August 2005
The tax consequences of an equity compensation award may vary significantly depending on how the award is structured. In general, the goal of the award recipient is to defer his out-of-pocket purchase price and tax costs related to the award for as long as possible and to maximize the portion of his income from the award that is taxable at long-term capital gain rates.i Stock options can be attractive to the recipient because, within specified parameters, they allow the recipient to decide in the future whether and when to pay the purchase price for the award. Often, however, the recipient of a stock option reports most or all of his income at ordinary income rates, or at least has to pay tax upon exercising the option, even if the option is issued as a supposedly tax-favored “incentive stock option” (or “ISO”). The infirmities in the option rules sometimes cause the parties to equity compensation transactions to consider the use of restricted stock as an alternative.
This article reviews the requirements and tax treatment of three forms of equity based compensation: options that are not ISOs (“non-qualified stock options” or “NQOs”), ISOs and restricted stock.
The grantee of a NQO generally reports ordinary compensation income upon exercising the NQO in an amount equal to the excess of (i) the fair market value, as of the time of exercise, of the stock received upon exercising the NQO over (ii) the exercise price of the NQO (the excess is sometimes referred to as the “spread”).ii The grantee then receives the underlying stock with a fair market value basis and a holding period beginning on the date of exercise.iii Thus, the grantee of a NQO generally reports the pre-exercise appreciation in the value of the underlying stock as ordinary income upon the exercise of the NQO and the post-exercise appreciation in the value of the underlying stock as capital gain (long-term if he holds the stock for more than a year after exercising) upon the disposition of the stock.
Subject to any applicable deductibility limitations, the corporation granting the NQO has a compensation deduction that mirrors the compensation income of the grantee in both amount and timing if it properly reports the grantee’s compensation income on a Form W-2 or 1099, as the case may be. The corporation must also withhold and pay employment tax with respect to the grantee’s compensation income if the grantee is an employee.
An option may qualify as an ISO only if:
In addition, an option will not qualify as an ISO to the extent that the underlying stock with respect to which the option is exercisable for the first time during any calendar year has a value exceeding $100,000 as of the grant date. For example, if an employee is granted an option to acquire stock worth $500,000 on the grant date and the option is immediately exercisable, only 20% of the option ($100,000/$500,000) may qualify as an ISO. If the option vests 20% per year over five years, the option may qualify as an ISO in its entirety.
The exercisability of an ISO may be made subject to conditions that are “not inconsistent” with the rules described immediately above. Accordingly, ISOs (like NQOs) may be granted subject to vesting provisions. Typically, options vest over time. It is also possible, however, for ISOs to vest as performance goals are met.iv
Under the general ISO rules, the grantee of an ISO is not taxed upon exercising the ISO. Instead, upon his disposition of the underlying stock, the grantee reports the amount he receives in the disposition less the exercise price of the ISO as long-term capital gain. Thus, and in contrast to the NQO rules (which, again, tax the pre-exercise appreciation as ordinary income upon the exercise of the option and the post-exercise appreciation as capital gain upon the disposition of the underlying stock), the general ISO rules tax both the pre-exercise and post-exercise appreciation as long-term capital gain upon the disposition of the underlying stock. The corporation granting the ISO reports no compensation deduction with respect to the ISO. Unfortunately, the general ISO rules have two significant caveats that often serve to defeat the tax objectives of ISO awards.
The first caveat is that the grantee must hold the underlying stock until at least two years after the grant of the ISO and at least one year after the exercise of the ISO. A disposition of the underlying stock before the holding period has run (referred to as a “disqualifying disposition”) requires the grantee to report ordinary compensation income for the year of the disposition equal to the spread on the option at the time of exercise.v Upon a disqualifying disposition, the corporation deducts the compensation income reported by the grantee subject to any applicable deductibility limitations and the compliance by the corporation with applicable reporting rules.
The second caveat is that the alternative minimum tax (or “AMT”) rules accord no special treatment to ISOs. Thus, the grantee must include the spread on the ISO at the time of exercise in computing his alternative minimum taxable income for the year of exercise. Depending on the size of the spread and the grantee’s other adjustments and preferences, the AMT rules can subject the grantee to tax for the year of exercise at a maximum rate of 28% on some portion of the spread at the time of exercise.
Despite the caveats, employees generally prefer ISOs to NQOs. If an employee exercises an ISO but then makes a disqualifying disposition, he is taxed at ordinary income rates on the spread measured at the time of exercise just as he would have been had the option been a NQO. That spread, however, is income for the year of the disqualifying disposition, which may be the year after the year of exercise. Further, any AMT liability resulting from the exercise of an ISO is likely to be less than the regular tax liability resulting from the exercise of a NQO with the same spread upon exercise.vi
As an alternative to options, corporations sometimes offer restricted stock to service providers. As used in this article, the term “restricted stock” means stock that the corporation issues at the outset to a service provider subject to a right of the corporation to repurchase the stock at the service provider’s cost (or some other amount that is less than fair market value at the time of repurchase) if specified service related vesting conditions are not met.vii Restricted stock can be made subject to the same time or performance based vesting conditions as might apply to options. In the case of an option, “vesting” permits the grantee to exercise the option and thereby purchase the underlying stock at a price fixed on the grant date. If the corporation retains any right to repurchase stock purchased by the grantee by exercising the option, the repurchase price is typically the fair market value of the stock at the time of the repurchase (or some formula price intended to approximate fair market value). In the case of restricted stock, “vesting” generally terminates the obligation of the recipient to sell the stock back to the corporation at a price that is less than fair market value. Thus, “vesting” in each case establishes the right of the service provider to receive any value of the stock in excess of the price established at the outset. The difference between the two approaches is that, under a restricted stock arrangement, the stock is actually issued to the service provider up front subject to a right of the corporation to repurchase the stock at the service provider’s cost if the service provider fails to vest.viii
A recipient of restricted stock generally has two choices for tax purposes. On the one hand, he may make a “Section 83(b) election” with respect to the stock. In that case, upon his receipt of the stock (receipt being the compensation event for tax purposes), he reports any excess of the then value of the stock (without regard to the service related restrictions) over the amount he pays for the stock as ordinary compensation income. He takes a fair market value basis in the stock, and his holding period begins. He then suffers no tax consequences upon vesting. Instead, if he vests, he reports capital gain upon selling the stock equal to the amount he receives in the sale less his basis in the stock (so that all of the post-issuance appreciation is capital gain upon the disposition of the stock). If he forfeits the stock by failing to vest, however, his loss (which is generally a capital loss) is limited to the excess of the amount he receives upon forfeiting the stock over the amount he paid for the stock (thus, he is not entitled to recoup any income he reported upon receiving the stock by taking a corresponding deduction upon forfeiture).ix Subject to any applicable limitations and the compliance with applicable reporting rules, the corporation’s compensation deductions mirror the recipient’s compensation income in both amount and timing.
On the other hand, the recipient may forego making a Section 83(b) election. In that case, he reports ordinary income when (or as) the stock vests equal to the excess of the value of the stock at the time of vesting over the amount he paid for the stock (so that vesting is the compensation event, and the appreciation between the time of issuance and the time of vesting is ordinary income at the time of vesting). His initial basis in the stock becomes the fair market value of the stock, and his holding period begins, at the time of vesting. Again, subject to any applicable limitations and compliance with the applicable reporting rules, the corporation’s compensation deductions mirror the recipient’s compensation income in both amount and timing.
A Section 83(b) election is often a good idea if the recipient believes (i) that the stock is likely to appreciate in value to a significant extent and (ii) that he is likely to vest. Of course, the recipient will need to weigh the benefits of the election against any tax he might owe upon receiving the stock as a result of making the election (and the consequences of any subsequent forfeiture of the stock). To be effective, a Section 83(b) election must be filed with the IRS by the recipient within thirty days after his receipt of the stock. The recipient must also provide the corporation (and others in certain instances) with a copy of the election and attach another copy to his tax return for the year of his receipt of the stock.
Particularly if the stock value is low at the time the award is to be made, a restricted stock award coupled with a Section 83(b) election can provide the recipient with a better tax result than an option award. In that case, the restricted stock award allows the recipient to report all of the post-issuance appreciation in the value of the stock as capital gain (long-term if he holds the stock for more than a year) when he disposes of the stock at a minimal up-front cost (in terms of purchase price, tax or some combination of the two).x If the value of the stock is high at the time the award is to be made, however, the up-front cost (or, if the recipient will forego making a Section 83(b) election, consequences of vesting) of a restricted stock award may cast the option alternative in a more favorable light.
The use of restricted stock may raise a number of practical issues, including the following:
If you would like to discuss stock options or restricted stock, please feel free to call Chip Wry.
Footnotes
i. Under current federal law effective through 2008, the maximum rates applicable to ordinary income (other than dividends) and most long-term capital gains (and dividends) of individuals are 35% and 15%, respectively.
ii. Section 409A of the Internal Revenue Code, which was enacted by the American Jobs Creation Act of 2004, subjects the grantee of a NQO that is granted at an exercise price below the then fair market value of the underlying stock to tax and a 20% penalty as the option vests. The NQOs discussed in this article are assumed to be granted at exercise prices that are at least equal to the fair market values of their underlying stock on their grant dates.
iii. If the stock received upon exercising the NQO is restricted (i.e., non-transferable and subject to a substantial risk of forfeiture – see discussion of restricted stock below), however, the grantee is deemed to exercise the NQO when or as the restriction lapses unless he makes a “Section 83(b) election” with respect to the stock (in which case the restriction is disregarded and the exercise of the NQO is the relevant tax event).
iv. Because vesting provisions may have an effect on the granting corporation’s financial reporting, it is generally a good idea for the corporation to seek the input of its accountants before implementing a plan.
v. Depending on the circumstances of the disposition, the grantee may then be able to report any difference between the fair market value of the underlying stock at the time of exercise and the disposition price as gain or loss, as the case may be, on the disposition.
vi. ISOs are also more attractive in that they are not subject to the provisions of Section 409A of the Internal Revenue Code.
vii. Technically, the applicable tax regulations refer to stock that is both “non-transferable” and “subject to a substantial risk of forfeiture,” as defined therein, upon its issuance to the recipient as “substantially non-vested” stock. The “restricted stock” referred to in this article is stock that is “substantially non-vested” within the meaning of those regulations.
viii. Because of the additional complexity, corporations often hesitate to make restricted stock available to as broad a pool of employees and contractors as might participate in an option plan.
ix. The consequences of the forfeiture rule may be even more significant if the corporation is an S corporation and the recipient has had to report a share of the corporation’s income without receiving a corresponding tax distribution.
x. Restricted stock is also attractive in that it is not subject to the rules of Section 409A of the Internal Revenue Code (regardless of whether or not the recipient makes a Section 83(b) election).
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