Stock Option Taxation

Equity ownership can be a very enticing carrot to dangle in front of driven executives, as well as a great way to compensate talented employees who like to have some “skin in the game.” It’s critical to understand the tax implications of utilizing non-cash forms of compensation so that both you and your employees can have appropriate expectations for how to approach this non-traditional method of compensation.

Often, employees can be caught in a difficult situation where they have an income tax obligation but no corresponding cash with which to pay it. Proper planning and a working understanding of relevant tax law can help to take advantage of a potentially lucrative bonus.

Let’s explore some relevant concepts:

  • §83(b) election. This is an election to include the value of non-vested non-cash compensation in taxable income in the year of the grant. These elections make the most sense for employees/contractors/board members of early-phase startups where the options/shares they are granted have little to no value. If this election is made, the grantee pays ordinary income tax on the value (if any) of the non-cash compensation granted to them during the year. If the shares or other securities granted vest and appreciate in value, the grantee is able to treat them as capital gain property and potentially save a large amount of tax.
  • Incentive stock options (ISOs). Also called “statutory stock options,” these are option grants that meet a series of strict criteria set out in the Internal Revenue code. They are generally required to be granted at the current value of the company’s stock, hence the “incentive” to work for stock appreciation. Exercising the option is generally not a taxable event, and assuming the requirements are met, the employee will pay tax at long-term capital gain rates when the shares are sold. However, selling shares within two years of grant and one year of exercise will disqualify the shares from this advantageous treatment.
  • Employee Stock Purchase Plans (ESPPs). Similar in many ways to the ISO, an ESPP is a way for employees to purchase company stock using after-tax payroll deductions which are exempt from Social Security and Medicare taxes. An ESPP can be a “qualified” plan that must pass eligibility criteria similar to those of the ISO, or “non-qualified” and offered to a select few employees, in which case there is no tax deferral opportunity. Qualified plans generally are not available to anyone who owns more than 5% of the company stock, as well as most company executives. ESPPs can be offered at a small discount and employers have some flexibility on the purchase price as well. Assuming all relevant requirements are met, employees can realize long-term capital gains on sale (and “ordinary” income in the event that shares were purchased at a discount).
  • Non-qualified stock options (NSOs). With reference to ISOs, these are any other type of stock option granted to a recipient. They are typically granted at less than fair market value, hence there is a “bargain element” for the recipient and a more immediate way to cash in. But here’s the rub: the exercise of an NSO is a taxable event and the bargain element on exercise is included in the grantee’s gross compensation for the year (e.g. on a W-2 or Form 1099-MISC depending on how the worker is classified). The worker will likely need to set funds aside to help with paying the tax on exercise, or if possible, a “cashless” exercise may be in order. This occurs when an employee borrows the funds to exercise and repays the loan immediately by concurrently selling the stock.
  • Restricted stock awards (RSAs). These are similar in many respects to the Non-qualified Stock Options. The income tax implications are nearly identical, i.e. when an award vests and is no longer restricted, the fair value of the stock must be included in the employee’s reportable compensation for the year. The critical difference between an RSA and an NSO, however, is one of timing. A worker determines when they will exercise an NSO; an RSA merely follows a vesting schedule, at the end of which the shares are owned by the worker. These may be a more attractive option for employers who prefer to retain more control over stock ownership.
  • Phantom stock. This is a strategy to incentivize employees without actually giving away any equity in the company. It provides for a cash bonus, in some cases equivalent to the increase in value of the company’s stock during a specified time period, in other cases perhaps a bonus based on the value of “shares” granted. For example, an annual bonus to an employee tied to the increase in stock value between Jan. 1 and Dec. 31 multiplied by the number of phantom “shares” owned. Privately held companies will typically spell out a valuation formula in the phantom stock plan, while publicly traded companies will reflect true market value. Taxation is straightforward as this is simply a cash bonus and would be the same as any other cash bonus paid to employees. Phantom stock can be a great motivational tool by giving high-performing employees a tangible stake in the welfare of your company without muddying corporate governance.
  • Stock appreciation rights (SARs). SARs are almost identical to phantom stock in that they provide for a bonus equal to a specified increase in stock value. However, SARs are occasionally issued in the form of stock, which can be exercised after they vest. They are frequently issued with stock options to help offset the tax consequences of exercise. This type of SAR is known as a “tandem SAR” and can help to mitigate the difficulty of taxes caused by non-cash compensation.

While only a brief introduction to complex forms of compensation, the foregoing list nevertheless reflects great opportunities to motivate your employees. Be aware that plan structures can potentially subject an otherwise simple arrangement to the provisions of the Employee Retirement Income and Security Act (“ERISA”) or the complex rules of non-qualified deferred compensation arrangements (Tax code section 409A), so be sure to consult with your tax/qualified plan expert prior to implementing any plan.

In addition, it’s critical to note which plans require strict adherence to a set of statutory criteria (i.e. ISOs and ESPPs) and which can trigger a taxable event without corresponding cash with which to pay the tax (83(b), NSOs, and RSAs). However, you choose to incentivize your employees, be sure they are educated about the tax consequences!

BeachFleischman PLLC has a team of experts that is ready to help you determine the right plan for you, as well as providing education to your employees so that it works as intended!

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