How Does a Restricted Stock Unit (RSU) Work?

Restricted Stock Units (RSUs) are a prevalent form of equity compensation, allowing companies to incentivize and retain employees. This article explains how RSUs operate, covering their nature, the vesting process, financial implications, and choices available to employees once shares are received.

What a Restricted Stock Unit Is

A Restricted Stock Unit (RSU) represents a promise from an employer to grant company stock shares to an employee at a future date, provided specific conditions are met. Unlike stock options, RSUs derive their value directly from the company’s stock price at the time they are granted. Employees do not own the underlying shares when an RSU is initially granted; instead, they receive a contractual right to receive them.

Companies use RSUs as a compensation tool to align employee interests with shareholder interests and promote long-term employee retention. By tying compensation to the company’s stock performance, RSUs encourage employees to contribute to the company’s success and remain with the company.

The Vesting Schedule

The process by which an employee gains full ownership of RSU shares is known as “vesting.” Until RSUs vest, they are not owned by the employee and can be forfeited. Vesting schedules are conditions that must be satisfied before the shares are officially transferred to the employee.

Common vesting schedules include time-based and performance-based criteria. Time-based vesting requires an employee to remain with the company for a specified period. Examples include “cliff vesting,” where 100% of RSUs vest on a single date (e.g., three years after grant), or “graded vesting,” where a percentage vests incrementally over several years (e.g., 25% each year over four years).

Performance-based vesting ties the release of RSU shares to specific company or individual metrics. This could involve reaching revenue targets, project milestones, or individual performance goals. If an employee leaves or targets are not achieved, unvested RSUs are typically forfeited.

Receiving Shares at Vesting

Upon vesting, the restricted period ends, and the employee receives the actual shares of company stock. The fair market value of the shares on the vesting date is considered ordinary income. This income is subject to federal income tax, Social Security tax, Medicare tax, and applicable state and local income taxes, similar to regular wages.

To cover these tax obligations, companies typically employ a method called “sell to cover.” With this approach, a portion of the newly vested shares is automatically sold to generate funds for the required tax withholdings. For instance, if an employee vests 100 shares and the tax withholding rate is 22%, approximately 22 shares might be sold. The remaining shares, after tax withholding, are then deposited into the employee’s brokerage account.

Some companies may offer employees the option to pay the tax liability in cash instead of selling shares. This allows the employee to retain all of their vested shares, assuming they have the liquid funds available to cover the tax burden. The vesting date is the tax event, and the ordinary income is reported on the employee’s Form W-2 for that tax year.

After Vesting

Once RSUs have vested and the employee has received the actual shares, they have full ownership and control over these shares. An employee typically has two primary options: holding the shares or selling them immediately. Each choice carries distinct financial and tax implications.

If an employee chooses to sell the shares immediately after vesting, there are generally no additional capital gains taxes owed, assuming the sale price is close to the fair market value at vesting. This is because the fair market value at vesting was already recognized as ordinary income, establishing the cost basis for the shares. The proceeds from the sale, after any brokerage fees, are then available to the employee.

If an employee holds shares and later sells them at a different price, capital gains or losses will be realized. The holding period for determining short-term or long-term capital gains begins on the vesting date. Shares sold within one year of vesting are subject to short-term capital gains tax, taxed at the ordinary income tax rate. Shares held for more than one year are subject to long-term capital gains tax, which typically has lower rates (0% to 20% depending on income bracket).