Employer stock options in one form or another have been utilized as compensation to employees for many years. It has been a vehicle for the building of immense wealth for high and mid-level company executives. Stock options extend the privilege of buying a specific amount of employer stock, within a specified time, at a specified price. If a stock value increases over time relative to the option price, the employee may exercise his option, immediately sell the stock and realize the gain, or alternatively, he my exercise and hold the stock (one year) for long term capital gain treatment. On the other hand, if there is no increase in value of the underlying stock over the option price, the employee simply does not exercise the option and loses nothing.
The dictionary definition of an employer stock option is a contract giving the holder the right (not the obligation) to purchase a certain number of shares of stock of employer the corporation at a set price.
There are generally two types of stock options, namely incentive stock options (ISOs) and non-qualified stock options (NQs). Both types are compensatory stock options. In the timeline on the life of an option there are three (3) main events, the grant of the option, the exercise of the option, and the sale of the underlying stock. There is never any taxable event at the time of the grant of the option.
There are significant, and differing, tax ramifications for the above options at the time the employee exercises the stock option. There are also differing tax ramifications at the time employee sells the underlying stock obtained through the exercise. Below is a list of the general features of incentive stock options and non-qualified stock options. Occasionally, there is confusion as to whether an employee has ISOs or NQs. An easy rule to remember is as follows: If the financial benefit of the exercise of a stock option is reflected in the employee’s payroll stub as W-2 taxable income in the year of exercise then that employee has a non-qualified stock option. The financial benefit on the exercise of an ISO stock does not appear in the employee’s W-2 on exercise unless he immediately sells the ISO stock in a disqualifying sale creating immediate reporting of the transaction as employee compensation and increased W-2 taxable income.
Non-Qualified Stock Options
- NQs may be granted to either employees or to independent contractors of the employer.
- NQs can be granted at FMV on grant date or even below the fair market value of the stock.
- No required term limits – generally ten years.
- Depending on date of sale of stock after exercise (creating ownership) there can be ordinary income (sale in less than one year) or long term capital gain.
Tax Consequences for NQs
- No income recognized at time of grant.
- Ordinary income included in employee’s W-2 equal to the option spread on the day of the exercise of stock option. Option spread is the value of the stock at the time of exercise less the grant price (price paid by the employee).
- The option spread is deductible by the company for income tax purposes in the year the employer exercises the option.
- Cashless transactions are common where the stock is sold immediately after exercise; can result in missing the opportunity for appreciation in future years.
- Employee income tax W-2 withholding requirement on taxable income (spread) in year of exercise the option. Medicare and Social Security taxes also applicable.
- Disposition of underlying shares result in either long-term or short-term capital transaction (can be either a gain or loss). Gain or loss determined by the difference between fair market value at the time of exercise and sales proceeds (value) at time of disposition.
- Many employees receiving options do not realize that there are two taxable events on the immediate sale of stock obtained through the exercise of a non-qualified stock option. The NQ exercise is reflected as a gross up of taxable income on the employee’s W-2. At the same time the employee must report any sale of the stock obtained through the exercise on Schedule D on his Form 1040. Many taxpayers forget the Schedule D reporting requirement causing subsequent inquiries from the IRS.
- Some taxpayers do not understand that on sale of N.Q stock their cost basis is FMV on the date of exercise and not the grant price paid for the stock. Result: overstated capital gain income. Option cost plus W-2 gross up equals cost basis of stock.
Incentive Stock Options
- • Option price must equal the fair market value on date of grant of option.
- • ISOs may be granted only to employees and not to independent contractors.
- • Option term may not exceed ten years.
- • Employer grants limited to $100,000 in stock value each year.
- Special rules if issued to a 10% shareholder in employer corporation.
Tax Consequences for ISOs
- No income tax recognized at time of grant.
- No income tax ramifications at time of exercise for regular income tax purposes; however, the phantom tax (AMT) can be a burden on the exercise of an ISO.
- ISO’s have the available advantage of no W-2 including as with N.Q.’s and restricted stock. The employer does not receive a tax deduction as with N.Q.’s and restricted stock.
- Employer may not deduct option spread (on exercise) on company tax return assuming no disqualification by employee.
- ISO spread at time of exercise is an alternative minimum tax “preference item” to employee and often creates an AMT tax liability in year of exercise.
- An ISO exercise creates cash flow problems: employee must pay option price to employer and may have an alternative minimum tax liability (no payroll withholding) in the year of the exercise (see discussion of alternative minimum tax elsewhere in this website) but only receives stock in return. However, the taxpayer can immediately sell the ISO stock upon exercise and convert transaction to a W-2 transaction (NQ treatment – ordinary W-2 income) rather than AMT tax. Wealth creation, however, would indicate paying the AMT tax and option price and holding the stock for long term capital gain treatment for future sale.
- Capital gain treatment in year of sale (stock held for 12 months) for underlying stock shares obtained through ISO exercise. Cost basis for regular income tax purposes is option price paid – and not FMV of stock on date of exercise as in the case with NQs. Capital gain treatment is available on sale of ISO stock. An AMT deduction on Form 6251 reduces AMT liability in year of sale of stock. An AMT tax credit against ordinary taxes may also be available to reduce regular income taxes in year of disposition of stock or in subsequent carryover year.
- Interplay between year of sale capital gain tax on sale and earlier AMT tax in year of exercise. Careful planning indicated.
Post – Exercise Tax Considerations
- Employee must hold ISO stock for requisite holding period or there will be a disqualifying disposition and the exercise and sale will be treated as a NQ to be reported on the employee’s W-2.
- Employee must hold for one year from exercise date to obtain benefit of long-term capital treatment.
- Capital gain recognized on sale of ISO stock can be offset by an alternative minimum tax credit (MTC) against capital gain taxes. Theory: One tax rather than both alternative minimum tax and regular income tax once stock option in granted, exercised and sold.
- Adjustment on sale of ISO stock (difference between AMT cost basis and ordinary income tax basis) is favorable AMT adjustment on Form 6251 in year of disposition of the ISO stock. This AMT favorable adjustment can create a window of opportunity to exercise new ISOs without triggering current AMT and/or qualify the taxpayer for minimum tax credit (MTC) against ordinary income taxes. Carryover of unused MTC available.
Exercise Strategies for All Stock Options
- Employee must use cash to satisfy option cost on exercising – existing employer stock of taxpayer can no longer be used to pay employer for cost on exercise of the option.
- Employee may sell underlying stock immediately after exercising option and receiving stock. Stock proceeds are then available for payment of option price to employer (employer usually has cashless exercise/sell arrangements in place for NQ’s at brokerage firms) as well as payment of income taxes. Employee retains net sales proceeds reduced by option cost and taxes withheld. Long term capital gain treatment not available on cashless transactions.
- ISO options are wealth planning vehicles. Careful planning allows for the conversion of ordinary employee compensation income into long term capital gain property. Cash availability on exercise and current AMT tax liability may be a problem.
Employer Restricted Stock/Employer Stock Grants
Employers often choose to compensate employees for services through stock grants that are subject to restrictions. Oftentimes stock grants have restrictions on sale or a requirement that the stock be returned if the employee leaves employment. An employee who receives restricted employer stock as compensation must report its value as taxable income in the year of receipt unless the property is substantially non-vested (IRC Section 83(a)). Restricted stock normally does not require a taxpayer to report taxable income in year of grant. Restrictions create lack of taxpayer vesting in stock, and in turn, does not require recognition of taxable income.
However, tax planning is available to immediately convert what would be ordinary income restricted stock into a long term capital asset. In many instances tax planning suggests that an employee who receives restricted stock should report the fair market value of the stock on the grant date as taxable income in the year of receipt of restricted stock grant.
IRC Section 83(b) affords an employee an election to report any value underlying the grant of employer stock as ordinary income at the time of the grant. The election will mean that any future appreciation in stock value will be treated as long term capital gain if the stock is held for one year or more and the stock restrictions have lapsed. An election document is required to be filed with the IRS within 30 days of the stock grant. Once an employee makes the 83(b) election the asset becomes a capital asset rather than employee compensation. It is no longer an untaxed asset which would have been treated as ordinary W-2 income to employee when the restricted stock vests and the stock has been transferred to the employee. An absence of 83(b) election results in W-2 withholding for income taxes as well as FUTA/FICA taxes on vesting.
The filed 83(b) election document is also ultimately attached to the tax return reporting the sale of stock subject to an 83(b) election. The 83(b) election also avoids stock dividends being treated as compensation in the intervening years before sale. This accomplishes the conversion of compensation income (taxed at ordinary income tax rates) into a favorable long term capital gain transaction if held for a year or more.
Here are the tax considerations. If you receive substantially non-vested stock in connection with the performance of employer services, whether to pay tax now under an 83(b) election (report as ordinary income) or wait until the property becomes substantially vested may depend on how you assess the future of the company. If the chances for increased company value are promising, your best planning is to make the election under IRS 83(b) and pay ordinary income taxes on FMV. In that manner you will limit your compensation income (ordinary income) to the property’s adjusted fair market value on the day the restricted stock was granted. Any future appreciation in value will be taxed to you when you dispose of the property at favorable capital gain rates.
On the other hand, if the value of the stock is stagnant or depreciating in value the risk is on the employee. If the value of the stock goes down he will not be able to recoup any tax paid because of the 83(b) election. The taxpayer is only entitled to a capital loss deduction on the ultimate sale or worthlessness of the stock.