
[ Back ] EMPLOYER STOCK OPTIONS Restricted Stock Grants Stock options in one form or another have been utilized as compensation for employees for many years. It has been a vehicle for the building of immense wealth for high and mid-level company executives. Stock options extend the privilege of buying a specific amount of employer stock, within a specified time, at a specified price. If a stock value increases over time relative to the option price, the employee may exercise his option, immediately sell the stock and realize the gain; or alternatively, he may exercise and hold the stock for further long term capital gain treatment. On the other hand, if there is no increase in value of the underlying stock over the option price, the employee simply does not exercise the option and loses nothing. The dictionary definition of an employer stock option is a contract giving the holder the right (not the obligation) to purchase a certain number of shares of stock in the employer corporation at a set price. There are generally two types of stock options, namely incentive stock options (ISOs) and non-qualified stock options (NQs). Both types are compensatory stock options. In the timeline of the life of an option there are three (3) main events, the grant of the option, the exercise of the option, and the disposition of the underlying stock. There is no taxable event at the time of the grant. There are significant, and differing, tax ramifications for the above options at the time the employee exercises the stock option. There are also differing tax ramificaitons at the time employee sells the underlying stock obtained through the exercise. Below is a list of the general features of incentive stock options and non-qualified stock options. Occasionally, there is confusion as to whether an employee has ISOs or NQs. An easy rule to remember is as follows: If the economic benefit of the exercise of a stock option is reflected in the emplolyee's payroll stub and W-2 taxable income in the year of exercise then that employee has a non-qualified stock option. The economic benefit on the exercise of an ISO stock does not appear in the employee's W-2 on exercise unless he immediately sells the ISO stock in a disqualifying sale. Non-Qualified Stock Options General Features NQs may be granted to either employees or to independent contractors of the employer. NQs can be granted at any strike price even below the fair market value of the stock. No required term limits - generally ten years. Tax Consequences for NQs No income recognized at time of grant. Ordinary income included in the employee's W-2 equal to the option spread on the day of the exercise of stock option. Option spread is the value of the underlying security at the time of exercise less the grant price (price paid by the employee). The option spread is deductible by the company for income tax purposes in the year the employer exercises the option. Employee income tax withholding requirement on taxable income (spread) in year of exercise of option. Cost basis of NQ stock for future sale (capital gain) is equal to fair market value of the shares on date of exercise and not the option cost. Disposition of underlying shares result in either long-term or short-term capital transaction (can be either a gain or loss). Gain or loss equal to the difference between fair market value at time of exercise and sales proceeds at time of disposition. Many employees receiving options do not realize that there is double taxation treatment on the immediate sale of stock obtained through the exercise of a non-qualified stock option. The NQ exercise is reflected as a gross up of taxable income in the employee's W-2. At the same time the employee must report any sale of the stock obtained through the exercise on Schedule D on his Form 1040. Many taxpayers forget the Schedule D reporting requirement causing subsequent inquiries from the IRS. Incentive Stock Options General Features Option price must equal the fair market value on date of grant of option. ISOs may be granted only to employees and not to independent contractors. Option term may not exceed ten years. Grant limited to $100,000 in stock value each year. Special rules if issued to a 10% shareholder in employer corporation. Tax Consequences for ISOs No income tax recognized at time of grant. No income tax ramifications at time of exercise for regular income tax purposes. Employer may not deduct option spread on company tax return. ISO spread at time of exercise is an alternative minimum tax "preference item" to employee and often creates an AMT tax liability in year of exercise. An ISO exercise creates cash flow problems: employee must pay option price to employer and may have an alternative minimum tax liability in the year of the exercise (see discussion of alternative minimum tax elsewhere in this website) but only receives stock in return. However, he can immediately sell the ISO stock and convert transaction to W-2 transaction (NQ option - ordinary income) rather than an AMT transaction. Wealth creation, however, would indicate holding the stock for long term capital gain treatment on future sale. Capital gain treatment in year of sale of underlying stock shares obtained through ISO exercise. Cost basis for regular income tax purposes is option price - and not FMV of stock on date of exercise as in the case with NQs. Capital gain treatment on sale of ISO stock. AMT deduction on Form 6251 which reduces AMT liability in year of sale of stock. AMT tax credit against ordinary taxes may be available to reduce taxes in year of disposition of stock or in subsequent year. Interplay between regular capital gains tax on sale and AMT tax caused by exercise. Careful planning indicated. Post - Exercise Tax Considerations Employee must hold stock for requisite holding period or there will be a disqualifying disposition and option will be treated as NQ and be reported on employee's W-2. Employee must hold for two years from grant date or one year from exercise date to obtain benefits of long-term capital gain treatment. Careful planning required in order to utilize the benefit of alternative minimum tax credit which can be created when a taxpayer is liable for AMT taxes in year of ISO exercise. Regular capital gain recognized on sale of ISO stock can be offset by minimum tax credit against capital gain taxes resulting in reduced taxes in year of sale. Theory: One tax at regular tax rates rather than both alternative minimum tax and regular tax. Adjustment on sale of stock on ISO stock (difference between AMT cost basis and ordinary income tax basis) is negative AMT adjustment on Form 6251 in year of disposition of the ISO stock. Can create window of opportunity to exercise new ISOs without triggering current AMT and/or qualify taxpayer for minimum tax credit (MTC) against ordinary income taxes. Carryover of MTC available. Exercise Strategies for All Stock Options Employee must use cash to satisfy exercise cost - employer stock can no longer be used to pay employer for cost of option. Employee may sell underlying stock immediately after exercising option and receiving stock. Stock proceeds are then available for payment of option price to employer (employer usually has cashless exercise/sell arrangements in place at brokerage firm) and payment of income taxes. Employee retains remaining sales proceeds. Long term capital gain treatment obviated. ISO options are a wealth planning vehicle. Careful planning allows for the conversion of ordinary employee compensation income into long term capital gain property. Employer Restricted Stock/Employer Stock Grants Employers often choose to compensate employees for services through employee stock grants that are subject to restrictions. Oftentimes stock grants have restrictions on sale or a requirement that the stock be returned if the employee leaves employment. An employee who receives employer stock as compensation must report its value as taxable income in the year of receipt unless the property is substantially non-vested. IRC Section 83(a). Restricted stock normally does not require a taxpayer to report taxable income in year of grant. Restrictions create vesting issues which, in turn, do not require recognition of taxable income. However, tax planning is available to immediately convert what would be ordinary income restricted stock into a long term capital asset. In many instances tax planning suggests that an employee who receives restricted stock should report the value of the stock as taxable income in the year of stock grant. IRC Section 83(b) affords an employee an election to report any value underlying the grant of employer stock as ordinary income at the time of the grant. The election will mean that any future appreciation in stock value will be treated as long term capital gain if the stock is held for one year or more. An election document is required to be filed with the IRS within 30 days of the stock grant. Once an employee makes the 83(b) election the asset becomes a capital asset. It is no longer an untaxed asset which will be treated as ordinary income to employee when the restricted stock vests and the stock has become transferable by the employee. The filed 83(b) election document is also ultimately attached to the tax return reporting the sale of stock subject to an 83(b) election. The 83(b) election is irrevocable and must be made within 30 days of the employee receiving the restricted stock. Tax is paid on the discounted value of the stock reported as taxable income in year of the grant. If the election is made, the downstream sales proceeds on the stock in excess of the value reported in the 83(b) election year will be treated as a capital gain transaction. This accomplishes the conversion of compensation income (taxed at ordinary income tax rates) into a favorable long term capital gain transaction if held for a year or more. Here are the tax considerations. If you receive substantially non-vested stock in connection with the performance of employer services, whether to pay tax now under an 83(b) election or wait until the property becomes substantially vested may depend on how you assess the future of the company. If the chances for increased company value are promising, your best bet is to make the election under IRC 83(b) and pay ordinary income taxes on its FMV as adjusted for restrictions. In that manner you will limit your commpensation income (ordinary income) to the property's adjusted fair market value on the day the restricted stock was granted. Any future appreciation in value will be taxed to you when you dispose of the property at favorable capital gain rates. The 83(b) election can turn ordinary income property into long term capital gain property as to future appreciation. On the other hand, if the value of the stock is relatively stagnant with minimal appreciation understand that the employee then takes a risk. If the value of the stock goes down he will not be able to recoup any tax paid because of the 83(b) election. The taxpayer is only entitled to a loss deduction on disposition for the amount paid for the property less the sales price. The sales price could be lower than the value reported as taxable income with the 83(b) election. [ Back ]

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EMPLOYER STOCK OPTIONS

Restricted Stock Grants

Stock options in one form or another have been utilized as compensation for employees for many years. It has been a vehicle for the building of immense wealth for high and mid-level company executives. Stock options extend the privilege of buying a specific amount of employer stock, within a specified time, at a specified price. If a stock value increases over time relative to the option price, the employee may exercise his option, immediately sell the stock and realize the gain; or alternatively, he may exercise and hold the stock for further long term capital gain treatment. On the other hand, if there is no increase in value of the underlying stock over the option price, the employee simply does not exercise the option and loses nothing.

The dictionary definition of an employer stock option is a contract giving the holder the right (not the obligation) to purchase a certain number of shares of stock in the employer corporation at a set price.

There are generally two types of stock options, namely incentive stock options (ISOs) and non-qualified stock options (NQs). Both types are compensatory stock options. In the timeline of the life of an option there are three (3) main events, the grant of the option, the exercise of the option, and the disposition of the underlying stock. There is no taxable event at the time of the grant.

There are significant, and differing, tax ramifications for the above options at the time the employee exercises the stock option. There are also differing tax ramificaitons at the time employee sells the underlying stock obtained through the exercise. Below is a list of the general features of incentive stock options and non-qualified stock options. Occasionally, there is confusion as to whether an employee has ISOs or NQs. An easy rule to remember is as follows: If the economic benefit of the exercise of a stock option is reflected in the emplolyee's payroll stub and W-2 taxable income in the year of exercise then that employee has a non-qualified stock option. The economic benefit on the exercise of an ISO stock does not appear in the employee's W-2 on exercise unless he immediately sells the ISO stock in a disqualifying sale.

Non-Qualified Stock Options

General Features

NQs may be granted to either employees or to independent contractors of the employer.
NQs can be granted at any strike price even below the fair market value of the stock.
No required term limits - generally ten years.

Tax Consequences for NQs

No income recognized at time of grant.
Ordinary income included in the employee's W-2 equal to the option spread on the day of the exercise of stock option. Option spread is the value of the underlying security at the time of exercise less the grant price (price paid by the employee).
The option spread is deductible by the company for income tax purposes in the year the employer exercises the option.
Employee income tax withholding requirement on taxable income (spread) in year of exercise of option.
Cost basis of NQ stock for future sale (capital gain) is equal to fair market value of the shares on date of exercise and not the option cost.
Disposition of underlying shares result in either long-term or short-term capital transaction (can be either a gain or loss). Gain or loss equal to the difference between fair market value at time of exercise and sales proceeds at time of disposition.
Many employees receiving options do not realize that there is double taxation treatment on the immediate sale of stock obtained through the exercise of a non-qualified stock option. The NQ exercise is reflected as a gross up of taxable income in the employee's W-2. At the same time the employee must report any sale of the stock obtained through the exercise on Schedule D on his Form 1040. Many taxpayers forget the Schedule D reporting requirement causing subsequent inquiries from the IRS.

Incentive Stock Options

General Features

Option price must equal the fair market value on date of grant of option.
ISOs may be granted only to employees and not to independent contractors.
Option term may not exceed ten years.
Grant limited to $100,000 in stock value each year.
Special rules if issued to a 10% shareholder in employer corporation.

Tax Consequences for ISOs

No income tax recognized at time of grant.
No income tax ramifications at time of exercise for regular income tax purposes.
Employer may not deduct option spread on company tax return.
ISO spread at time of exercise is an alternative minimum tax "preference item" to employee and often creates an AMT tax liability in year of exercise.
An ISO exercise creates cash flow problems: employee must pay option price to employer and may have an alternative minimum tax liability in the year of the exercise (see discussion of alternative minimum tax elsewhere in this website) but only receives stock in return. However, he can immediately sell the ISO stock and convert transaction to W-2 transaction (NQ option - ordinary income) rather than an AMT transaction. Wealth creation, however, would indicate holding the stock for long term capital gain treatment on future sale.
Capital gain treatment in year of sale of underlying stock shares obtained through ISO exercise. Cost basis for regular income tax purposes is option price - and not FMV of stock on date of exercise as in the case with NQs. Capital gain treatment on sale of ISO stock. AMT deduction on Form 6251 which reduces AMT liability in year of sale of stock. AMT tax credit against ordinary taxes may be available to reduce taxes in year of disposition of stock or in subsequent year.
Interplay between regular capital gains tax on sale and AMT tax caused by exercise. Careful planning indicated.

Post - Exercise Tax Considerations

Employee must hold stock for requisite holding period or there will be a disqualifying disposition and option will be treated as NQ and be reported on employee's W-2.
Employee must hold for two years from grant date or one year from exercise date to obtain benefits of long-term capital gain treatment.
Careful planning required in order to utilize the benefit of alternative minimum tax credit which can be created when a taxpayer is liable for AMT taxes in year of ISO exercise.
Regular capital gain recognized on sale of ISO stock can be offset by minimum tax credit against capital gain taxes resulting in reduced taxes in year of sale. Theory: One tax at regular tax rates rather than both alternative minimum tax and regular tax.
Adjustment on sale of stock on ISO stock (difference between AMT cost basis and ordinary income tax basis) is negative AMT adjustment on Form 6251 in year of disposition of the ISO stock. Can create window of opportunity to exercise new ISOs without triggering current AMT and/or qualify taxpayer for minimum tax credit (MTC) against ordinary income taxes. Carryover of MTC available.

Exercise Strategies for All Stock Options

Employee must use cash to satisfy exercise cost - employer stock can no longer be used to pay employer for cost of option.
Employee may sell underlying stock immediately after exercising option and receiving stock. Stock proceeds are then available for payment of option price to employer (employer usually has cashless exercise/sell arrangements in place at brokerage firm) and payment of income taxes. Employee retains remaining sales proceeds. Long term capital gain treatment obviated.
ISO options are a wealth planning vehicle. Careful planning allows for the conversion of ordinary employee compensation income into long term capital gain property.

Employer Restricted Stock/Employer Stock Grants

Employers often choose to compensate employees for services through employee stock grants that are subject to restrictions. Oftentimes stock grants have restrictions on sale or a requirement that the stock be returned if the employee leaves employment. An employee who receives employer stock as compensation must report its value as taxable income in the year of receipt unless the property is substantially non-vested. IRC Section 83(a). Restricted stock normally does not require a taxpayer to report taxable income in year of grant. Restrictions create vesting issues which, in turn, do not require recognition of taxable income.

However, tax planning is available to immediately convert what would be ordinary income restricted stock into a long term capital asset. In many instances tax planning suggests that an employee who receives restricted stock should report the value of the stock as taxable income in the year of stock grant. IRC Section 83(b) affords an employee an election to report any value underlying the grant of employer stock as ordinary income at the time of the grant. The election will mean that any future appreciation in stock value will be treated as long term capital gain if the stock is held for one year or more. An election document is required to be filed with the IRS within 30 days of the stock grant. Once an employee makes the 83(b) election the asset becomes a capital asset. It is no longer an untaxed asset which will be treated as ordinary income to employee when the restricted stock vests and the stock has become transferable by the employee. The filed 83(b) election document is also ultimately attached to the tax return reporting the sale of stock subject to an 83(b) election.

The 83(b) election is irrevocable and must be made within 30 days of the employee receiving the restricted stock. Tax is paid on the discounted value of the stock reported as taxable income in year of the grant. If the election is made, the downstream sales proceeds on the stock in excess of the value reported in the 83(b) election year will be treated as a capital gain transaction. This accomplishes the conversion of compensation income (taxed at ordinary income tax rates) into a favorable long term capital gain transaction if held for a year or more.

Here are the tax considerations. If you receive substantially non-vested stock in connection with the performance of employer services, whether to pay tax now under an 83(b) election or wait until the property becomes substantially vested may depend on how you assess the future of the company. If the chances for increased company value are promising, your best bet is to make the election under IRC 83(b) and pay ordinary income taxes on its FMV as adjusted for restrictions. In that manner you will limit your commpensation income (ordinary income) to the property's adjusted fair market value on the day the restricted stock was granted. Any future appreciation in value will be taxed to you when you dispose of the property at favorable capital gain rates.

The 83(b) election can turn ordinary income property into long term capital gain property as to future appreciation. On the other hand, if the value of the stock is relatively stagnant with minimal appreciation understand that the employee then takes a risk. If the value of the stock goes down he will not be able to recoup any tax paid because of the 83(b) election. The taxpayer is only entitled to a loss deduction on disposition for the amount paid for the property less the sales price. The sales price could be lower than the value reported as taxable income with the 83(b) election.

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Cincinnati Tax Lawyer
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Cincinnati, OH 45242

Phone: (513) 563-4555
Fax: (513) 563-9097
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