The Deferral and Diversification of Restricted Stock Units
In the first blog in this series, we discussed how the design of long-term equity compensation plans has evolved from a primary emphasis on stock options to the portfolio approach commonly used today. And within the portfolio of equity compensation awards, Restricted Stock Units, both time-vested and performance-vested, have become the vehicles of choice for many companies because of the flexibility of plan design, potential tax advantages and simplified stock plan administration.
In the second blog we provided a hypothetical analysis illustrating the potential advantage of the deferral of taxation upon vesting of RSUs and discussed various issues associated with participation in a non-qualified deferred compensation plan.
In the third blog, we addressed the issue of diversification; that is, the ability of a participant in a non-qualified deferred compensation to reallocate some or all of the RSUs deferred to other fund choices offered under the plan (such as a notional S&P 500 fund). We noted that, contrary to conventional thinking, it may be possible to design a plan that permits the voluntary deferral and diversification of RSUs deferred without triggering accounting issues.
In this fourth and final blog in the series, we will turn our attention to the critical importance of professional, on-going plan administration and participant communications; specifically, related to the timing of RSU deferral elections and the management of distributions.
Deferral Election Timing – Introduction
An election to defer income taxes on RSUs beyond the vesting and payment date must be made in compliance with Section 409A, the Code section that deals with the taxation of non-qualified deferred compensation arrangements. The rules are quite specific but allow for a good deal of flexibility as to the timing of a deferral election, and the timing and form of the elected benefit distributions.
The following is an overview of the general deferral election timing rule and a few valuable exceptions to the general rule.
Deferral Election Timing – Time Vested RSUs – General Rule
- A deferral election must be made in the year before the year of grant, e.g., December 2021 for RSUs to be granted in 2022.
- A separate election is made for each vesting tranche including: the percentage of the RSUs granted to be deferred, the period of deferral (to retirement or to a specified date), and the form of benefit payments (in a lump sum or in installments).
- Note that the deferral election applies to income taxes (which are deferred until distribution) but not to FICA and Medicare taxes, which are due upon vesting.
Deferral Election Timing – Performance-Based RSUs – General Rule
- Once again, the deferral election must be made in the year before the year of grant as illustrated in the graphic below.
Deferral Election Timing – Exceptions to the General Rule
There are a few important and potentially valuable exceptions to the general rule regarding the timing of deferral elections.
- 12 Month / 5 Year Exception: Under this exception, it is possible to make deferral election at any time up to 12 months prior to the vesting date as long as the elected distribution date is at least 5 years after the originally scheduled distribution date (upon vesting). This exception is applicable to either time vested or performance vested RSUs.
- “Look-back” Deferral Election. As illustrated in the graphic below, an election to defer RSUs that are part of a vesting traunch that is more than 12 months out, could be made after the date of grant. Once again, this exception to the general rule could be used for either time-vested or performance-vested RSUs.
Example 1: “Look-Back” Deferral Election for Time Vested RSUs
- The graphic below illustrates such a “look-back” election made more that 12 months before the vesting date for the March 1, 2024 and 2025 vesting tranches. Once again, the elected deferral would have to be for a minimum of 5 years.
Example 2: “Look-Back” Deferral Election for Performance-Vested RSUs
- As illustrated below, a deferral election could be made anytime at least 12 months prior to the original cliff vesting / distribution date, as long as the new distribution date is at least 5 years later than the original date.
Deferral Election Timing – Exceptions to the General Rule
A second valuable exception to the general deferral election timing rule is for “performance-based compensation” as defined under Section 409A.
- In this case, a deferral election can be made anytime up to 6 months prior to the end of the performance measurement / vesting period if:
- Vesting is contingent on the attainment of pre-established performance criteria and,
- The award qualifies as “Performance-Based Compensation” as defined in Section 409A.
Example 3: Deferral Election Timing – Performance-Vested RSUs – “Performance-Based Compensation” Exception to the General Rule
- Assuming the P-V RSUs meet the Section 409A definition of “performance-based” compensation, a deferral election could be made anytime at least 6 months prior to the end of the performance measurement/vesting period.
Proxy Research / Analysis To Do
EBS has developed a standard process for the review of proxy statements to identify situations where the deferral of RSUs could be of significant value to executives, especially in the case of a “look-back” election for RSUs previously granted.
The following is an example of a report produced by the review process. Note:
- In Column 13 an indication of whether that specific vesting trance is eligible for deferral,
- In Column 15, the market value of the RSUs eligible for deferral and,
- In Column 16, an estimate of the income taxes that would be due upon vesting without a deferral election.
Note: Hypothetical results are for illustrative purposes only and are not intended to represent the past or future performance of any specific investment.
- For the 8/1/2019 one-time integration PSU grant, the maximum payout reported as unearned was used in the analysis; and for the 2/28/2020 grant for the 2020-2022 performance period, the target payout was used.
- For illustrative purposes, the total reported for RSUs and Restricted Stock Awards were shown as RSUs.
- For illustrative purposes, it was assumed that ABC Corp. granted PSUs and RSUs similar in value to those awarded in 2020.
First, from a plan design standpoint, it may be possible to structure a non-qualified deferred compensation plan that could significantly enhance the value of the total rewards package for senior executives by permitting the voluntary deferral and (subject to specific requirements) diversification of RSUs deferred.
Secondly, it is essential that such a plan be managed professionally on an on-going basis by a firm that understands the nuances of the non-qualified deferred compensation tax rules, and stock plan administration. For example, as noted above, the opportunity for a “look-back” election to defer RSUs previously granted could potentially generate significant tax savings with respect to RSUs grants made in the past, such as the receipt of a signing bonus in the form of a significant RSU grant.
If you are interested in having EBS complete a review of the company’s proxy statement to identify the potential value of the RSU deferral and diversification strategy or if the company currently sponsors a non-qualified deferred compensation program that doesn’t offer this feature, please contact one of the firm’s Managing Directors and we would be glad to set up an exploratory call.
Restricted stock units (RSUs) are a form of stock-based employee compensation with no liquidity until vested. They provide no dividends or voting rights. The value of the RSU may decrease before it can be liquidated. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
Complimentary Proxy Review Request
EBS is an executive benefit consulting firm. It does not provide accounting or tax advice. The tax and accounting treatment described above for the deferral and diversification of RSUs is based on the firm’s experience working with its clients and their advisors on similar plan designs.