What Is a Restricted Stock Unit (RSU) Plan?

Restricted Stock Units (RSUs) have become a prevalent form of equity compensation, serving as a strategic tool for companies to attract, motivate, and retain skilled employees. These compensation awards offer employees a stake in the company’s future success, aligning individual interests with the broader performance of the organization. RSUs provide a deferred compensation mechanism, promising shares of company stock upon the fulfillment of specific conditions.

Defining Restricted Stock Units

A Restricted Stock Unit (RSU) represents a promise from an employer to deliver shares of company stock, or their cash equivalent, to an employee at a future date. This promise is contingent upon the employee meeting certain predetermined conditions, which typically involve continued employment or the achievement of specific performance milestones. The “restricted” aspect of an RSU indicates that the shares are not immediately owned by the employee upon grant; instead, they are subject to a vesting schedule and other limitations. Employees do not possess the full rights of a shareholder, such as voting rights or dividend entitlements, until the shares officially vest and are distributed.

The “unit” component signifies that each RSU represents one share of the company’s common stock, or its equivalent value in cash, that will be delivered once vesting requirements are satisfied. Unlike stock options, which grant the right to purchase shares at a set price, RSUs do not require any upfront payment from the employee. This characteristic makes RSUs appealing to employees as they retain value as long as the company’s stock price remains above zero. RSUs also allow companies to manage equity dilution more effectively compared to immediately issuing shares. Shares are only transferred out of the company’s treasury when the RSUs vest, preventing immediate dilution of existing shareholder ownership. This deferred issuance mechanism can be particularly advantageous for privately held companies and startups, although RSUs are widely used by public companies as well. The value of an RSU fluctuates with the company’s stock price, meaning the ultimate benefit to the employee depends on the market value of the shares at the time of vesting.

How Restricted Stock Units Operate

The operation of Restricted Stock Units follows a defined lifecycle, beginning with the initial grant and culminating in the distribution of shares. The journey of an RSU begins on the “grant date,” which is when the employer officially awards the units to the employee. At this point, the RSUs are merely a promise of future shares and hold no immediate ownership rights for the employee. No actual shares are issued, and the employee cannot sell or transfer these units. The grant agreement outlines the number of RSUs awarded and the specific conditions that must be met for them to convert into actual shares.

Following the grant date, the RSUs enter a “vesting schedule,” which dictates when the restrictions on the units lapse and the employee gains full ownership. Vesting conditions are typically based on either time or performance. Time-based vesting is common, often structured over several years, such as a four-year schedule with a one-year “cliff.” A one-year cliff means no shares vest until the employee completes one full year of service, after which a portion of the RSUs, such as 25%, vests, with the remainder vesting incrementally, often monthly or quarterly, over the subsequent years.

Performance-based vesting requires the employee or the company to achieve specific metrics, such as sales targets, project completion, or certain financial benchmarks, before the RSUs vest. Some RSU grants may combine both time-based and performance-based conditions, requiring both continued service and the achievement of defined goals. Once the vesting conditions are met, the RSUs are considered “vested,” meaning the employee now has full rights to the shares.

The final step is the “distribution” or “settlement” date, which is when the vested RSUs are converted into actual shares of company stock and delivered to the employee’s brokerage account. This date often coincides with the vesting date, but in some plans, there might be a short delay between vesting and actual share delivery for administrative purposes. At this point, the employee officially owns the shares and can choose to hold them or sell them, subject to any company trading policies.

Taxation of Restricted Stock Units

The taxation of Restricted Stock Units is a significant consideration for employees and differs from other forms of equity compensation. Unlike stock options, where taxation often occurs at exercise, RSUs are typically taxed at the time of vesting. This tax treatment impacts both the employee’s immediate income and future capital gains.

RSUs are generally not taxed at the grant date when the promise of shares is initially made. The primary taxable event for RSUs occurs on the vesting date. On this date, the fair market value (FMV) of the vested shares is considered ordinary income to the employee. This income is treated similarly to regular wages or a cash bonus and is subject to federal income tax, Social Security, and Medicare taxes. The value reported as ordinary income is calculated by multiplying the number of shares that vested by the stock’s FMV on the vesting date.

Employers are responsible for withholding taxes from the vested RSU income. This withholding typically includes federal income tax, often at a flat supplemental wage withholding rate, which can be 22% for income up to $1 million, and 37% for amounts exceeding $1 million. State and local income taxes, as well as FICA taxes (Social Security and Medicare), are also withheld. To cover these tax obligations, employers commonly use a “sell to cover” strategy, where a portion of the newly vested shares is automatically sold. The remaining shares, after taxes are withheld, are then deposited into the employee’s brokerage account. Alternatively, some plans may allow employees to pay the withholding taxes with cash from other sources, enabling them to retain all vested shares. The RSU income and the taxes withheld are reported on the employee’s Form W-2 for the year of vesting.

The fair market value of the shares at vesting also establishes the “tax basis” for those shares. This means that the amount included as ordinary income at vesting becomes the cost basis for calculating any future capital gains or losses when the shares are eventually sold. When the vested shares are subsequently sold, the sale price is compared to this cost basis. Any difference between the sale price and the tax basis results in a capital gain or loss.

If the shares are sold within one year of the vesting date, any gain is considered a short-term capital gain and is taxed at the employee’s ordinary income tax rates. If the shares are held for more than one year after vesting before being sold, any gain is classified as a long-term capital gain. Long-term capital gains generally benefit from lower tax rates, typically 0%, 15%, or 20%, depending on the taxpayer’s overall taxable income. The sale of shares and any resulting capital gains or losses are reported on Form 1099-B by the brokerage firm and must be reconciled on the employee’s tax return using Form 8949 and Schedule D.

RSUs in Common Employment Scenarios

Restricted Stock Units are a dynamic form of compensation, and their treatment can change significantly depending on an employee’s employment situation. The specific terms are always outlined in the individual RSU grant agreement and the company’s equity plan documents.

When an employee leaves a company, the fate of their RSUs depends on whether the units are vested or unvested. Generally, any RSUs that have already vested and been distributed to the employee’s brokerage account before their departure are retained by the employee. These shares are fully owned by the individual, and their employment status no longer affects ownership. The employee can hold or sell these shares as they deem appropriate, subject to any post-employment trading restrictions.

Conversely, unvested RSUs are typically forfeited when an employee resigns or is terminated. Since these units are still subject to the vesting conditions, the promise to deliver shares is revoked if those conditions, such as continued employment, are no longer met. This forfeiture means the employee loses any potential value associated with those unvested units. Companies often include specific clauses in RSU agreements that clarify these forfeiture rules, emphasizing the retention aspect of RSUs.

In the event of a company acquisition or merger, the treatment of outstanding RSUs can vary widely based on the terms negotiated in the deal. One common outcome is “accelerated vesting,” where some or all unvested RSUs become fully vested upon the acquisition. This can be a “single-trigger” acceleration, meaning the acquisition alone triggers vesting, or a “double-trigger” acceleration, which requires both an acquisition and a subsequent event, such as the employee’s termination without cause by the acquiring company, to trigger vesting. Accelerated vesting ensures employees receive the value of their RSUs before the change in ownership.

Another possible treatment is “assumption” or “substitution,” where the acquiring company replaces the original RSUs with new equity awards in the acquiring company. This typically involves converting the unvested RSUs into an equivalent number of the acquiring company’s shares or RSUs, often maintaining the original vesting schedule. In some cases, especially for private companies without a public market for their shares, RSUs might be cashed out. This means employees receive a cash payment equivalent to the value of their RSUs, either at the time of the acquisition or on a deferred basis. The specific handling of RSUs during an acquisition is a critical component of the merger agreement and is communicated to employees as part of the transaction details.