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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.
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.
Restricted 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.
EMPLOYEE STOCK PURCHASE PLANS (ESPP)
When a company offers an employee stock purchase plan (ESPP), it allows employees to use after-tax payroll deductions to buy its stock. What makes this employee benefit appealing is that you can purchase your company’s shares at a discount, depending on the structure of the ESPP. Even if the plan does not have a discount, you pay no commission on the stock purchase.
In an ESPP that follows the rules under Section 423 of the tax code, the purchase discount can be up to 15% off the market price of the company’s stock. That type of ESPP is called a “qualified” ESPP (not to be confused with qualified retirement plans). Other types of ESPPs are either nonqualified plans or direct purchase plans. An ESPP that is tax-qualified under Section 423 offers favorable tax treatment of the purchase discount when you hold the shares long enough (more than two years from your enrollment date and one year from purchase).
Biggest Potential Gains When Plan Has Lookback For Setting Purchase Price
ESPP participation is an even better deal when your company’s plan has a lookback provision. A lookback takes the purchase-price discount from either the stock price at the start of the offering or the stock price on the purchase date, whichever is lower. If the stock price rises between the offering date and the purchase date, your discount is based on the lower offering-date price. Even if the stock price falls between the offering date and purchase date, you still profit because your discount comes off the lower stock price on the purchase date. This means that, unlike stock options, an ESPP with a lookback cannot go underwater.
Example: Your company’s ESPP has a 15% discount with a six-month lookback.
• The stock price on the offering date is $10 per share.
• The stock price on the purchase date is $12 per share.
• With the lookback, your purchase price for stock worth $12 is only $8.50 (15% of $10).
• This gives you a gain of 41% ($3.50 spread at purchase divided by $8.50 purchase price).
• If instead the stock price falls to $8 on the purchase date, your purchase price is $6.80.
• Even after that price drop, you still have an increase of 17.64% ($1.20 spread at purchase divided by $6.80 purchase price).
Another advantage of an ESPP is that you can often sell the shares easily to pay for immediate cash needs or to reinvest in other long-term savings. By contrast, company stock in your 401(k) can be sold only for other investments in the plan. The taxation and special tax requirements of shares purchased under a Section 423 ESPP are detailed by the articles, FAQs, and videos in the section ESPPs: Taxes section at myStockOptions.com, an educational resource on stock options, restricted stock/RSUs, and ESPPs.
Top Questions To Ask About Your ESPP
Before you participate in your company’s employee stock purchase plan, you want to understand its key terms, rules, and dates. These affect whether you want to participate, how much salary you want to contribute for stock purchases, and how to fit the ESPP into your financial plan. Become familiar with the essential features of ESPPs by asking the questions on the following checklist:
1. What type of ESPP is it?
2. When am I eligible to participate?
3. Does the ESPP have a purchase discount? Does it have a company match, which would make it a nonqualified plan?
4. Does the plan have a lookback feature?
5. How long is the offering period for the salary deductions?
6. Are there shorter purchase periods within the offering period? Example: 12-month offering period with two separate six-month purchase periods.
7. How do I enroll in the ESPP? Once enrolled, am I automatically enrolled in subsequent offering periods?
8. Is there a maximum contribution amount/percentage and number of shares I can purchase with my eligible compensation? Related to this question, how and when can I increase or decrease my contribution percentage, or withdraw from an ESPP offering?
9. Is there a mandatory transfer restriction or holding period after share purchases? Many companies require you to keep the ESPP shares with a specific brokerage firm or transfer agent to track the tax reporting. Some prevent you from flipping shares at purchase by enforcing a holding period.
10. How will the ESPP fit into my financial planning for long-term goals (e.g. house purchase, college funding, retirement savings) and more immediate goals (e.g. medical expenses, car purchase, vacation).
How To Answer These ESPP Questions
Unlike most grants of stock options or restricted stock/RSUs, ESPPs are broad-based (i.e. open to all or most employees). Therefore, you will probably learn about your company’s plan during your orientation or when a new ESPP is rolled out.
Before you participate in an ESPP, you should review the plan documents: these state the plan’s terms, features, and procedures and include enrollment forms (usually online). If the materials are not on your company’s intranet, ask your HR department for a copy of the plan materials and confirm whether you are eligible to participate and when the next enrollment date occurs.
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