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Tax Implications for Stock-Based Compensation
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As a tax pro, you understand the complexity of helping clients with decisions around stock-based compensation. Stock options and similar plans require close consideration and a comprehensive understanding of how taxes factor into the equation, weighing potential gains against IRS rules to ensure your client remains compliant. The key is understanding the different types of stock-based compensation and when that income is taxable for the employee and deductible for the employer.
What is stock-based compensation?
Stock-based compensation is a form of employee compensation that compensates employees through granting company shares, stock options, or restricted stock units (RSUs) instead of cash payments. This compensation method has become increasingly popular in recent years – particularly among start-ups – as it doesn’t require an outlay of cash. It also incentivizes employees to stay with the company because they have to wait for their shares to vest.
There are several types of stock-based compensation plans, each with its own tax implications. The four common types of stock-based compensation are restricted stock awards, restricted stock units, nonqualified stock options, and incentive stock options.
Here’s an overview of each and a look at the tax consequences.
Restricted stock awards
Restricted stock awards (RSAs) are a grant of company stock in which the employee’s rights to the stock are restricted until the shares vest. Vesting can be met by the passage of time or by meeting specific performance metrics. The employee forfeits their shares if they leave the company or don’t meet the conditions the company set forth before the end of the vesting period.
Employees who are granted a restricted stock award can accept or decline the grant. If they accept, they may need to pay a purchase price to the employer.
Normally, RSAs are not taxed at the time of the grant (assuming the employee doesn’t elect to be taxed under Section 83(b).
Instead, the employee pays taxes on the grant when the shares vest. The employee’s taxable income is the difference between the fair market value (FMV) of the grant when it vests minus the amount the employee paid for it, if anything.
For grants that pay actual shares, the employee’s tax holding period begins at the time of vesting. Their tax basis is the amount they paid for the stock plus the amount included in their compensation.
Later, they recognize a capital gain or loss when they sell the shares. Whether that gain or loss is long-term or short-term depends on whether they hold the shares for more than a year, starting from the date the shares vest until the date of sale.
Section 83(b) elections
Employees can alter the tax treatment of their RSAs by choosing to make a Section 83(b) election. This means they elect to include the RSAs in their taxable income upfront at the time of the grant rather than over time as the shares vest. Their taxable income is the stock’s FMV at the time of grant minus the amount paid for the shares (if anything). This election also causes the stock holding period to begin immediately after the employer grants the award.
Employees don’t have to pay taxes on the RSA when it vests, regardless of the FMV at the time of vesting. However, they must pay tax on any capital gains when they sell the shares.
If the employee leaves before their shares vest, they’re not entitled to any refund of taxes previously paid or a tax loss for the stock forfeited.
For the employer, the timing of the tax deduction for RSAs typically corresponds with the employee’s recognition of income. When employees make a Section 83(b) election, the employer can take the tax deduction in the year the employee reports the compensation in gross income. Employers should report the amount of compensation the employee recognizes on the employee’s W-2.
Planning Tip: With a Section 83(b) election, employees are taxed on shares they have not received yet, and the election is irrevocable. A Section 83(b) election may be beneficial for employees with a strong chance of meeting the milestones required to vest the shares, and when the stock price is likely to appreciate over the vesting period.
Restricted stock units
Restricted stock units (RSUs) are another type of stock-based compensation in which employees receive company shares that vest over time. However, unlike RSAs, employers don’t issue stock at the time of the grant – only once the recipient satisfies the vesting requirement. Once the employee meets the vesting requirements, the company distributes shares or a cash equivalent.
An employee receiving RSUs isn’t taxed at the time of the grant, and the option to make an 83(b) election isn’t available. Instead, the employee is taxed when the shares vest unless they choose to defer receipt of the cash or shares.
If the employee chooses to defer receipt, they must pay a statutory minimum tax determined by their employer at vesting. However, they can postpone paying all other taxes until the time of distribution when they receive the shares or cash equivalent.
Their taxable income is the difference between the FMV of the grant at the time of vesting or distribution, less the amount paid for the grant (if anything).
When the employee later sells the shares, they recognize a capital gain or loss. Whether the gain or loss is long-term or short-term depends whether they held the shares for over 365 days, starting on the vesting date through the subsequent sale date.
For the employer, the timing of the tax deduction for RSUs corresponds with the employee’s recognition of income upon vesting. Employers report RSU income on the employee’s W-2, and the employer can take a tax deduction in the year they transfer the vested shares. An RSU is a promise to deliver shares in the future – not an actual property interest. So, the employee doesn’t have taxable income on the grant date. The employer can’t claim a tax deduction until the shares are both vested and transferred.
Planning Tip: RSAs or RSUs must be held for at least one year after the vesting date in order to qualify for the lower capital gains tax rate.
Nonqualified stock options
Nonqualified stock options (NSOs) allow employees (and outside service providers such as advisors, board directors, and independent contractors) to purchase company shares at a predetermined price – known as the exercise price, strike price, or grant price – within a fixed period of time.
Planning Tip: Employees typically wait to exercise an NSO until the current FMV exceeds the exercise price.
When employees exercise their stock options, they generally have three options:
- Exercise and hold. Employees exercise their options with cash and receive the full number of shares from exercising their options. The difference between the FMV at exercise and the grant price is taxable as ordinary income and subject to payroll taxes. The employee must have cash available to cover the purchase, tax withholding, and fees. When they later sell the shares, they pay capital gains on the difference between the FMV at exercise and the sale price. Whether the gain is short-term or long-term depends on how long they hold the shares after exercising them.
- Exercise and sell. Employees exercise and immediately sell their shares. They receive the net proceeds in cash after option exercise costs, taxes, commissions, and fees. The employee can use the proceeds from the sale to cover the purchase price, fees, and taxes. The employee pays ordinary income tax and payroll taxes on the difference between the FMV at exercise and the grant price.
- Sell to cover. The employee exercises their stock options and sells enough shares to cover the exercise costs and taxes. They then receive the remaining shares and can benefit from any appreciation in value. The employee pays ordinary income taxes and payroll taxes on the difference between the FMV at exercise and the grant price. When the employee later sells the shares they held onto, they pay capital gains taxes on the difference between the FMV at exercise and the sale price. Whether the gain is short-term or long-term depends on whether they hold the shares for more than one year. Employers can take a tax deduction for NSOs in the year the employee exercises their options and reports the compensation in gross income.
Employers should report the amount of compensation the employee recognizes on the employee’s W-2. From the employer’s perspective, NSOs aren’t treated as property on the grant date unless the options have a readily ascertainable FMV at that time, which is uncommon in companies that aren’t publicly traded. When employees receive vested shares upon exercising their options, the employer can claim a tax deduction at the time of exercise. However, if the shares aren’t vested and taxation is delayed, the employer’s tax deduction is delayed as well under IRC 1.83-6(a)(1).
Incentive stock options
Incentive stock options (ISOs) give employees the right to buy a specific number of shares of the company’s stock at a set price within a fixed period. One of the primary differences between ISOs and NSOs is ISOs are available only to employees – not independent contractors, partners, or anyone not on the company payroll.
Like NSOs, employees can exercise and hold, exercise and sell, or sell to cover when exercising their stock options. However, the tax treatment of those choices differs.
- Exercise and hold. Employees generally don’t pay taxes when they exercise and hold. However, the difference between the grant price and FMV at exercise is included in alternative minimum tax (AMT) calculations. If the employee sells the stock within two years from the grant or one year from exercise, the difference between the grant price and the lesser of FMV at exercise or the sales price is taxed as ordinary income. Any additional gain is taxed as a capital gain. If the employee sells the shares more than two years from the grant AND one year from exercise, the difference between the grant price and sales price is taxed as a long-term capital gain or loss.
- Exercise and sell. The difference between the grant and sales prices is taxable as ordinary income when the employee exercises the ISO.
- Sell to cover. For the immediately sold shares, the employee pays ordinary income taxes on the difference between the grant price and the sale price. For received shares, the difference between the grant price and FMV at the time of exercise is included in AMT calculations. If the employee sells the received net shares within two years from the grant or one year from exercise, the difference between the grant price and the lesser of FMV at exercise or the sales price is taxed as ordinary income. Any additional gain is taxed as a capital gain. If the employee sells the received net shares more than two years from the grant AND one year from exercise, the difference between the grant price and sales price is taxed as a long-term capital gain or loss.
Planning Tip: Be aware of the holding period requirements for ISOs – two years from the grant AND one year from exercise – to ensure that additional gains from sales of ISOs are taxed at the lower capital gains tax rates.
Employers receive a tax deduction for ISOs only upon a disqualifying disposition (sale in two years or less from grant or one year or less from exercise). With a disqualifying disposition, the employer can claim a tax deduction only if:
- the employee recognizes ordinary income at the time of sale
- the employer reports the income
Employee stock purchase plans
Employee stock purchase plans (ESPPs) grant employees options to buy shares of the company’s stock at a stated discount price and are generally offered to all eligible employees of a company. Employees are given a period between the offering date and the purchase date to fund the purchase, typically through payroll deductions, before exercising the option to buy shares of company stock on the purchase date. The offering date is the grant date of the ESPPs. Upon buying shares on the purchase date, the ESPPs are transferred to the employees.
- Purchase and hold. Employees generally don’t pay taxes when they purchase and hold ESPP shares. Unlike ISOs, the difference between the grant price and FMV at purchase is not included in alternative minimum tax (AMT) calculations. If the employee sells the stock within two years from the grant or one year from purchase, the difference between the grant price and the lesser of FMV at purchase or the sales price is taxed as ordinary income. Any additional gain is taxed as a capital gain. If the employee sells the shares more than two years from the grant AND one year from purchase, the difference between the grant price and sales price is taxed as a long-term capital gain or loss.
- Purchase and sell. The difference between the grant and sales prices is taxable as ordinary income when the employee exercises the ESPP.
- Sell to cover. For the immediately sold shares, the employee pays ordinary income taxes on the difference between the grant price and the sale price. If the employee sells the received net shares within two years from the grant or one year from purchase, the difference between the grant price and the lesser of FMV at purchase or the sales price is taxed as ordinary income. Any additional gain is taxed as a capital gain. If the employee sells the received net shares more than two years from the grant and one year from purchase, the difference between the grant price and sales price is taxed as a long-term capital gain or loss.
Planning Tip: Similar to ISOs, be aware of the holding requirements for ESPPs. Employees must hold the shares purchased under an ESPP for at least two years after the grant date and one year after the purchase date in order to receive the preferential capital gains tax treatment upon disposition.
Employers receive a tax deduction for ESPPs only upon a disqualifying disposition (sale in two years or less from grant or one year or less from purchase). With a disqualifying disposition, the employer can claim a tax deduction only if:
- the employee recognizes ordinary income at the time of sale
- the employer reports the income
If an employee purchased the shares at a price less than 100% of the FMV at purchase (i.e., the purchase contained a “bargain” element), some gain may be taxable to the employee as ordinary income at the time of sale or other disposition regardless of the holding period. Further, the employer may not receive a corresponding tax deduction despite the employee recognizing and reporting ordinary income at the time of sale.
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