The Executive Comp Insider
Considering Granting Restricted Stock or Restricted
Stock Units? Remember the Tax Differences
By James D.C. Barrall
Financial Accounting Standard 123(R) is leveling the
playing field for the accounting treatment of various forms
of equity compensation and is eliminating variable ac-
counting for performance-based awards that are settled
in stock. Simultaneously, public companies are trying to
conserve shares under their equity plans and create reten-
tion incentives that may not be provided by stock options
(which have been known to go underwater). Accordingly,
more public companies are granting restricted stock (RS)
and/or restricted stock units (RSUs) that are settled in
stock and are starting to experiment with performance
vesting conditions.
While RS and RSUs have much in common, there are
very important tax differences between the two that have
surprised more than a few companies and should be con-
sidered when making RS or RSU grants.
The essence of RS is that it constitutes an up-front
transfer of shares of a company’s stock at the time the
RS award is made, subject to a vesting schedule based
on either the holder’s continued employment (time vest-
ing) or the attainment of specified company or individual
performance goals (performance vesting). RSUs, on the
other hand, constitute a promise to transfer shares of a
company’s stock at a later date, after the applicable vesting
conditions on the promise have been satisfied.
Similarities Between RS and RSUs
The similarities between RS and RSUs are: (1) they are
“full value” awards in today’s parlance and both provide
the same economics; (2) under FAS 123(R) they have the
same accounting expense impact (but only if the RSUs
are settled in stock, not cash); and (3) they are subject to
the same treatment under Code Section 162(m). This last
point means that if RS or RSUs vest based on time vesting
alone, they don’t qualify as “qualified performance-based
compensation” (QPBC) and the value of the stock is treat-
ed as compensation subject to the $1 million deduction
cap. But if they vest based on the attainment of objective
performance targets that are based upon shareholder-
approved performance goals and meet all of the Section
162(m) requirements for QPBC, the compensation isn’t
subject to the deduction cap. (See my February column on
Section 162(m) and QPBC requirements.)
The Big Difference Between RS and RSUs
The most important difference between RS and stock-
settled RSUs is that RS results in a transfer of property
 March 2006 | Executive Compensation Strategies
and is subject to tax under Code Section 83 at the time the
award is made, while RSUs are promises to deliver stock
in the future, which may constitute nonqualified deferred
compensation subject to Section 409A – and which don’t
result in a transfer of property subject to Section 83 until
the stock is delivered. This is more than a theoretical dis-
tinction and can create problems for the unwary.
Restricted Stock. A holder of RS is taxable on the
fair market value (FMV) of the stock when it vests, unless
the holder elects to be taxed on the FMV of the stock as of
the date of grant under Code Section 83(b). At most public
companies, holders don’t make such elections in order to
avoid the risk of being taxed on compensation they never
realize, either because they forfeit the RS or the value of
the RS drops prior to vesting. This means that RS holders
generally are taxable when the shares vest, which has two
important implications for designing RS awards. First,
provision needs to be made for income taxes that must
be withheld from the holder at the time the shares vest.
Second, “vesting” for tax purposes means the first date on
which the RS is no longer subject to a “substantial risk of
forfeiture” (SROF), not when restrictions are removed
from the shares or the shares are delivered. For example, if
an RS holder can retire after a stated date (such as age 65
or age 55 with at least 10 years of service), the holder will
be taxable on the FMV of the stock the instant the condi-
tions are satisfied, even if the stock isn’t delivered to the
holder until termination of employment.
Restricted Stock Units. Because RSUs don’t result
in a transfer of property until the stock is actually delivered
to the holder, RSUs provide companies and executives
with more tax planning flexibility than RS, since RSUs
can vest prior to the time the stock is delivered and is tax-
able to the holder. While the deferral of taxes is generally
a good thing, appreciation in the FMV of the stock above
its FMV on the vesting date is taxable as ordinary income
(in contrast to post-vesting appreciation of RS, which is
taxable as capital gains). More importantly, RSUs that de-
fer payment after vesting constitute nonqualified deferred
compensation, which is subject to Section 409A unless the
deferral is a “short term deferral” (for calendar year com-
panies, distributed by March 15 of the year following the
year in which the RSUs vest).
James D.C. Barrall is Global Chair of the Benefits and
Compensation Group of Latham & Watkins LLP.