August 6, 2012
Many companies use equity-based compensation to reward employees. But are the employees aware of the income tax consequences?
The two most common types of equity-based compensation are corporate stock and options to acquire corporate stock. Employees who receive equity-based compensation are especially affected if they will have to dip into their own cash resources to pay any resulting income tax obligation.
Often, their employers are large publicly traded corporations with stock listed on an exchange and readily tradable. But smaller privately owned businesses occasionally use equity as a form of compensation. Included in this latter group are startups – particularly those in technology industries – and established companies that may lack the necessary cash resources to sufficiently reward their employees.
An employee who receives shares of stock in the employer corporation as compensation for services is taxed on the fair market value of the stock received. If the employer corporation is publicly traded, the fair market value can be determined from the exchange on which the stock is listed.
If the stock is not publicly traded, valuation may be more difficult. In some cases, the services of an appraiser may be required to determine the fair market value of the shares received.
Sometimes the employer-corporation places restrictions on the shares it issues to employees as compensation. For example, a restriction may state that employees must forfeit the shares unless they remain employed with the company for some specified period.
When shares are subject to a substantial risk of forfeiture, the tax law provides that the compensatory event occurs only when the restrictions lapse.
In other words, instead of paying tax on the value of the shares on the date of the award, the employee is taxed on the value of the shares determined at the date the restrictions lapse. By that time, the shares may be worth significantly more – or less – than they were worth on the date of the award.
Employees who receive restricted shares are offered the opportunity to elect to pay tax at the date of the award instead of waiting until the restrictions lapse. This election is known as the “Section 83(b) election,” which refers to the operable Internal Revenue Code provision.
The Section 83(b) election is generally advantageous if the stock increases in value and the employee remains with the company until the restrictions lapse.
But the election has possible disadvantages:
- If the stock declines in value, the employees will have paid more tax than necessary.
- If the stock is forfeited because the restrictions are not fulfilled, the employees will have paid tax on the value of an asset that they no longer own. There is no tax deduction for employees who forfeit restricted stock.
For anyone who chooses the Section 83(b) election, time is of the essence. The election must conform to requirements specified in the income tax regulations. A signed copy of the election must be provided to both the IRS and the employer within 30 days after the initial transfer of the restricted shares to the employee.
A stock option is a contractual right granted to the employee by the employer, giving the employee the opportunity to purchase shares of stock in the employer corporation at a specified price during a specified period.
Because the employee must pay a price to exercise the option, many employees tend to wait as long as possible, exercising their options shortly before the options are set to expire. When an option is exercised, the difference between the fair market value of the stock at the date of exercise and the exercise price is known as the “bargain element.”
Employee stock options come in two varieties: nonqualified stock options (NQSOs) and incentive stock options (ISOs):
- When an NQSO is exercised, the employee pays tax on the bargain element as ordinary compensation income.
- When an ISO is exercised, the bargain element is treated as a preference item for alternative minimum tax (AMT) purposes.
So, the employee who exercises an incentive stock option may be subject to AMT but not to ordinary income tax.
Another quirk about ISOs is that the employee exercising the option must wait more than one year after exercise – and two years after the option was originally granted – before selling the underlying stock. Failure to meet the holding period requirement causes the option to be treated as a NQSO instead of an ISO.
ISOs must meet strict requirements specified in the tax law. In addition, the employer must designate the option as an ISO.
For a variety of reasons, most employers choose to offer nonqualified stock options rather than incentive stock options. Employees can determine whether they have an ISO by reviewing the option document. If the document does not state that the option is an ISO, it is a NQSO.
Employees holding options generally prefer to wait as long as possible to exercise the option since the exercise price does not change. However, if the value of the underlying stock is increasing, the amount of the bargain element – and the corresponding income tax consequences – is also increasing.
If you receive equity-based compensation, be sure you understand the income tax consequences.
This article was originally posted on August 6, 2012 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at firstname.lastname@example.org.