impact (but only if the RSUs             to the holder, RSUs provide companies and executives
are settled in stock, not cash); and (3) they are subject to     with more tax planning flexibility than RS, since RSUs
the same treatment under Code Section 162(m). This last          can vest prior to the time the stock is delivered and is tax-
point means that if RS or RSUs vest based on time vesting        able to the holder. While the deferral of taxes is generally
alone, they don’t qualify as “qualified performance-based        a good thing, appreciation in the FMV of the stock above
compensation” (QPBC) and the value of the stock is treat-        its FMV on the vesting date is taxable as ordinary income
ed as compensation subject to the $1 million deduction           (in contrast to post-vesting appreciation of RS, which is
cap. But if they vest based on the attainment of objective       taxable as capital gains). More importantly, RSUs that de-
performance targets that are based upon shareholder-             fer payment after vesting constitute nonqualified deferred
approved performance goals and meet all of the Section           compensation, which is subject to Section 409A unless the
162(m) requirements for QPBC, the compensation isn’t             deferral is a “short term deferral” (for calendar year com-
subject to the deduction cap. (See my February column on         panies, distributed by March 15 of the year following the
Section 162(m) and QPBC requirements.)                           year in which the RSUs vest).
The Big Difference Between RS and RSUs                             James D.C. Barrall is Global Chair of the Benefits and
   The most important difference between RS and stock-             Compensation Group of Latham & Watkins LLP.
settled RSUs is that RS results in a transfer of property

4                                       March	2006	|	Executive	Compensation	Strategies

				
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