Have You Evaluated Your Employee Stock Options Lately?
posted Dec 3, 2018 by Erica Beneduce in the Global Tax Blog
* This blog was originally written in 2016 and was updated on December 3rd, 2018.
In general, there are two kinds of employee stock options: incentive stock options (ISOs) and nonqualified stock options (NQSOs), as covered in our blog “Tax Treatment of Employee Stock Options”. Now that the 2015 tax year has ended, it is important to remind yourself of the different rules surrounding the various deferred compensation options. There are special rules that apply to stock based executive compensation that you will want to be sure you take into account.
What are some important dates to keep in mind?
There are three critical dates that should be considered for tax purposes:
- The date the options are granted
- The date the options are exercised
- The date the stock acquired via the options is sold
The tax consequences of each of these events differ significantly based on the type of stock option the employee holds.
What are ISOs?
Incentive Stock Options (ISOs) allow the employee the right to buy company stock in the future at a fixed price that is determined at the time the options are granted.
In addition to this:
- Generally, ISOs must be exercised within ten years of receiving them. ISOs cannot be transferred and must be exercised during employment, or within three months of leaving the company.
- The exercise price cannot be less than the stocks fair market value at the time of the grant, therefore ISOs must appreciate before they have any value.
There are several key tax consequences relating to the granting and exercising of ISOs:
- First, there is no tax liability on the date the options are granted.
- Second, there is no regular tax liability when you exercise a previously granted ISO. However, the difference between the exercise price and the fair market value at the time of exercise is treated as an adjustment for AMT purposes. Read more about the AMT’s effect on ISOs in our blog: “Got Incentive Stock Options? Beware of the AMT”
- Third, if the stock is owned at least two years from the date the option was granted, or one year after they were exercised (whichever is later); any gain will be taxed as a long-term capital gain. On the other hand, if the stock is sold within 24 months of the grant date, or 12 months of the exercise date (whichever is later), the sale will be considered a disqualified disposition. The gain will be taxed as ordinary income tax rates.
What about NQSOs?
Unlike ISOs, the exercise of nonqualified stock options (NQSOs) creates taxable ordinary income in the year of exercise for both regular tax and AMT purposes. In addition to this:
- The income is equal to the excess of the stock’s fair market value on the date of exercise over the exercise price. This income is taxed as compensation, and will be subject to social security and Medicare taxes.
- The granting of a NQSO generally does not create taxable income unless the value of the option is readily ascertainable. When the stock is sold, any appreciation or depreciation after exercising will be taxed as a capital gain.
**It should be noted that the holding period of the sale starts when the shares are acquired, not when the option was granted. Therefore, in order to get long-term capital gain treatment, the employee must actually hold the shares for more than one year.
Any other types of deferred compensation?
Another type of deferred compensation is restricted stock. The tax treatment of which varies significantly from the stock options discussed above in a few ways:
- If an employee receives stock that is subject to a substantial risk of forfeiture, they can defer the recognition of income until the stock is no longer subject to that risk, or the stock is sold.
- There is an option to elect under code section 83(b) to recognize ordinary income when the stock is received. This allows the employee to convert future stock appreciation from ordinary income into long-term capital gain income.
**Please note, the election must be made within 30 days of receiving the stock. If the election is not made, the employee will pay tax at ordinary income tax rates on the appreciation when the restrictions lift.
- The disadvantage of making the election is that you pay tax at ordinary income tax rates in the current year, and cannot receive a refund of the tax if the stock depreciates in value.
In conclusion, there are many different tax consequences surrounding the sale of stock received as deferred compensation. All of the issues discussed above should be considered when choosing to exercise an option or sell stock.
If you have any questions or would like to discuss further, please contact any member of our Tax Services Team.