Taxation of Employee Stock Options

Key employees of a corporation often receive stock options as part of their compensation package. Employee stock options give the employee the right, but not the obligation, to purchase stock in the corporation at a fixed price on a specified date or during a specified time. When the options are granted, there are restrictions as to when they can be exercised or when the acquired stock can be sold or there may be a risk of forfeiture of the acquired stock until the employee satisfies certain conditions, such as working for the employer a certain number of years. When all restrictions or risk of forfeiture are removed, the options or the acquired stock are said to be vested, meaning the employee has an irrevocable right to the property.

How the options are taxed depends on the type of options, whether there was a discount when the options were granted, and the time intervals between the options grant date, exercise date, and stock sale date. A disadvantage of compensating employees with stock options rather than with restricted stock, however, is that options may lose significant value before they become vested. Restricted stock, on the other hand, will always have some value unless the business becomes financially insolvent.

There are 3 key events in compensating an employee with stock options:

1. The stock option is granted, at which time the employee pays the option price to receive the grant or receives it as a benefit of employment;
2. the employee must hold the option for a specified period until it can be exercised, at which time, the employee receives the stock;
3. the employee sells the stock, and the difference between the proceeds of the sale and the cost of acquiring the stock options is the employee's gain.

Employee stock option terms range up to 10 to 15 years, usually with the strike price = the stock price on the grant date.

Common features include:

• A vesting period of up to 4 years when the options cannot be exercised.
• Employee options must be exercised, they cannot be sold.
• When the options are exercised, the company issues new shares to sell to the employee for the strike price.
• The options are forfeited if the employee leaves their job.
• If they leave after the vesting period, they lose the out-of-the-money options and must exercise in-the-money options soon after leaving.

Tax law distinguishes between statutory options, which must comply with IRC §421-424, and includes incentive stock options (ISO) and options purchased under an Employee Stock Purchase Plan (ESPP), and nonstatutory options, which do not qualify under these regulations, but are, instead, subject to the less favorable tax treatment of IRC §83.

Statutory Options

Statutory options receive preferential tax treatment. If certain holding rules are followed, employees do not incur regular income tax liability either when the option is granted or exercised, and any gains are treated as capital gains rather than as ordinary income. However, if vested options are exercised, the option spread, equal to the exercised stock price minus the option price, must be reported as a positive adjustment to the alternative minimum tax (AMT) if held after the tax year. AMT liability need not be reported if the stock is sold during the tax year since it will have to be reported as taxable income under the regular tax system.

ISOs are taxed when the purchased stock is sold — ISOs are not taxed when they are granted or exercised. For ISOs to qualify under the tax rules as statutory stock options, they must be exercisable within 10 years of the grant date and the option price must at least equal the FMV of the stock when granted. If the aggregate FMV of the stock that can be acquired by exercising ISOs when the exercise restriction has been removed for the 1^st time during any tax year exceeds $100,000, the excess is treated as nonstatutory stock options. If the employee leaves the corporation, the ISO must be exercised within 3 months after employment termination; otherwise, the income is taxed as nonstatutory stock options.

To be treated as ISOs, these requirements must be satisfied:

• ISOs must be granted under a plan adopted by the corporation and approved by shareholders;
• the total number of shares and the employees who may receive the options must be specified;
• the plan must be approved by stockholders within 12 months either before or after the date such plan is adopted;
• options must be granted within 10 years of the earlier of either the plan adoption or approval date;
• the options must be exercisable within 10 years from the grant date;
• the option price cannot be less than the FMV of the stock when granted;
• the options may not be transferable except because of the grantee's death;
• the options may only be exercised by the employee;
• the employee at the time of the grant, may not own more than 10% of the total combined voting power of all classes of stock of the employer corporation, or of its parent or subsidiary.

The option holder should receive Copy B of Form 3921, Exercise of an Incentive Stock Option under Section 422(b) from the company when the ISO is exercised, showing this information:

1. date of grant
2. date of exercise
3. exercise price per share
4. FMV per share on exercise date
5. number of shares acquired when option was exercised

Copy A of Form 3921 goes to the IRS. The information contained in this form should be used to calculate gain when the shares are sold or to calculate the AMT adjustment, if applicable.

Holding Period Rules

A long-term capital gain or loss can be claimed on the stock only if the stock was held for at least 2 years after the ISO was granted and at least 1 year after the exercise of the option. These holding period rules are considered satisfied if an earlier sale was motivated to comply with conflict-of-interest requirements.

If the holding period test was not satisfied, the gain on the stock sale is treated as ordinary wage income equal to the option spread:

The tax basis for the stock is increased by any amount treated as wages.

Employee Stock Purchase Plans

Employee Stock Purchase Plans (ESPPs) are written shareholder approved plans where employees are granted options to purchase shares of the employer's stock or of its parent or subsidiary corporation. The option period is the time from when the options were granted to when the stock was purchased. The tax consequences of selling ESPP stock depend on:

• whether the ESPP is qualified and nonqualified
• whether the sale is a qualified or disqualifying disposition
• the holding period for the stock

To be treated under statutory option rules as a qualified ESPP and as a qualified disposition, these rules must be satisfied:

• No options can be granted to any employee who owns more than 5% of the voting power of the employer's stock or of the parent or subsidiary of the employer.
• All full-time employees must be included except those with less than 2 years of employment, part-time or seasonal employees.
  • The plan must be nondiscriminatory but the amount of stock that any employee can buy may be based on the employee's compensation.
• No employee may have the right to buy more than $25,000 worth of stock annually based on the stock price when the option is granted.
• The option price may not be less than 85% of the lesser of:
  1. the FMV of the stock when the option is granted, or
  2. the FMV of the stock when the option is exercised.
• The option must be exercised within 27 months from the grant date, or 5 years if the option price is based on the FMV of the stock when the option is granted.
• The employee must be employed continuously from the option grant date until 3 months before its exercise.

If the employee purchased the option at a lower price than the stock FMV on the day of the grant, the discount, which cannot exceed 15%, is treated as ordinary wage income. Stock purchases under an ESPP are subject to the same holding period rules as for ISOs. Tax need not be paid until the stock is sold and the gain, minus any amount treated as wages, is treated as capital gain. Stock sold at a loss is a capital loss.

If holding periods are not satisfied, the employee recognizes ordinary income as the lesser of

• the sale proceeds or the FMV at the employee's death minus the option price, or
• the FMV of the shares when the option was granted minus the option price.

Employees who exercised an option granted under an ESPP should receive Form 3922, Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423(c) after the end of the tax year. Stock sales are reported on Form 8949, Sales and Other Dispositions of Capital Assets and Schedule D, Capital Gains and Losses.

For a non-qualified ESPP, the discount (= stock FMV at the time of the purchase − purchase price) is treated as ordinary income in the purchase year.

Nonstatutory Stock Options

Nonstatutory stock options (aka nonqualified stock options, NQSOs), are subject to less favorable tax treatment under IRC §83, and, under certain circumstances, can be considered nonqualified deferred compensation subject to Section 409A if the exercise price is less than the underlying stock value when the option is granted. NQSOs incur taxes twice: when the option is exercised and when the stock is sold.

To prevent employees from exercising options right away and to ensure that they will work at least a few more years at the company, most companies require a waiting period called the vesting period when the options cannot be exercised until the end of that time. When an employee exercises the options, they receive shares in their employer's company. The difference between the FMV of the shares, sometimes called the 409A value, and the strike price of the option is taxable as wages, subject to ordinary income tax rates and employment taxes. When the shares of stock are subsequently sold, only a capital gains tax applies to the difference between the sale price and the 409A value. The long-term capital gains rate will apply if the shares are held longer than 1 year after the exercise date.

When the options are exercised, the employer will usually only withhold a portion of the tax, often 25%, that will be due upon exercise because the tax bill is often larger than the employee's salary, so the employee must pay additional tax when filing the tax return. So, the employee will need money to buy the shares at the strike price and pay the tax on the exercise.

If the company is expected to continue growing, exercising the option as soon as possible minimizes the income subject to ordinary income tax and employment taxes. Any gains afterward will only be subject to the capital gains tax, and if held longer than 1 year, the preferable long-term capital gains rate will apply. However, if allowed, many employees will sell their shares on the same day they exercise their options so that the stock and the taxes can be paid out of the proceeds.

To summarize with more details, if the stock option has a readily ascertainable FMV, then:

A nonstatutory option has a readily ascertainable fair market value if:

• the option is transferable;
• the option can be exercised when granted;
• there are no conditions or restrictions that would affect this FMV; and
• the value of the option privilege is readily ascertainable.

An option may not have a readily ascertainable FMV unless it is traded on a public exchange, and since employee options are never traded on public exchanges, they will not have a readily ascertainable FMV. Vested options without an ascertainable FMV are taxed as wages when the option is exercised:

If the stock is not vested, the income is deferred until the year the stock vests. In the vesting year, gains are taxed as ordinary wage income that equals the stock value on the vesting date, even if the stock is not sold, minus the amount paid.

Ordinary wage income is subject to both income and employment taxes. the gain reported as wage income is added to the tax basis of the stock:

Afterwards, when the stock is sold, any gain or loss is treated as a capital gain or loss:

Nonstatutory stock options may be granted in addition to incentive stock options. Unlike ISOs, the number of nonstatutory stock options that can be granted is not restricted since they do not receive favorable tax treatment.