Phantom stock provides a cash or stock bonus based on the value of a stated number of shares, to be paid out at the end of a specified period of time. To give Madeline an incentive to stay with the company and receive the 1, shares, it puts the RSUs on a five-year vesting schedule. Time-based restrictions may lapse all at once or gradually. Only employees of the employer sponsoring the ESPP and employees of parent or subsidiary companies may participate. The employer grants the stock to you at no cost or very little cost, sometimes as low as a penny per share. Any other gain or loss is a long-term capital gain or loss.
The increasing use of Restricted Stock Units (RSUs) has led to a good deal of confusion about their use and how similar they are to stock options.
Any one company, however, may provide for just one or two of these alternatives. Private companies do not offer same-day or sell-to-cover sales, and, not infrequently, restrict the exercise or sale of the shares acquired through exercise until the company is sold or goes public.
Accounting Under rules for equity compensation plans to be effective in FAS R , companies must use an option-pricing model to calculate the present value of all option awards as of the date of grant and show this as an expense on their income statements.
The expense recognized should be adjusted based on vesting experience so unvested shares do not count as a charge to compensation. Restricted Stock Restricted stock plans provide employees with the right to purchase shares at fair market value or a discount, or employees may receive shares at no cost.
However, the shares employees acquire are not really theirs yet-they cannot take possession of them until specified restrictions lapse.
Most commonly, the vesting restriction lapses if the employee continues to work for the company for a certain number of years, often three to five. Time-based restrictions may lapse all at once or gradually. Any restrictions could be imposed, however. The company could, for instance, restrict the shares until certain corporate, departmental, or individual performance goals are achieved.
With restricted stock units RSUs , employees do not actually receive shares until the restrictions lapse. In effect, RSUs are like phantom stock settled in shares instead of cash. With restricted stock awards, companies can choose whether to pay dividends, provide voting rights, or give the employee other benefits of being a shareholder prior to vesting.
Doing so with RSUs triggers punitive taxation to the employee under the tax rules for deferred compensation. When employees are awarded restricted stock, they have the right to make what is called a "Section 83 b " election. If they make the election, they are taxed at ordinary income tax rates on the "bargain element" of the award at the time of grant. If the shares were simply granted to the employee, then the bargain element is their full value.
If some consideration is paid, then the tax is based on the difference between what is paid and the fair market value at the time of the grant. If full price is paid, there is no tax. Any future change in the value of the shares between the filing and the sale is then taxed as capital gain or loss, not ordinary income. An employee who does not make an 83 b election must pay ordinary income taxes on the difference between the amount paid for the shares and their fair market value when the restrictions lapse.
Subsequent changes in value are capital gains or losses. Recipients of RSUs are not allowed to make Section 83 b elections. The employer gets a tax deduction only for amounts on which employees must pay income taxes, regardless of whether a Section 83 b election is made. A Section 83 b election carries some risk.
If the employee makes the election and pays tax, but the restrictions never lapse, the employee does not get the taxes paid refunded, nor does the employee get the shares. Restricted stock accounting parallels option accounting in most respects. If the only restriction is time-based vesting, companies account for restricted stock by first determining the total compensation cost at the time the award is made.
However, no option pricing model is used. If the employee buys the shares at fair value, no charge is recorded; if there is a discount, that counts as a cost. The cost is then amortized over the period of vesting until the restrictions lapse. Because the accounting is based on the initial cost, companies with low share prices will find that a vesting requirement for the award means their accounting expense will be very low. If vesting is contingent on performance, then the company estimates when the performance goal is likely to be achieved and recognizes the expense over the expected vesting period.
If the performance condition is not based on stock price movements, the amount recognized is adjusted for awards that are not expected to vest or that never do vest; if it is based on stock price movements, it is not adjusted to reflect awards that aren't expected to or don't vest. Restricted stock is not subject to the new deferred compensation plan rules, but RSUs are.
Both essentially are bonus plans that grant not stock but rather the right to receive an award based on the value of the company's stock, hence the terms "appreciation rights" and "phantom. Phantom stock provides a cash or stock bonus based on the value of a stated number of shares, to be paid out at the end of a specified period of time.
SARs may not have a specific settlement date; like options, the employees may have flexibility in when to choose to exercise the SAR. Phantom stock may offer dividend equivalent payments; SARs would not. When the payout is made, the value of the award is taxed as ordinary income to the employee and is deductible to the employer.
Some phantom plans condition the receipt of the award on meeting certain objectives, such as sales, profits, or other targets. These plans often refer to their phantom stock as "performance units. Careful plan structuring can avoid this problem. Because SARs and phantom plans are essentially cash bonuses, companies need to figure out how to pay for them.
Even if awards are paid out in shares, employees will want to sell the shares, at least in sufficient amounts to pay their taxes. Does the company just make a promise to pay, or does it really put aside the funds?
If the award is paid in stock, is there a market for the stock? If it is only a promise, will employees believe the benefit is as phantom as the stock? If it is in real funds set aside for this purpose, the company will be putting after-tax dollars aside and not in the business. Many small, growth-oriented companies cannot afford to do this. The fund can also be subject to excess accumulated earnings tax. On the other hand, if employees are given shares, the shares can be paid for by capital markets if the company goes public or by acquirers if the company is sold.
Phantom stock and cash-settled SARs are subject to liability accounting, meaning the accounting costs associated with them are not settled until they pay out or expire. For cash-settled SARs, the compensation expense for awards is estimated each quarter using an option-pricing model then trued-up when the SAR is settled; for phantom stock, the underlying value is calculated each quarter and trued-up through the final settlement date.
Phantom stock is treated in the same way as deferred cash compensation. In contrast, if a SAR is settled in stock, then the accounting is the same as for an option. The company must record the fair value of the award at grant and recognize expense ratably over the expected service period. If the award is performance-vested, the company must estimate how long it will take to meet the goal. If the performance measurement is tied to the company's stock price, it must use an option-pricing model to determine when and if the goal will be met.
Employee Stock Purchase Plans ESPPs Employee stock purchase plans ESPPs are formal plans to allow employees to set aside money over a period of time called an offering period , usually out of taxable payroll deductions, to purchase stock at the end of the offering period. Plans can be qualified under Section of the Internal Revenue Code or non-qualified. Qualified plans allow employees to take capital gains treatment on any gains from stock acquired under the plan if rules similar to those for ISOs are met, most importantly that shares be held for one year after the exercise of the option to buy stock and two years after the first day of the offering period.
Qualifying ESPPs have a number of rules, most importantly: Only employees of the employer sponsoring the ESPP and employees of parent or subsidiary companies may participate. Plans must be approved by shareholders within 12 months before or after plan adoption. All employees with two years of service must be included, with certain exclusions allowed for part-time and temporary employees as well as highly compensated employees. The maximum term of an offering period may not exceed 27 months unless the purchase price is based only on the fair market value at the time of purchase, in which case the offering periods may be up to five years long.
Plans not meeting these requirements are nonqualified and do not carry any special tax advantages. In a typical ESPP, employees enroll in the plan and designate how much will be deducted from their paychecks. As Fred Wilson said , and I agree with him:. Each of the three choices; options, restricted stock, and RSUs, has benefits and detriments. What could Congress do? Award documents vary widely in the wild, especially RSU award documents.
And this blog post has made simplifying assumptions that may not apply in your particular situation. Good luck and have fun out there! This is excellent Joe.
I think your summary gives people a foundation to decide what makes the best sense. Another big issue for startups and equity awards is documenting them correctly and in real time! They need to be treated with the same care as share issuances. I often see this advice to find a good tax advisor or lawyer for this sort of thing.
But I see much less advice on how to choose such a professional. State Equity Crowdfunding vs. The Taxation of Stock Options Stock options are not taxable upon receipt, as long as they are priced at fair market value. The Taxation of Restricted Stock Awards Restricted stock awards can either be taxable upon receipt by making an 83 b election or will be taxable upon vesting if no 83 b election is made.
What Should You Do? One thing you could do is lobby your Congressional representatives to change the law. As Fred Wilson said , and I agree with him: No Yes, if vested or an 83 b election is made No, as long as priced at fair market value Taxation Upon Vesting?
Yes, because usually shares are delivered upon vesting; and there is ordinary income at that time at the then value of the shares. Yes, if subject to vesting and no 83 b election was made No, as long as priced at fair market value Taxation Upon Settlement or Exercise?
You are dead right on. Casually approaching stock options can be a disaster. I think Congress should repeal A as it applies to early stage and startup companies.
What is a 'Restricted Stock Unit - RSU'
Stock Options Vs. RSUs Another way companies motivate employees is to offer stock options and restricted stock units (or RSUs), thereby giving employees a . Restricted Stock Units seem like a natural fit because they are quite similar to options. Pros and Cons of Restricted Stock Units (RSUs) Restricted Stock Units (RSUs) are a company’s promise to give shares or cash to an employee in the future. Dell Computer Corp., Cendant Corp., and DaimlerChrysler AG have also moved toward restricted stock in lieu of stock options. Continue Reading Understanding Restricted Stock Unit Grants and Their Implications.