Pros and Cons of Pro Rata vs. Full Payouts to Retirees
June 30, 2022
Companies that want to provide an equity benefit to retirees face a number of decisions, one of which is whether to pay out equity awards in full or on a pro rata basis. (I discuss the considerations of another such decision, accelerating vs. continuing vesting upon retirement, in "Pros and Cons of Accelerating vs. Continuing Vesting Upon Retirement.”)
Full vs. Pro Rata Payouts
The decision to pay out equity awards in full or on a pro rata basis has no bearing on the timing of the payout; in either case, vesting can accelerate or can continue according to the original schedule. This decision affects only the amount of the award that is paid out.
If equity awards are paid out in full, retirees receive their equity awards in their entirety and forfeit no portion of them. With a pro rata payout, however, retirees receive only a portion of their equity awards, commensurate with the amount of service they have performed.
For example, say that a retirement-eligible employee is granted an RSU that cliff vests over four years and the employee retires after 82% of the cliff period has elapsed.
Full Payout: If the RSU will be paid out in full, the retiree receives the entire award. If vesting is accelerated, 100% of the award is paid out to the employee upon retirement. If vesting continues, the award is paid out in full at the end of the four-year cliff vesting period.
Pro Rata Payout: If the RSU provides for a pro rata payout, the retiree is entitled to only 82% of the award (because 82% of the vesting period has elapsed at the time the employee retires). The retiree forfeits the remaining 18% of the award. Here again, the portion of the award that the retiree is entitled to can be paid out at the time of retirement or at the conclusion of the four-year cliff vesting period.
Tax Considerations for RSUs
RSUs are subject to FICA taxation when they are no longer subject to a substantial risk of forfeiture. Where RSUs will be paid out in full to retirees (either at the time of retirement or over the original vesting schedule), the awards generally are no longer subject to a substantial risk of forfeiture when the award holder is eligible to retire. As a result, any outstanding RSUs employees hold at the time they become eligible to retire will be subject to FICA in that year. If employees are already eligible to retire in the year their RSUs are granted, the awards will be subject to FICA in the year of grant.
It may not be necessary for companies to withhold FICA immediately, however. There a several tax rules that allow companies to defer collecting FICA, which are discussed in the article "Retirement Provisions for RSUs.” One of these rules, the Rule of Administrative Convenience, allows companies to defer collecting FICA until the end of the calendar year in which the FICA obligation is triggered.
Where RSUs provide for a pro rata payout, the FICA treatment is a little more complicated. Because the awards are conditioned on employees continuing to provide services to the company, the substantial risk of forfeiture lapses gradually, as those services are performed. This results in an ongoing FICA obligation for the awards. Essentially, a small portion of the award ceases to be subject to a substantial risk of forfeiture every day.
Consequently, when employees holding unvested RSUs become eligible to retire, only the portion of the awards that are attributable to the service they have performed at that time are subject to FICA. As the employees continue to work for the company, an additional portion of the awards will be subject to FICA. Likewise, when retirement eligible employees are granted RSUs, the awards are not initially subject to FICA, but as the employees continue to work for the company, the awards will gradually become subject to FICA. See the article “Retirement Provisions for RSUs” for an example.
Income Tax Treatment of RSUs
RSUs are subject to income tax only when a transfer of property and/or constructive receipt of the underlying stock occurs. Thus, income taxes will not be due until the awards are paid out to retirees.
Tax Treatment of Other Types of Equity Vehicles
Stock Options: Nonqualified stock options are subject to both FIT and FICA only upon exercise; providing pro rata payouts to retirees does not change this treatment. Incentive stock options are subject to FIT only upon disposition and are not subject to FICA, so providing pro rata payouts to retirees does not change the tax treatment of ISOs either. Note however that the acceleration of vesting upon retirement of even a pro rata portion of the option, could cause the ISO or other ISOs held by the retire to exceed the $100,000 limitation.
Performance Awards: Generally, performance awards are paid out to retirees only at the end of the performance period and only to the extent that the performance conditions are met. Where this is the case, the awards are still subject to a substantial risk of forfeiture through the end of the performance period and providing pro rata payouts to retirees should not have any effect on the tax treatment of the awards.
Restricted Stock: Unfortunately, restricted stock is subject to both FIT and FICA when the substantial risk of forfeiture lapses. Thus, when restricted stock provides for pro rata payouts to retirees, once a holder is eligible to retire, a small portion of the award will be subject to tax for both FIT and FICA purposes each day. Moreover, there are no Treasury regulations that would allow for deferral and aggregation of the taxes due. As a result, pro rata payouts of restricted stock to retirees are not advisable due to the practical difficulties of managing the tax payments.
Simplified Accounting Treatment
Paying out equity grants to retirees on a pro rata basis rather than paying out grants in full can simplify the accounting consequences of paying out grants to retirees.
When grants of either stock options or awards that provide full payout to retirees (on either an accelerated or continued basis) are granted to retirement eligible employees, any stated vesting requirements are considered nonsubstantive. Consequently, the expense for the awards is recognized in full in the period of grant.
Attribution of expense for awards that provide for full payouts to retirees can be quite complicated when an award recipient is not eligible for retirement at grant but will become eligible to retire before the conclusion of the stated vesting period. In this situation, the company must forecast when the award holder will become eligible to retire and record expense over the shorter of i) the vesting period or ii) the period in which the award holder will become eligible to retire.
For example, let’s say that a grant with a stated vesting schedule of four years is issued to an employee who will be eligible for retirement in one year and vesting in the grant is automatically accelerated in full upon the employee’s retirement. Expense for the grant is recorded over the one-year period that elapses before the employee becomes eligible for retirement, rather than the stated four-year vesting schedule.
At many companies, retirement eligibility is based on a combination of age and service. At some companies there are two or three different ways that employees can achieve retirement eligibility (e.g., employees might be eligible to retire at age 65, after 15 years of service, or at age 55 with ten years of service). Depending on the complexity involved in how a company defines which employees are eligible to retire (see "4 Trends in Retirement Provisions for Equity Awards”), it can be challenging to predict the period over which expense must be recognized for employees who are nearing retirement.
A significant advantage of pro rata payouts is that any accounting concerns vanish. Even when employees are eligible to retire, the portion of their awards that relate to future service are still subject to forfeiture and, thus, substantive vesting conditions. It is only the portion for which service is complete that will be paid out in the event of their retirement and thus, subject to nonsubstantive vesting conditions. Because expense is accrued over the service period of the award, the rate at which the award becomes eligible for payout upon retirement on a pro rata basis will generally be the same rate that expense would be accrued for the award absent the pro rata payout. See the article “Retirement Provisions for RSUs” for an example.
Pros and Cons
Pros of Pro Rata Payouts as Compared to Full Payouts
- Retirees receive only the portion of award that has been earned.
- Less dilution and share usage if retirees don’t provide service through their full vesting date.
- FICA payments for RSUs are smaller and spread out over several years. Where RSUs are paid out in full to retirees, the entire award becomes subject to FICA in the same year. (No FICA implications for stock options or performance awards.)
- No special accounting is required; expense is accrued at the same rate as awards held by employees who are not eligible to retire.
Cons of Pro Rata Payouts as Compared to Full Payouts
- Payout out awards on a pro rata basis does not fully remove the awards from the retirement decision. Employees have to choose between retiring and earning their full award; some employees who are otherwise ready to retire may continue working to earn more of their award.
- FICA calculations for RSUs are more complicated and RSU awards are repeatedly included in FICA until employees retire or achieve their full vesting dates. (No FICA implications for stock options or performance awards.)