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 interval of time. When the options are granted, there are usually 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, then the options or the acquired stock are said to be vested, meaning that the employee has an irrevocable right to the property. How the options are taxed depends on what type of options they are, 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:
- 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;
- the employee must hold the option for a specified period until it can be exercised, at which time, the employee receives the stock;
- then 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.
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 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 when it is exercised, and any gains are treated as capital gains rather than as ordinary income. However, if vested options are exercised, then 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 beyond the end of the tax year. AMT liability does not have to be reported if the stock is sold before the end of the tax year, since it will then have to be reported as taxable income under the regular tax system.
Option Spread = Fair Market Value of Stock When Exercised – Option Price
AMT Adjustment Example
Your employer grants you an incentive stock option to buy 100 shares of company stock at its fair market value (FMV) of $9 a share:
- 1 year later, you exercise the option when the stock's FMV is $14 a share;
- 2 years later, when the stock's FMV is $16 a share, your rights to the stock become vested.
- Consequently, your AMT adjustment, reported on Form 6251, is increased by $1,600 – $900 = $700.
ISOs are generally taxed when the purchased stock is sold — ISOs are not taxed when they are granted or when they are 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 fair market value of the stock when granted. If the aggregate fair market value of the stock that can be acquired by exercising ISOs when the exercise restriction has been removed for the 1st time during any tax year exceeds $100,000, then the excess is treated as nonstatutory stock options. If the employee leaves the corporation, then 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, the following 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 fair market value 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 the following information:
- date of grant
- date of exercise
- exercise price per share
- fair market value per share on exercise date
- 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, then the gain on the stock sale is treated as ordinary wage income equal to the option spread:
Ordinary Wage Income = Option Exercise Price – Option Grant Price
The tax basis for the stock is increased by any amount that was treated as wages.
Example: Holding Period Rules
- March 12, Year 1: Your employer grants you an ISO to buy 100 shares of stock at its FMV of $10 per share.
- January 6, Year 2: You exercise the option when the stock's FMV was $12 per share.
- January 26, Year 3: You sell the stock for $15 a share.
Although you held the stock for more than 1 year, you did not hold it for at least 2 years from the option grant date. In the year of the sale, you must report the difference between the option price of $10 per share and the exercise price of $12 per share as wages; the rest is capital gain:
|Selling price ($15 × 100 shares):||$1,500|
|Purchase price ($10 × 100 shares):||- $1,000|
Amount reported as wages:
($12 × 100 shares) - $1,000
Amount reported as capital gain:
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, the following 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 per year based on the stock price when the option is granted.
- The option price may not be less than 85% of the lesser of:
- the fair market value of the stock when the option is granted, or
- the fair market value 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 fair market value 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 fair market value of the stock on the day of the grant, then the amount of the discount, which can be no greater than 15%, is treated as ordinary wage income. Stock purchases under an ESPP are subject to the same holding period rules as for ISOs. Tax does not have to be paid until the stock is sold and the gain, minus any amount treated as wages, is treated as capital gain. If the stock is sold at a loss, then it is a capital loss.
If holding periods are not satisfied, then the employee recognizes ordinary income as the lesser of
- the sale proceeds or the fair market value at the employee's death minus the option price, or
- the fair market value of the shares when the option was granted minus the option price.
If the employee exercised an option granted under an ESPP, then he 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 year of the purchase.
- You pay $10 per share for an option to buy 1000 shares of company stock when the fair market value of the stock was $11.
- One year later, you exercise the option when the fair market value of the stock was $15 per share.
- 2 years later, you sell the stock for $20,000.
Since you purchased the option at a discount of $11 – $10 = $1 per share, $1000 of your gain is treated as wages in the year of the option purchase; the rest is treated as a long-term capital gain of $20,000 – $11,000 = $9000 in the year of the stock sale. However, if you had not satisfied the holding period rules, then $15,000 – $10,000 – $1000 = $4000 must be treated as additional wages and your long-term capital gain would only be $20,000 – $15,000 = $5000.
Nonstatutory Stock Options
Nonstatutory stock options (aka nonqualified stock options) 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.
If the stock option has a readily ascertainable fair market value, then:
Ordinary Wage Income = (Fair Market Value of Option – Option Price Paid) × Number of Shares
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 fair market value; and
- the value of the option privilege is readily ascertainable.
An option may not have a readily ascertainable fair market value 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 fair market value. Vested options without an ascertainable FMV are taxed as ordinary income in the year the option is exercised:
Ordinary Wage Income = (Exercise Price – Option Price Paid) × Number of Shares
If the stock is not vested, then the income is deferred until the year that the stock vests. In the vesting year, gains are taxed as ordinary wage income that equals the value of the stock as of the vesting date minus the amount paid, even if the taxpayer holds onto the stock.
Ordinary Wage Income = (Stock FMV on Vesting Date – Option Price Paid) × Number of Shares
Ordinary wage income is subject to both income and employment taxes. the gain that is reported as wage income is added to the tax basis of the stock:
Tax Basis of Stock = Option Price Paid + Gain Reported as Income
Afterwards, when the stock is sold, any gain or loss is treated as a capital gain or loss:
Capital Gain or Loss = Stock Sale Proceeds – Tax Basis of Stock
Nonstatutory stock options may be granted in addition to incentive stock options. Unlike ISOs, there is no restriction on the number of nonstatutory stock options that can be granted since they do not receive favorable tax treatment.