Editor: Kevin D. Anderson, CPA, J.D.
Many companies find stock-based compensation is a great way to attract and retain key employees. Over the past year, many employers focused primarily on changes from the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. Now that the TCJA dust has settled a bit, it may be a good time for employers to go back to basics and review some important but complex tax rules involving compensatory transfers of employer stock. This discussion summarizes some fundamental income tax considerations for employers related to stock-based compensation under U.S. federal income tax laws.
The most common forms of stock-based compensation are restricted stock awards (RSAs), restricted stock units (RSUs), nonqualified stock options (NQSOs), and incentive stock options (ISOs). Each type is treated differently for tax purposes, and each has its advantages and disadvantages. The table "Tax Consequences of Employer Grants," below, summarizes the tax implications for employers for each type of grant.
Restricted stock awards
RSAs are shares of company stock that employers transfer to employees, usually at no cost, subject to a vesting schedule. When the stock vests, the fair market value (FMV) of the shares on that date is deductible by the employer and constitutes taxable W-2 wages to the employee. Typically, employers withhold applicable federal, state, and local income tax and Federal Insurance Contributions Act (FICA) taxes from the employee's other taxable income, but there are other options. For example, employees may remit cash (or other vested stock) to the employer to cover the taxes, or the employer may withhold some of the newly vested shares with a value equal to the amount of the taxes.
If an employee makes an irrevocable election under Sec. 83(b) within 30 days after the RSA grant, the employee would recognize taxable income immediately on the grant date without having to wait for the shares to vest. This election may be attractive for employees of companies where the stock value is expected to increase, since the election could minimize ordinary income and maximize capital gain when the stock is eventually sold. But Sec. 83(b) elections must be used with caution, since employees cannot get a refund of taxes paid if the stock does not vest or if the value declines after its grant date.
Restricted stock units
RSUs are a promise from the employer to deliver stock or cash to the employee in the future, based on the stock's performance. Since RSUs are not property, they are not governed by Sec. 83. Accordingly, there are no tax implications when employers grant RSUs. Rather, RSUs are deferred compensation taxed under Sec. 451 and are also potentially subject to penalties under Sec. 409A. Pursuant to Sec. 451, when RSUs are actually or constructively paid to the employee, the employer may take a compensation tax deduction equal to the wage income recognized by the employee (i.e., generally, the amount reported on Form W-2, Wage and Tax Statement). The employer is required to withhold applicable federal, state, and local income taxes from RSU payouts.
Unlike RSAs, RSUs are subject to the Sec. 3121(v)(2) special timing rules for FICA taxes on deferred compensation. If the RSU permits, the employer may defer delivering the RSU payout (which may be in cash or in shares) to the employee to a date beyond the vesting date (but the employee may need to make a timely election to defer receipt). So, both the employer and employee shares of FICA are typically due when RSUs vest, even if the payment of the RSUs does not happen until a later tax year.
Incentive stock options
ISOs are preferred by employees when long-term capital gain rates are lower than ordinary income rates, because there is no taxable compensation when ISO shares are transferred to an employee and 100% of the stock's appreciation is taxed to the employee as capital gains when sold.
Both employers and employees must satisfy many requirements laid out in Secs. 421, 422, and 424 and the regulations thereunder for the employee to obtain the favorable tax treatment. Requirements for the grant to qualify as an ISO include (but are not limited to):
- The option price must be at least the FMV of the stock at the grant date;
- The option must be granted pursuant to a written plan that generally must be approved by the shareholders within 12 months before or after the date the plan is adopted;
- Grants are only to employees and are generally nontransferable;
- The option plan term does not exceed 10 years, and the employees must exercise the option within 10 years of the grant date;
- The total FMV of the stock options that first become exercisable is limited to $100,000 in any calendar year; and
- The employee must not dispose of the ISO shares sooner than two years after the grant date and one year after the exercise date.
If all of the ISO requirements are met, the employer would never get a tax deduction for the ISO stock compensation. However, if any of the ISO conditions are not satisfied, the ISO is treated as an NQSO (see below for taxation of NQSOs). Upon a "disqualifying disposition" of an ISO, the proceeds up to the FMV of the shares on the exercise date, less the exercise price paid by the employee, will be taxable compensation income to the employee. The proceeds from a disqualifying disposition in excess of the shares' FMV on the exercise date will be taxed to the employee as a long-term or short-term capital gain, depending on the time the shares are held after exercise.
Upon a disqualifying disposition, the employer is entitled to a tax deduction equal to the taxable compensation reported on the employee's Form W-2 (in fact, the deduction is contingent upon reporting the income on Form W-2). Employers are not required to withhold income taxes on the amount of taxable compensation created by a disqualifying disposition of stock that was acquired through the exercise of ISOs (Sec. 421(b)).
Nonqualified stock options
NQSOs are stock options that are not ISOs. The tax treatment of NQSOs is generally governed by Sec. 83 unless Sec. 409A applies. Application of Sec. 409A is avoided when the exercise price is no less than the stock's FMV on the grant date. Because most compensatory NQSOs do not have a readily ascertainable FMV on the grant date, they are not considered "property" on the date of grant under Sec. 83 and are not eligible for an 83(b) election. Therefore the taxable event generally occurs when the NQSO is exercised. However, there is a special rule that could delay the taxable event beyond the NQSO exercise date. If the stock acquired upon exercise of the NQSO is subject to a substantial risk of forfeiture (e.g., if the stock is subject to a vesting schedule) and a Sec. 83(b) election is not made with respect to that stock, then the taxable event occurs when the substantial risk of forfeiture lapses (e.g., when the stock becomes vested).
If the taxable event occurs on exercise of the NQSO, the employer is entitled to an ordinary compensation deduction equal to the amount of ordinary income recognized by the employee on the spread between the FMV of the stock on the exercise date and the option exercise price. The employer is also required to withhold the applicable federal, state, and local income taxes, as well as FICA taxes (and pay the employer's share of employment taxes), on the compensation at that time.
If the taxable event occurs when the stock received from the exercise of the NQSO vests, the employer is entitled to an ordinary compensation deduction equal to the amount of ordinary income recognized by the employee on the spread between the FMV of the stock on the vesting date and the option exercise price. The employer is also required to withhold the applicable federal, state, and local income taxes, as well as FICA taxes (and pay the employer's share of employment taxes), on the compensation at that time.
Opportunity to defer payment of taxes
New Sec. 83(i), enacted as part of the TCJA, allows employees of certain privately held companies to elect to defer the payment of income taxes on certain equity compensation for up to five years. The amount of tax owed by the employee is calculated on the taxable event and compensation amount as described above, with only the remittance of the tax being delayed by the Sec. 83(i) election. The delayed payment by the employee in turn delays the employer's tax deduction to the year in which the employee's tax is paid. Plans of qualifying employers are not automatically subject to these deferral rules.
Grants to independent contractors
All of the above-mentioned awards, except for ISOs, are available for awards to independent contractors. Tax reporting for independent contractors is on Form 1099-MISC, Miscellaneous Income, not Form W-2.
Consider tax effects
Employers can attract or retain employees by compensating them with employer stock. There are a few different kinds of compensatory stock-based awards to consider, and each has advantages and disadvantages. When considering what equity-based compensation to offer, employers and their advisers need to analyze thoroughly the tax impacts on both the company and its employees.
Kevin D. Anderson, CPA, J.D., is a partner, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.