What Are Stock Units and How Do They Work?
Demystify stock units: learn how this form of employee equity compensation functions, from grant to becoming owned shares, and its financial implications.
Stock units represent a form of equity compensation offered by companies. They are not actual shares when granted, but a promise to deliver shares at a future date, provided specific conditions are met. Understanding how stock units work, from their nature to tax implications, helps individuals navigate this valuable component of their compensation.
Fundamental Nature of Stock Units
Stock units represent a contractual right to receive company stock in the future. No shares are immediately transferred to the employee at grant. Instead, the company promises to deliver shares once predetermined conditions, such as continued employment, are satisfied. Until these conditions are met, the employee does not hold legal ownership of the shares.
Companies use stock units to align employee interests with long-term performance. By linking compensation to stock value, companies incentivize contributions that enhance shareholder value. Stock units also serve as a retention tool, as employees must remain with the company for a specified duration to receive the promised shares. This compensation can be less dilutive to existing shareholders upfront compared to issuing actual shares or certain stock options.
Stock units differ from stock options. Stock options grant an employee the right to purchase company stock at a predetermined strike price; their value depends on the stock price rising above this price. Stock units, conversely, derive value as long as the company’s stock price is above zero. They represent the full value of the shares upon vesting, without an exercise price. This makes stock units less susceptible to becoming worthless if the stock price declines, offering a more predictable value component to compensation.
Key Types of Stock Units
The two primary types of stock units are Restricted Stock Units (RSUs) and Performance Stock Units (PSUs). Each type is designed to achieve specific corporate objectives through different vesting conditions.
Restricted Stock Units (RSUs) represent a promise to deliver company shares after a specified time period. The term “restricted” means the employee cannot sell or transfer these units until they vest, which requires continued employment for a set duration. For example, an employee might receive RSUs that vest 25% each year over four years. This time-based vesting primarily serves as a retention incentive.
Performance Stock Units (PSUs) link vesting to the achievement of specific performance metrics. These metrics can be company-wide, such as revenue growth targets or earnings per share, or individual performance goals. A PSU grant might stipulate that units vest only if the company achieves a predefined market share increase. The number of shares received can vary based on how well these targets are met, potentially ranging from zero to more than the initial grant. PSUs align employee rewards directly with business success, motivating performance that drives company value.
The Grant and Vesting Process
The journey of stock units begins with the grant date, when an employer formally awards the units. The employee receives an agreement outlining the terms, including the number of units granted and conditions for conversion into shares. There are no immediate tax implications or share transfers at the grant date.
A vesting schedule dictates when stock units transition into ownership. Common schedules include “cliff” vesting, where all units become available on a single future date after a specific period, such as after three years of employment. Another structure is “graded” vesting, where units become available in installments over time, for example, 25% each year for four years. The vesting schedule encourages employee retention.
The vesting event occurs on the designated vesting date, at which point the conditions tied to the stock units are met, and the employee gains full ownership of the underlying shares. On this date, the “restricted” nature of the units is removed, and they are no longer subject to forfeiture. Once vested, the company typically facilitates the delivery of these shares, often by depositing them directly into a brokerage account established for the employee. This process ensures that the employee can then manage these shares as they would any other investment, subject to applicable tax rules and any company-specific trading policies.
Understanding Stock Unit Taxation
Taxation of stock units primarily occurs at the point of vesting, not when they are initially granted. When stock units vest, their fair market value (FMV) on that vesting date is generally treated as ordinary income. This means the value is added to an employee’s regular wages and is subject to federal income tax, Social Security (FICA) tax, and Medicare tax. Employers typically withhold a portion of the vested shares to cover these tax obligations, a process often referred to as “sell-to-cover” or “withhold-to-cover.” This ensures that the immediate tax liability is addressed, though the amount withheld may not always cover the employee’s full tax burden, especially for those in higher tax brackets.
The fair market value of the shares at vesting also establishes their cost basis for tax purposes. The cost basis is essentially the adjusted value used to determine capital gains or losses when the shares are eventually sold. For example, if shares vest when the stock price is $50 per share, that $50 becomes the cost basis for those shares. This prevents the employee from being taxed again on the income already recognized at vesting.
When the vested shares are subsequently sold, any difference between the sale price and the established cost basis is treated as a capital gain or loss. The tax rate applied to this gain depends on the holding period after vesting. If the shares are sold within one year of vesting, any gain is considered a short-term capital gain and is taxed at the employee’s ordinary income tax rate. However, if the shares are held for more than one year after vesting before being sold, any gain qualifies as a long-term capital gain, which is typically taxed at a lower, more favorable rate. Understanding these two distinct tax events—at vesting and upon subsequent sale—is important for managing the financial implications of stock units.