Restricted stock units (RSU) are a popular form of incentive compensation. RSU awards, like other forms of phantom equity, help align an executive’s compensation incentives with the employer’s share value. An RSU is a contractual “phantom” grant, representing the right to receive a share of employer stock, or more commonly: cash equal to the value of the underlying share value, on a future date.
Some private companies are attracted to making grants of RSUs because this contract does not require actual issuance of shares from the company treasury, may demonstrate less disturbance to the cap table, would not involve voting rights, or unless dividend equivalent rights are part of the RSU contract, involves no dividend rights. One perceived advantage of an RSU, especially for private companies, is that there is no requirement to establish fair market value at the time of grant, unlike a stock option grant which must provide an exercise price at least equal to the fair market value of the underlying share of stock for U.S. tax compliance. One challenge associated with the design of RSUs is navigating the deferred compensation tax rules under Section 409A.
Key Difference between RSUs and Restricted Stock
This is the key distinction between a transfer of restricted stock and an RSU: with restricted stock, there is a transfer of property on day one, and an ability to make a section 83(b) election for tax purposes, but no ability to defer taxation beyond the lapse of the substantial risk of forfeiture – the participant is already in receipt of the stock, so the lapse is the income point. In contrast, a RSU is a contract right – an unfunded, unsecured promise of payment in the future. There is no initial transfer of property, so a section 83(b) election is not permissible, but the timing of income can be deferred beyond vesting (subject, of course, to compliance with section 409A).
Are RSUs Deferred Compensation that would be Subject to Section 409A?
Some employers are surprised to find out that RSUs could be “non-qualified deferred compensation,” whether intentionally or unintentionally. If the RSUs are non-qualified deferred compensation (NQDC) then Section 409A of the Internal Revenue Code applies, which limits the flexibility around payout timing. Section 409A requires a fixed date or other permitted payment event for payment timing, and prohibits most accelerations or delays of payout.
So when are RSUs deferred compensation? RSUs are deferred compensation whenever the payment is made, or could be made, in a calendar year later than the year in which the awards vest (or in 409A-speak, in the year awards become “no longer subject to a substantial risk of forfeiture.”) Any forfeiture risk due to a non-compete or similar covenant is ignored under 409A – it’s not considered a “substantial” risk of forfeiture.
Some common plan design features that cause RSUs to be deferred compensation are:
Vesting on Termination without Cause – if the plan provides for vesting, but still pays on the deferred schedule, then the entire arrangement is deferred compensation, even if none of the participants experience the type of termination that triggers vesting.
Retirement Privilege – if the plan provides for a waiver of forfeiture, such as after achievement of a certain age or age/service combination in such a manner that the participant no longer has to continue to perform significant services until the payment date.
Disability Privilege – if the plan provides for vesting on disability, but still pays on a deferred schedule.
Change in Control Vesting – vesting alone, without accelerated payment, causes the RSU to be no longer subject to a substantial risk of forfeiture.
Exemption: On the flip side of RSUs that provide for a deferral of compensation, sometimes RSUs can be designed to be exempt from Section 409A. To be exempt, the payment must always be made in the same calendar year as vesting, or within 2 ½ months after the end of that year. An RSU could be exempt from 409A (no deferral), depending on the special vesting features of the plan. If all special vesting features also result in prompt payment, the RSU is exempt under the above exception.
If subject to 409A, what are the compliance rules?
If a plan is subject to 409A, then it must comply with the restrictive tax rules. In very summary form: the basic tax rule is that there must be pre-determined, permitted event for payment for all “deferred compensation.” Payment may only be made on a fixed date or another permitted payment event. “Separation from Service” is a permitted event, but key officers will be subject to a required six-month delay on termination. Death, Disability, Unforeseen Emergency and Change in Control are also permitted payment events. No delays or accelerations of payments are allowed, with a few minor exceptions.
Our payment terms could comply with 409A. If they comply, what’s the problem? What are the negative consequences of being subject to 409A?
Reduced flexibility – Plan can no longer pay early or delay payment, or substitute for a different award.
Some changes to your plan text would be necessary: Re-evaluating certain plan definitions, limiting somewhat the discretion, and most importantly: adding a six-month delay for key officers if there are any payouts upon termination, including without Cause terminations. The six-month delay is required to be written into the plan text (a trap for the unwary). You can limit the effect of the necessary Plan language to just U.S. taxpayers, or apply the rules to everyone.
Administrative reporting obligations, to report the amount deferred as of Dec 31, each year, on Form W-2. This is applicable for U.S.-based employees, however, the rules are currently suspended pending new IRS guidance. It’s reasonable to interpret the rules as not requiring W-2s for U.S. citizens working in Canada or other countries where you don’t currently issue Form W-2.
Mistakes are expensive – If the plan is subject Section 409A, but fails to comply with the rules, the participant would be subject to early income inclusion, a 20% additional tax, plus interest. All similar plans are aggregated for purposes of this penalty, even if the other plans are compliant.
When are RSUs Subject to Required Tax Withholding?
Generally, RSUs are taxable wages, subject to both income and FICA (social security) and HI (Medicare) tax withholding and employer-reporting when paid. Although Code Section 3121(a) provides that FICA is due when wages are paid, section 3121(v)(2) provides a different rule for amounts that are classified as “deferred compensation.” Under this provision, wages are included for FICA withholding purposes when the right to the wages vest, or the services are provided, if later. As discussed above, RSUs can be deferred compensation arrangements that involve delays in timing for the actual payment, so special arrangements must be made for withholding FICA. Cohen & Buckmann addresses the timing of employment tax deposits in this prior post: https://cohenbuckmann.com/insights/2020/7/20/a-tax-topic-when-are-rsus-deferred-compensation-for-fica-purposes.
Conclusion
The use of RSUs as deferred compensation presents significant planning opportunities if parties comply with their tax and reporting obligations. Employers may wish to review their RSU awards agreements and related tax administrative practices and consider whether any changes are appropriate or desired.
Sandra Cohen is Managing Partner and Co-Founder of Cohen & Buckmann P.C. She frequently writes and speaks on the topic of taxation of employee benefits and deferred compensation.