The Advisors' Blog

– Ed Burmeister, Baker & McKenzie

I was perusing the NASPP’s very helpful new “Domestic Stock Plan Design and Administration Survey” the other day. I was surprised to see how many companies are still issuing restricted stock (as opposed to restricted stock units). I frankly cannot think of any good reasons to keep issuing restricted stock, but of course some of you may wish to correct my thinking on this.

Historical Practice

In the old (pre-FAS123R) days, companies traditionally issued stock options as their primary equity vehicle under their long term incentive plan, with restricted stock grants to a few key executives.

Current Trends

With the advent of FAS123R, grants of full value awards (restricted stock or restricted stock units (RSUs)) have grown in prevalence for a variety of reasons, including share conservation, ease of administration (i.e., no Black-Scholes value issues), retention value in a flat or down market, high employee perceived value as compared with Black-Scholes value of options, etc. The survey confirms this.

So, as companies expand the use of full value awards, it initially made sense to look at making restricted stock grants (based on the historical practice) to a broader group of employees. However, the form of grant suitable to a handful of key executives based in the U.S. is, in my view, unsuitable for broader award groups, particularly if the group includes non-U.S. award recipients.

Key Features of Restricted Stock/RSUs

Restricted stock for this purpose means shares actually issued at grant, with full voting and dividend rights, but subject to a forfeiture back to the company if the employee leaves before the specified vesting period. So, the shares are issued, but placed in escrow or otherwise “restricted” so that the forfeiture provisions can be applied upon a termination of employment. Although dividends on such shares are real dividends from a corporate perspective, they are not dividends from a tax perspective, but rather are compensation in the hands of employee, subject to income and FICA/FUTA taxes and withholding.

The grant of restricted stock is eligible for a so called section 83(b) election allowing the employee to be taxed upfront at grant (otherwise tax is at vesting). So, the company needs to communicate with the award recipients the pros and cons of section 83(b) elections, provide forms, etc. This is all compressed, in that any section 83(b) election must be made within 30 days of grant.

My experience is that essentially no one at a public company makes a section 83(b) election on restricted stock, so the availability of this election is more of a curse than a benefit for restricted stock.

RSUs are, of course, economically equivalent to restricted stock (assuming dividend equivalents are provided on the RSUs), but the shares are not typically issued until vesting. Tax rules are almost identical (although RSUs are technically taxed under constructive receipt principles, so release is the income tax event rather than vesting, but these are typically the same). No actual dividends are paid during the vesting period (since no shares have actually been issued), but dividend equivalents can be paid or (better yet, in my view) accumulated as notionally reinvested into shares and paid only at vesting along with the underlying shares.

Pros and Cons of Restricted Stock/RSUs

The accounting treatment for restricted stock and RSUs is essentially identical, with relatively minor differences too complicated to discuss here. So, why are RSUs superior to restricted stock?

First, companies do not need to worry about section 83(b) elections, communicating the pros and cons of this to a broad range of employees and hearing the complaints when an employee makes a bad choice or files his/her form a day late. Second, since the shares are not issued until vesting/release, there is no need to deal with the hassles of recovering forfeited shares. Third, net share withholding (the method of withholding which most companies choose for broad based RSU grants) is certainly no more difficult to deal with than withholding with respect to restricted shares which have already been issued.

Finally, restricted stock issued outside the U.S. is typically taxed at grant (with no election) in many countries, including many key European countries, which presents adverse tax consequences to the employee and withholding challenges for the employer. I am aware that restricted stock is not subject to the section 409A rules whereas RSUs may be. However, if RSUs are designed properly (e.g., paid out at vesting) or in accordance with a fixed payment schedule, the section 409A problems are manageable.

So, for my part, issue RSUs and forget about restricted stock.