When your company offers equity compensation, it's essential to know precisely what you're getting.
- Do you own the stocks immediately?
- Do you have to wait until a specific date to own your shares?
- Will you have to buy the shares offered to you, or are they gifted as part of your hiring, bonus, etc.?
Restricted stock awards (RSAs) are typically awarded to key or early-stage employees at the executive level. On the other hand, restricted stock units (RSUs) are commonly distributed across most levels for full-time employees.
If you were one of the first employees at a startup and are given both RSAs and RSUs, you’ll want to familiarize yourself with the difference between the two.
Here’s a hint:
- For Restricted Stock Awards, think “early-stage executives”.
- For Restricted Stock Units, think “all employees.”
The Breakdown: Restricted Stock Awards vs. RSUs
Whoever came up with the industry jargon for the various types of equity compensation certainly wasn't doing anyone any favors.
While the vernacular surrounding these investments tends to complicate things unnecessarily, it is still possible to sift through the noise and complexity. When push comes to shove, equity compensation is based on facts. You just need to understand what's going on so you can take the appropriate action.
There are four primary differences between RSAs and RSUs:
- Share Issue Dates
- Dividend Timing and Voting Rights
Let’s take a closer look at each.
Difference #1: Price
Owners of RSAs are required to actually purchase the company shares with their personal funds. In most cases, this is in the early stages of the company and offered at a reasonably low price. For example, an executive offered RSAs might purchase the stock at $5 per share, expecting the company to grow to $20 per share over the next few years.
As for RSUs, there is no requirement to purchase the shares with your own funds. In fact, you are given RSUs at zero cost to you (other than the tax burden, which we will discuss later).
It’s easiest to think about RSUs like you do an annual bonus. On certain dates throughout the year (vest dates), the stock is given to you, you pay taxes on the transaction, and you are free to do as you please with the shares (i.e., sell or hold for the long term).
Difference #2: Share Issue Dates
- When RSAs are granted to you, you legally own the shares. With that in mind, the grant date and vest date are the same from an ownership perspective (assuming you meet your employment requirements with the company). In some scenarios, employees could be forced to forfeit their RSAs if they do not meet the vesting requirements.
- RSU shares have a more formalized process. It’s easiest to utilize an example here.
- Grant Date: On 3/1/21, you are granted 100 shares of company stock scheduled to vest equally over 4 years. Notice that, unlike RSAs, your shares have not vested yet.
- Vest Date: On 3/1 of every year for the next 4 years, 25 shares will vest and become available to you (¼ of the 100 shares). At this point, you legally own the shares.
Difference #3: Timing of Dividends and Voting Rights
Restricted stock awards give the recipient access to dividends and voting rights immediately on the grant date. Restricted stock units, on the other hand, don’t kick in until they vest. Using our previous example, the vesting of those 100 shares would take place over 4 years.
It’s important to note that recipients of RSAs have a lot of direction and control over the company's approach early in its growth. This includes the period before the company goes public. RSUs will not become available for sale until the company goes public.
Difference #4: Taxation
- We discussed how the grant date and vest date are the same for ownership purposes with RSAs. After the restrictions associated with the RSAs are met (i.e., length of employment), the shares will vest for tax purposes. Let’s revisit our example.
- After purchasing 100 shares of your company via an RSA for $5/share, the company value increases to $20/share. At this point, you have satisfied any restrictions, and your shares are fully vested (for ownership AND tax purposes). On the vesting date, you will owe ordinary income taxes on the $15 gain ($15 x 100 = $1,500 of ordinary income).
- 3 years later, you sell the stock for $30/share. The company share value has increased from $20 to $30 since your vest date. The $10 gain will be taxed at capital gains rates ($10 x 100 = $1,000 of capital gains).
- The Exception: 83b election
- A strategic way to reduce the amount you pay in ordinary income taxes is to utilize the 83b election. For RSAs, you can elect to pay taxes on the grant date. In our example, this was when the stock was valued at $5/share. Because you purchased the stock with your own funds (you were not granted any sort of unearned value), you don’t owe any ordinary income taxes at all! Instead, you will pay capital gains taxes on the entire gain from $5/share to $30/share when you sold the shares ($25 x 100 = $2,500 of capital gains).
- RSUs don’t have quite the same flexibility from a tax standpoint that RSAs do.
- On the grant date, nothing happens from a tax standpoint. The conditions of the RSUs are laid out (i.e., number of shares, vesting schedule, etc.).
- On the vesting date, the entire amount is taxed at ordinary income rates. If you receive 25 shares at $20/share, you owe taxes on $500.
- From there, let's assume you hold the shares for 3 years following the vesting date, and the stock increases to $30/share. When you sell, you will owe capital gains tax on the gain from $20 to $30.
- The Exception: 83b election
- For pre-IPO companies, there is often an opportunity to utilize an 83b election for RSUs to pay taxes when shares are granted instead of when they vest (hopefully at a price much lower than the future value when the company goes public). The risk with this strategy is that you are paying a lot of taxes upfront, hoping that the company will perform well in the years to come. The decision to use an 83b election for RSUs is circumstantial and should be evaluated on a case-by-case basis.
There are some highly detailed nuances regarding the taxation of RSAs and RSUs that are far too in-depth for this post. With that said, the above illustrations paint a pretty accurate picture of what you can expect.
Take Control Of Your Equity
At Rivermark Wealth Management, we specialize in helping clients with complex compensation in the form of equity—or what the finance world calls equity compensation.
If you have questions on your equity profile or how to best leverage this important asset to achieve better life outcomes, contact us for a complimentary consultation.