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Stock Option Taxation

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Stock options are a benefit that allows employees to buy stock in their employer’s company at a discount. The options themselves do not create ownership but exercising them to acquire stock does. For business owners, giving your executive team – or any employee for that matter – their piece of the business pie can be used to reward hard work, entice star performers to stay, and create a way for team members to feel a stronger connection to the company. However, venturing into this area without understanding the tax implications can create a crushing tax burden for stock option recipients and surprising consequences for business owners too. Wading into these waters should be done with caution since improper structuring can mean your company becomes subject to ERISA or the even more complex rules applied to non-qualified deferred compensation arrangements.

Services we offer
  • Discuss the best strategy for exercising options
  • Estimate taxes due upon exercise and advise on how to do so with the least tax burden
  • Prepare and file your tax returns
  • Assistance with Section 83(b) elections for restricted property
  • Assistance with 10b5-1 plans

There are multiple types of options, each with its tax situation, so it is important to have a tax professional by your side that understands the nuances of each kind.

Types of stock options

§83(b) Election

Most commonly used by start-ups or early-phase businesses since their value is limited until the company grows, these options are non-vested, non-cash compensation, and taxable as income the year the recipient elects to use them. Once they appreciate, they are taxed as capital gains.

Employee Stock Purchase Plans (ESPPs)

This catch-all category covers options offered below market value. But there’s a catch: exercising these options is a taxable event and the reduction in the cost is included in the recipient’s gross compensation. Most people need to set aside funds to pay for the additional tax if they plan to keep them for a while. Another option is to do a “cashless” exercise by borrowing the funds to buy the stocks, then repaying the loan immediately with money earned by immediately selling the stock.

Incentive Stock Options (ISOs)

These “statutory stock options” must meet strict IRS criteria and are typically granted at the current value of the company’s stock to reward the recipient for adding value to the company. Exercising the options is not usually taxable, but the employee will pay long-term capital gains tax when the shares are sold, as long as that is more than two years after they are granted, and one year after they are exercised.

Non-qualified stock options (NSOs)

This catch-all category covers options offered below market value. But there’s a catch: exercising these options is a taxable event and the reduction in the cost is included in the recipient’s gross compensation. Most people need to set aside funds to pay for the additional tax if they plan to keep them for a while. Another option is to do a “cashless” exercise by borrowing the funds to buy the stocks, then repaying the loan immediately with money earned by immediately selling the stock.

Restricted stock awards (RSAs)

Similar to NSOs, with one critical difference: while an employee determines when to exercise NSOs, RSAs follow a vesting schedule where the shares become the employee’s property at the end. Employers who want to retain more control over their stock ownership tend to prefer RSAs.

Phantom stock

In reality, this isn’t a stock option at all, but a way to tie bonuses to a company’s stock appreciation or overall success. Privately-held companies will give bonuses based on a pre-determined valuation formula for each “share,” while public companies tend to stick to true market value to determine the bonus employees receive. From a tax perspective, this is no different than a regular bonus in the eyes of the IRS.

Stock appreciation rights (SARs)

Nearly identical to phantom stock, SARS is given in the form of stock that the employee can exercise when they vest. To offset the tax consequences, they are often issued with stock options, known as a “tandem SAR.”

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BeachFleischman provides accounting, assurance, tax, and comprehensive advisory services that businesses of all sizes need to succeed. Contact us today to learn more.

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