Stock Compensation – Tax Impact to Recipients

By Ally Brophy July 7, 2014

Introduction

Attracting and retaining talented employees can play a significant role in an organization’s long-term success. While recruiting efforts tend to broadcast a variety of benefits attempting to influence the candidate’s decision, the backbone of an employer’s offer has always been compensation. Employers with the ability to offer compensation in the form of equity interests can have the upper hand in a lineup of competing firms. The variations, rules, and taxable consequences of stock compensation arrangements are extensive and undeniably complex. This article will focus on the taxable consequences to the recipient of compensatory stock options.

A stock option grants the recipient a legally enforceable right to purchase the employer’s stock during a specified period in the future at a specified price. In general, there are two common types of compensatory stock options that employers can grant employees: Statutory Stock Options and Non-statutory Stock Options. The timing, type, and amount of income inclusion depends on which option the employee receives. The way the options are structured by the employer determines whether they are considered “statutory” or not. Oversimplifying, if criteria described in Internal Revenue Code Sections 421 and 422 are followed (related to dollar amount, holding period, relationship between employer and recipient, and others), the options will be statutory. All others are non-statutory.

Restricted property

To gain a general understanding on the taxation of options, we must (quickly) highlight the mechanics of Internal Revenue Code Section 83(a). Property transferred in connection with the performance of services is taxable to the recipient in the year in which the rights to the property become transferable or are not subject to a substantial risk of forfeiture. That is to say, if rights to the property are restricted in some form, the recipient of the property does not recognize an amount in gross income upon grant of the rights. When the restriction lapses, the recipient recognizes ordinary income (typically in the form of compensation) to the extent that the fair market value (FMV) of the property exceeds the amount paid for such property.

Non-statutory Stock Options (NSO)

NSO’s, often referred to as Nonqualified Stock Options, are similarly governed by the mechanics of §83. However, options bring in the added taxable event known as the date of exercise. NSO’s are taxable to the extent of FMV over the purchase price on the option’s grant date only if the option has a readily ascertainable fair market value. Options that are actively traded on an established market, such as the American Stock Exchange or the Chicago Board of Options Exchange are deemed to have a readily ascertainable FMV. For NSO’s that are not traded on an established market, readily ascertainable FMV can only be determined if the option is 1) transferable by the recipient, 2) exercisable immediately in full, and 3) not subject to any restrictions. NSO’s are otherwise taxable upon the recipient’s exercise of the option. The recipient includes in gross income an amount equal to the FMV of the stock on the date of exercise over the strike price (exercise price). This is more commonly referred to as the bargain element of the option. The bargain element is included as compensation and taxed at ordinary income tax rates.

Statutory Stock Options

Statutory stock options fall into two categories:

Incentive Stock Options (ISOs)

ISO’s can produce favorable capital gain tax advantages to the recipient if the option is held for the required period of time. Capital gain rates are applied to dispositions of ISO’s that are held at least two years from the option’s grant date and at least one year from the option’s exercise date. For ISO’s that do not meet this holding period requirement, the bargain element becomes taxable as ordinary income to the recipient in what is known as a disqualifying disposition.

ISO’s are a unique form of stock compensation in that no taxable event is triggered for regular tax purposes when the recipient exercises the option to purchase the shares of stock. Therefore, the employee only reports regular taxable income from an ISO when he/she disposes of the shares. If the disposition of an ISO is a qualifying disposition, the employee will only report capital gain equal to the FMV of the shares upon disposal over the grant price of the option. However, recipients of ISO’s should not overlook the Alternative Minimum Tax (AMT) consequences. Some ISO holders may be surprised to be hit with a substantial Alternative Minimum Tax bill in the year of exercise or share purchase when the intention was to buy and hold the shares for capital gain treatment for regular tax purposes! There can be a later credit on sale of these shares which can help recoup alternative minimum taxes paid on purchase. It’s best to plan ahead before exercising ISO’s to map out a tax strategy.

Employee Stock Purchase Plan (ESPP)

Stock compensation in the form of ESPP shares likewise have unique characteristics. Similar to ISO’s, ESPP shares do not trigger a recognition event upon either the grant or exercise of the option. The holding period requirements for a qualifying disposition apply to ESPP shares as well. Unlike ISO’s, however, there are no additional AMT consequences associated with the exercise/purchase of ESPP shares. The most distinguishing characteristic of ESPP shares is that they can be granted at a discount, not to exceed 15% of the stock’s FMV. Shares are typically purchased through payroll deductions and can be purchased for the lesser of 85% of the FMV of the stock at time of grant or 85% of the FMV of the stock at the time of purchase. If the shares are disposed of in a qualifying disposition, the 15% discount is required to be characterized as ordinary income (compensation) to the extent of gain recognized on the disposition. Any remaining gain is characterized as long term capital gain. If the shares are disposed at a loss, no ordinary income is recognized on the transaction. The ordinary income component is generally handled through the corporation’s payroll department as an item of W-2 income.

Conclusion

Stock compensation can come in various forms. As a result, the tax implications of each stock compensation arrangement requires careful consideration and thorough comprehension. Though investment decisions should not be made solely on the basis of tax consequences, tax planning for stock options can help an employee maximize the after-tax return on such benefits. We’d be happy to discuss your benefits with you and help you understand the tax and cash flow consequences of your equity incentives.