Restricted Stock Units are time based whereas Performance Stock Units are time and performance based.
Both allow the company to incentivize employees to contribute to the success of the company, as a higher stock price results in a greater benefit to the employee when they receive stock shares at the time of vesting.
Both result in taxable compensation upon vesting, and future capital gains or losses when the shares are sold.
Performance Stock Units provide an even greater incentive to perform, as these programs can provide a kicker of additional shares for exceeding the targeted goal.
Let’s get into the details to break down the benefits and tax implications.
Key Differences of RSUs vs PSUs
| Category | Restricted Stock Units (RSUs) | Performance Stock Units (PSUs) |
|---|---|---|
| Vesting | Time based (Graded or Cliff) | Time and performance based (sliding scale) |
| Individual Income Taxes | Ordinary income at Vesting; Capital Gain or (loss) when share are sold | Ordinary income at Vesting; Capital Gain or (loss) when shares are sold |
| Shares or Cash | Yes – Actual Shares or Notional Shares (cash) | Yes – Actual Shares or Notional Shares (cash) |
| Example | 1,500 RSUs vest in 500 RSU increments annually over 3 years | 500 PSUs vest each year if the company achieves its profit goals. An additional 100 PSUs can vest each year if the profit goal is beaten by 20% or more |
| Employer benefit | Employee retention is the primary benefit | Employee performance is the primary benefit |
| Employee benefit | Predictable vesting by hitting the required dates | Can earn more than the base goal by achieving more |
| Employer cost | Company expense is more predictable (based on time) | Company expense is more variable due to sliding performance scale |
| Employee cost | Lost benefit if termination is before vesting; Vesting triggers ordinary income | Underperformance can result in low to no benefit; Vesting triggers ordinary income |
Restricted Stock Units (RSUs)
These are time based promises of a company to issue shares to an employee. This allows companies to retain top talent by providing deferred compensation at future time intervals based on the vesting schedule.
The Restricted Stock Unit promise is issued on the grant date. With the promise comes the RSU vesting schedule.
Cliff vs Graded Vesting
A graded vesting schedule gives the employee vesting at specific time intervals. For example, a graded vesting schedule could be 25% of RSUs vesting per year over the next four years. A cliff vesting schedule would be all at once. For example, the employee is 100% vested after four years.
| Year | Cliff Vesting | Graded Vesting |
|---|---|---|
| 1 | 0% | 25% |
| 2 | 0% | 25% |
| 3 | 0% | 25% |
| 4 | 100% | 25% |
The vesting schedule is important for income tax purposes. Once the employee vests and the stock shares are issued, it creates a taxable event to the employee.
Vesting = compensation
Receiving the shares is treated as a form of compensation, which is subject to payroll tax (social security and Medicare tax) as well as ordinary income tax. The compensation is equal to the fair market value of the stock on the vesting date times the number of shares received.
Since the RSUs are converted to shares of stock in the company, the benefit to the employee can be significant if the company’s stock price experiences significant gains. Of course, the opposite can occur if the stock price goes down in value.
Public companies have a readily available fair market value. Private companies do not. RSUs issued to employee of private companies have the additional complexity of determining the fair market value (FMV) using an appraisal or formula. In addition, the employee has the issue of having to liquidate shares, which is not as straightforward as selling public shares. Private companies will need to address both the FMV and liquidation issues.
US Federal Income Tax
Below is a graphic that breaks down the tax implications related to RSUs for the US income taxpayer.
In the example the shares were sold in less than one year after ownership, resulting in short term capital gains. If the shares were held for more than a year, it would have resulted in long-term capital gains.
Performance Stock Units (PSUs)
PSUs are very similar to RSUs. They are both promises from the company to issue stock to the employee at a future date.
The tax treatment is the same. Ordinary income is generated at the time of vesting and a capital gain or loss occurs when the shares are sold.
The difference is in the vesting schedule and in the number of Units that are issued.
PSUs are performance and time based. This is more complex than the pure time based RSUs. There can be individual or company goals and metrics that go into determining the target goals needed in order to vest the PSUs.
For example, if the PSU target is for the company to hit a profit target by the end of the year, the employee would vest in the shares issued for hitting the goal. In addition, there could be a sliding scale whereby the employee could receive fewer or more shares by achieving most of the goal, or beating the goal by a significant amount.
The grant agreement for the PSU would define the goals and scale for vesting. In this example, the performance achievement at the end of the year would be determined and then the PSUs would vest accordingly.
So, the only difference is that the number of shares issued to the employee at the end of the vesting period for a PSU is based on the achievement of a goal over a time period, rather than purely based on a time period for an RSU.
Notional Shares (cash)
Notional shares are a slight twist to these restricted and performance stock units.
This just means the company pays the employee cash compensation at vesting rather than issuing shares. The dollar amount would be the same, which would be the number of shares times the fair market value per share. But, instead of issuing shares, the company would issue the cash value instead.
The same ordinary income tax obligation would exist at the time of vesting as with shares.
Risks of owning company stock
You can make a lot, and also lose a lot, by holding a significant amount of money in the stock of one company. This is an inherent risk of these programs that result in the employee owning company stock.
Even companies that appeared to be leaders in their market can go to zero in a heartbeat due to a scandal (Enron), lawsuit (Pacific Gas & Electric) or technology that obsoletes the company’s business (Blockbuster). For most people, this is too much risk to bear.
You should develop your own investment policy statement, where you determine your investment goals and assess your risk tolerance. In most cases you will determine that having a diversified portfolio is more stable and less risky for your financial future.
Part of this policy statement might limit the amount you would invest in any one company’s stock. For example, you might decide that you won’t hold more than 5% of your total investments in any one company stock.
You can read more about the risks of owning individual company stocks here.
Executive Summary: Benefits of Restricted vs Performance Stock Units
- RSUs are Restricted Stock Units and PSUs are Performance Stock Units.
- Both are a form of compensation from an employer that provides company stock at future time intervals.
- Both are paid out according to the grant agreement
- The vest date is key, as it results in compensation to the employee (taxable event) in the form of company stock
- RSUs vest based on the simple passage of time and can be a Cliff vest (all on one date) or a Graded vest (portions vest at different dates)
- PSUs vest based on a performance period (time) and a company performance metric.
- Once an employee receives the shares the standard capital gains tax rules apply when the shares are sold
- Notional shares are when the grant agreement calls for the equivalent value of stock in the form of cash
- Owning too much stock in one company is risky. Be sure have a balanced investment portfolio to reduce the risk.
