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The Often Complicated Tax Implications of Stock Options

September 26, 2016

Employee Stock Options are fast becoming a standard component of compensation for many emerging growth sector companies. Stock option plans are a very popular way of attracting and retaining high performing employees for startups, who often lack the cash to offer big salaries and bonuses.

These plans give founders the ability to offer stock options to employees, officers, directors, consultants and advisors – in short all the people often needed to get a business up and running. It allows people to buy stock in the company when they exercise the options, and in some cases make loads of money in the process.

The most common types of stock option plans include: Incentive Stock Options (ISO), Non-Qualified Stock Options (NQSO) and Restricted Stock.

But there is often overlooked aspect of these stock option plans: They are all taxed in different ways. If an employee or other option holder is not familiar with the taxation parameters of the plan they enter into, they may end up facing some unforeseen (and often unpleasant) tax liabilities.

In a few words, the tax implications of various stock option plans can be very complicated.

It’s wise for anyone being offered stock options to seek the help of a qualified CPA or other tax expert when accepting or exercising the stock options, or when selling shares that came from a stock option plan.

INCENTIVE STOCK OPTIONS (ISOs)

Incentive Stock Options are typically offered only to senior executives and other key employees of a company. It grants the holder the right to purchase a certain number of company shares at pre-established price. There are two different types: Incentive Stock Options (ISOs) and Nonqualified Stock Options (NQSOs) and they are treated very differently from a tax liability standpoint.

Screen Shot 2016-07-13 at 9.30.59 AMIn most cases, ISOs offer a more favorable tax treatment than NQSOs. When Incentive Stock Options are exercised (purchased at a pre-established price) they can be priced well below the actual market value. The advantage of the ISO is that income is not reported when the stock option is granted nor when the option is exercised.

The taxable income is reported only when the stock is sold. And, depending on how long the stock is held, that income can be taxed at the capital gain rate of 0 to 20% plus 3.8% net investment income tax, if applicable. This rate is typically lower than most people’s regular income tax rate.

For the company granting the options, ISOs cannot be deducted on the company’s tax return.

With ISOs, the tax liability depends on the dates of the transactions (that is, when the option is exercised – to buy the stock and when the stock is sold). The price difference between the grant price paid and the fair market value on the day the option is exercised is known as the bargain element.

There is a catch with Incentive Stock Options, however: The bargain element needs to be reported as taxable compensation for Alternative Minimum Tax (AMT) purposes in the year the options are exercises (unless the stock is sold in the same year).

The stock option plot thickens when it comes to a Disqualifying Disposition. This is the legal term for selling, transferring or exchanging ISO shares before satisfying the ISO holding-period requirements: Two years from the date of the grant and one year from the date of exercise. This causes the loss of the ISO tax benefit – the holder then needs to report the income in the year of the disqualifying disposition as ordinary income, and most likely pay a higher tax rate.

NON QUALIFIED STOCK OPTIONS (NQSOs)

NQSOs are normally offered to non-executive employees and outside consultants and directors. While they are similar to ISOs in regard to taxation, there are some differences. Like ISOs, there is usually no income recognition upon their grant. But unlike ISOs, there is income recognition upon exercising the options. For companies, unlike the ISOs, NQSOs are allowed as a deduction on their tax returns.

With Nonqualified Stock Options, you must report the price break as taxable compensation in the year you exercise your options, and it’s taxed at your regular income tax rate, which can range from 10 percent to 39.6% percent. If you then hold the stock the required holding period, then further appreciation may qualify for capital gains when it is sold.

RESTRICTED STOCK

A restricted stock award share is a grant of company stock in which the recipient’s rights in the stock are restricted until the shares vest (or lapse in restrictions). The restriction period is called a vesting period. Once the vesting requirements are met, an employee owns the shares outright and may treat them as they would any other share of stock.

Screen Shot 2016-07-13 at 9.33.23 AMRestricted stock shares are not taxed until the share vests, and are assigned a fair market value. Once the stock vests, ordinary income is recognized. The amount of income subject to tax is the difference between the fair market value of the grant at the time of vesting minus the amount paid for the grant, if any. Then when the employee sells the stock, a capital gain is recognized.

There’s tax twist with Restricted Stock as well. A recipient can make a Section 83(b) election, which allows the holder to report income in the year the stock is transferred, despite the fact that it has not yet vested. When the stock vests, no further income pickup is required. Later, when the stock is sold, there may be a capital gain tax liability. Put simply, it can accelerate your ordinary income tax. For a successful company, It is anticipated that the value of the stock when it vests would be much higher than when it is initially acquired. Thus, it is hoped that a large tax savings can be realized by making the election. Also keep in mind that the IRS Section 83(b) must be filed within 30 days of the date the equity is granted.

The bottom line here is that you should work with a qualified CPA or other tax expert to understand the tax implications and potential liabilities of stock option plans. It’s always best to find plans that allow use of lower long-term capital gains tax rates vs. higher ordinary income tax rates.

This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.