Tax Impact of Stock-Based Compensation
Compensation may take several forms, including salary, fringe benefits and bonuses. If one is an executive or other key employee, one might also receive stock-based compensation, such as restricted stock, restricted stock units (RSUs), or stock options. These awards can be valuable, but the tax consequences are complex. They involve not only a variety of special rules but also several types of taxes — including ordinary- income taxes, capital gains taxes, employment taxes and more.
Restricted Stock
Restricted stock is stock an employer grants subject to a “substantial risk of forfeiture.” Income recognition is normally deferred until the stock is no longer subject to that risk (that is, it’s vested) or you sell it. When the restriction lapses, you pay taxes on the stock’s fair market value (FMV) at your ordinary-income rate.
However, with a Section 83(b) election, one can instead opt to recognize ordinary income when one receives restricted stock. This election, which one must make within 30 days after receiving the stock, allows one to convert potential future appreciation from ordinary income to long-term capital gains income and defer it until the stock is sold.
There are some potential disadvantages of a Section 83(b) election, however. First, prepaying tax in the current year could push one into a higher income tax bracket and trigger or increase exposure to the additional 0.9% Medicare tax. Nonetheless, if a company is in the earlier stages of development, the income recognized may be relatively small (or zero). Second, any taxes one pays because of this election cannot be refunded if the stock were to eventually be forfeited or sold at a decreased value.
Restricted Stock Units
Restricted stock units are contractual rights to receive stock, or its cash value, after the award has vested. Unlike restricted stock, RSUs are not eligible for the Section 83(b) election, so there is no opportunity to convert ordinary income into capital gains.
Nevertheless, RSUs do offer a limited ability to defer income taxes: Unlike restricted stock, which becomes taxable immediately upon vesting, RSUs aren’t taxable until the employee receives the stock. This provides an opportunity for individuals to arrange with
their employer a delay in delivery (and thus income deferral) rather than having the stock delivered immediately upon vesting. 1 This of course assumes that deferral of income is advantageous, which may not always be the case. For example, depending on one’s facts and circumstances, it may be more advantageous to recognize income immediately based on current tax rates or if that individual’s current tax bracket is lower than it is expected to be in the future.
Incentive Stock Options
Incentive stock options (ISOs) allow one to buy company stock in the future (but before a set expiration date) at a fixed price equal to or greater than the stock’s FMV at the date of the grant. Accordingly, ISOs do not provide a benefit until the stock appreciates in value. If it does, one can buy shares at a price below what they’re then trading for, provided one is otherwise eligible to exercise the options.
Although ISOs must comply with many rules, they receive tax-favored treatment. For example, no tax is owed when ISOs are granted or exercised. There could be alternative minimum tax (AMT) consequences, but the AMT is currently less of a risk now
because of the high AMT exemption under the Tax Cuts and Jobs Act.2
There are regular income tax consequences when an ISO is sold. If an ISO is sold after holding it at least one year from the exercise date and two years from the grant date, the tax paid on the sale is at long-term capital gains rate, potentially including the 3.8% net investment income tax (NIIT).
However, if an ISO is sold before long-term capital gains treatment applies, a “disqualifying disposition” occurs, and any gain is taxed as compensation at ordinary- income rates.
Nonqualified Stock Options
Nonqualified stock options allow one an option to purchase shares of company stock in exchange of service. The grant determines the number of shares awarded and determines the price paid to purchase or exercise the shares. The tax treatment of nonqualified stock options is different from the tax treatment of ISOs in that NQSOs create compensation income (taxed at ordinary-income rates) on the bargain element when exercised (regardless of whether the stock is held or sold immediately), but NQSOs do not create an AMT preference item. Instead, the tax treatment of NQSOs is like that of the RSUs previously discussed within. For example, like RSUs, tax is owed when one receives the shares. The primary difference between NQSOs and RSUs is that the holder of the NQSO can decide when he or she receives the shares allowing for some additional flexibility in timing income recognition.
Conclusion
Stock-based compensation can be a valuable component of an employee’s overall compensation package. However, the tax implications are complex and vary significantly depending on the type of award. Careful planning and consideration of individual circumstances are crucial to minimizing tax liabilities and maximizing the benefits of these awards. Consulting with a qualified tax advisor, such as Topel Forman, is highly recommended to navigate these complexities and make informed decisions regarding stock-based compensation.
1 Any income deferral must satisfy the strict requirements of Internal Revenue Code Section 409A.
2 If an ISO is not sold in the year of exercise, a tax “preference” item is created for the difference between the stock’s FMV and the exercise price (the “bargain element”) that can trigger the alternative minimum tax.
