RESTRICTED STOCK UNITS

An RSU is the right to receive from the company, after the satisfaction of vesting requirements, either:

• A specified number of shares of common stock.

• Cash equal to the value of a specified number of shares of common stock.

If the employee fails to satisfy the vesting requirements, the RSU is simply forfeited. If the employee satisfies the vesting requirements, the company issues shares of common stock following the vesting date or, in certain cases, pays cash, which, in either case, is referred to as settlement.

A holder of an RSU is not the beneficial owner of the underlying shares. Unlike a restricted stock award, which is considered a transfer of property on grant, property is not transferred when an RSU is granted and the RSU is not taxed until the RSU vests and is settled.

Settlement can be delayed beyond the vesting date, which allows for some tax planning, but this may make the RSU subject to Section 409A, which:

• Significantly limits the settlement date options.

• Can lead to severe tax penalties if the complex payment rules of Section 409A are violated.

RSUs retain value regardless of the performance of the startup company’s stock price (unless the stock price goes to zero). Therefore, RSUs are considered more valuable than stock options, the value of which is dependent on the company’s stock price exceeding the stock option’s exercise price. Accordingly, an award of RSUs typically covers fewer shares than a stock option grant.

Federal Tax Consequences

RSUs that are either exempt from or comply with Section 409A are generally taxed at ordinary income rates on settlement. Any payment of cash or stock on settlement is characterized as gross income from compensation for services under Code Section 61. As gross income, the fair market value of the shares or the amount of cash received on settlement is subject to federal income tax at ordinary income rates. Because this gross income is considered wages, the company must withhold or collect the taxes due on settlement. When the employee sells the shares, the employee is then subject to capital gain or loss on the difference between the sale proceeds over the fair market value of the shares at the time of settlement.

Although federal income taxes are not recognized until settlement (assuming the RSU is either exempt from or complies with Section 409A), employment taxes, including FICA and FUTA taxes, are due on vesting of the RSU. The amount includible in income is based on the value on vesting for FICA and FUTA purposes and the value on settlement for income tax purposes.

RSUs are generally treated as nonqualified deferred compensation plans for purposes of FICA and FUTA. Under a special timing rule in Code Section 3121(v)(2)(A) (for FICA) and Code Section 3306(r)(2) (for FUTA), an amount deferred under a nonqualified deferred compensation plan (that is, the RSU) must be taken into account as income for purposes of FICA and FUTA as of the later of when:

• The services are performed.

• The right to the amount deferred is no longer subject to a substantial risk of forfeiture (that is, vesting).

For purposes of FICA and FUTA, services creating the right to an amount deferred are considered performed when, considering the relevant facts and circumstances and the terms of the plan or agreement, the employee has performed all of the services necessary to obtain a legally binding right to the amount deferred, disregarding any substantial risk of forfeiture.

For RSUs, this occurs at vesting. Under a nonduplication rule in Code Section 3121(v)(2)(B), because the RSUs are taken into account as wages under the special timing rule, the value of the RSUs are not subject to FICA or FUTA taxes again when the RSUs are actually settled and become subject to federal income taxation, assuming those taxes are paid on vesting.

Property is not considered transferred at the time an RSU is granted and, therefore, an employee may not choose to make a Section 83(b) election to be taxed on receipt of the RSU. In the case of stock-settled RSUs, long-term capital gain treatment is possible on the later increase in the value of shares after settlement, but most holders sell all shares on settlement if the shares are saleable.

The company is generally entitled to a tax deduction in the amount, and at the time, the employee recognizes ordinary income.

Accounting Treatment

Assuming the typical vesting provisions used by a startup company described earlier, the fair value of a stock-settled RSU granted to an employee generally must be reflected as a compensation expense for financial accounting purposes on grant and expensed over the expected vesting period.

Advantages and Disadvantages

Key advantages of granting a stock-settled RSU include:

• The company is not required to make any cash payments.

• No appraisal is required to grant RSUs, unlike stock options.

A key disadvantage of granting an RSU is that the employee does not control the timing of the tax event, unlike with a stock option or, to some extent, a restricted stock award (to the extent a Section 83(b) election is made). Also, the RSU vesting and settlement must be structured to be exempt from or compliant with Section 409A.

Common Usage

RSUs are not often granted by a startup company in its early stages. Due to tax complexities, issuing RSUs requires that the company or the employee have sufficient cash to fund the taxes that are due on settlement or postpone vesting until sufficient cash is available to fund the taxes. As a result, RSUs are rarely granted by startups, except in one-off situations, until the startup has sufficient cash and a reliable income stream.

RSUs are usually granted by mature, highly valuable companies typically when the fair market value of the common stock is too high for stock options to be motivating to employees. RSUs do not offer employees the opportunity to obtain long-term capital gains treatment, but when the value of the common stock is high, the opportunity to eventually acquire stock for no purchase price can be attractive for employees.