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The following section summarizes some of the key individual income tax considerations related to stock-based compensation under US federal income tax laws and regulations. It is intended to provide helpful context for considering plan design from the employer perspective. However, it is not intended to be and should not be considered comprehensive authoritative guidance for any specific employer or employee tax consequences.

10.6.1 Basic rules for employees' taxable income

An understanding of how employees are taxed for stock-based compensation in the US requires knowledge of the underlying principles of deferred compensation: the principles of economic benefit and constructive receipt. Application of these principles, together with certain statutory provisions (described in SC 10.6.1.1), determines when a taxable event occurs and the amount that should be taxed.

10.6.1.1 Economic benefit and constructive receipt

The economic benefit doctrine specifies that when an employer transfers property to an employee, such as shares of restricted stock or an economic benefit in cash or property (e.g., the funded and secured right to receive cash in the future), the employee's receipt of that cash or property should be taxed immediately unless the transfer is subject to a substantial risk of forfeiture.
The constructive receipt rules govern the timing of an employee's inclusion of compensation, such as a stock-based compensation award, in taxable income. As a general rule, a cash-basis individual taxpayer is taxed when the individual receives an item of income. However, income that is not actually received (or deemed to have been received under the economic benefit doctrine) will be taxed if it has been constructively received. Income is constructively received when the income is set aside, credited to, or made available so that the individual may draw upon it at any time without substantial limitation or restriction. IRC Section 409A partially codifies the constructive receipt rules but does not alter or affect the application of any other IRC provision or common law.
Together, the doctrines of economic benefit and constructive receipt provide a framework for determining when stock-based compensation awards will be included in the employee's taxable income. However, in the vast majority of situations, statutory provisions specifically dictate how those doctrines apply to stock-based compensation awards. The IRC (including IRC Section 83, discussed further in SC 10.6.1.2) specifically addresses the most common stock-based compensation awards, including restricted stock, restricted stock units, nonqualified stock options, and statutory stock options. Those awards are described in SC 10.6.2, SC 10.6.3, SC 10.6.4.1, and SC 10.6.4.2.

10.6.1.2 IRC Section 83

Generally, stock-based compensation will be taxed under IRC Section 83, which requires that property (such as shares of stock) that is transferred to an employee or independent contractor will be taxed as ordinary income at the earlier of when the property is transferable by the employee or is not subject to a substantial risk of forfeiture. Shares of stock are considered property; however, neither cash nor an unfunded and unsecured promise to pay is considered property. A transfer of property occurs when an employee acquires a beneficial ownership interest in the property.
If an employee receives the benefits and risks of holding the property, generally the employee is considered to have beneficial ownership and a transfer to the employee has occurred within the meaning of IRC Section 83.
Property is transferable by the employee (and therefore taxable to the employee) if (1) the employee receiving the award can sell, assign, or pledge (such as for collateral for a loan) his or her interest in the property and (2) the employee is not required to give up the property or its value in the event the substantial risk of forfeiture materializes. A substantial risk of forfeiture is a condition which if not met can result in a forfeiture of the property. Whether a risk of forfeiture is substantial depends upon the facts and circumstances. The most common risk of forfeiture is the risk that the employee will fail to meet a requirement to continue to perform services for the employer during a specified period (i.e., an employee's failure to fulfill a service condition) or that designated performance or market conditions are not met. Treasury Regulation Section 1.83-3(c)(2) describes other situations that may result in a substantial risk of forfeiture, as well as provides examples of conditions that do not cause a substantial risk of forfeiture.

10.6.1.3 Section 83(i) “qualified stock” deferrals

As a result of the 2017 Tax Cuts and Jobs Act, qualified employees of certain private companies may elect to defer tax for up to five years after the exercise of stock options or the settlement of RSUs (“qualified stock”), with the taxable value locked in at exercise or settlement. This election is not available with respect to any current or prior CEO or CFO, any 1% shareholder, the top four officers during the preceding 10 years, or any relatives of such persons. If the entity is no longer a private company (such as through an IPO) or the stock otherwise becomes transferable (including back to the company), the deferral period would end.

10.6.2  Restricted stock awards - tax implications to employees

In a typical restricted stock award, the employer gives the employee, or allows the employee to purchase, shares of the employer's stock. As discussed in SC 1.3, ASC 718 also refers to restricted stock as unvested or non-vested shares. While the employee is considered the owner of the restricted stock for purposes of state law, the employee's right to the stock is generally subject to a substantial risk of forfeiture and generally cannot be transferred until the service, performance, or market condition associated with the award is satisfied. If the specified condition is not satisfied during the award's requisite service period, the employee will forfeit the stock and return the shares to the employer. Because the employee's right to the restricted stock cannot be transferred and is subject to a substantial risk of forfeiture, the employee will postpone including the restricted stock in taxable income until the right becomes transferable or the risk of forfeiture lapses or expires, whichever occurs first.
Once the substantial risk of forfeiture lapses (i.e., vesting occurs), the employee recognizes compensation (i.e., ordinary) income equal to the fair market value of the restricted stock on the vesting date less any price the employee has paid for the stock (i.e., the intrinsic value). For stock of a publicly traded corporation, the fair market value of restricted stock equals the traded market price of a similar unrestricted share of the same class of stock. The employee's income from the restricted stock will be subject to federal income tax, employment taxes, and potentially state and local taxes. Thereafter, the employee's tax basis in the stock is the fair market value of the stock on the vesting date; the employee's holding period for capital gains purposes begins immediately after the vesting date.
Once the employee is vested, the employer must report the income to the IRS on a timely basis, and also withhold the applicable taxes. As a result, employees should be prepared to sell sufficient shares or have cash available to pay the withholding taxes. Alternatively, if the employer permits, employees may choose to have the employer withhold shares with a value equal to the required withholding taxes. Employers that withhold shares (often referred to as a net settlement) should carefully review the accounting implications of this withholding alternative. As described in SC 3.3.6, if an employer withholds an amount that exceeds the employee's maximum statutory rate in a jurisdiction, the stock-based compensation award would be classified as a liability under ASC 718.
A service recipient (i.e., a company who engages an independent contractor) must report to the IRS compensation paid to independent contractors. There is no required withholding unless the backup withholding rules apply.

10.6.2.1 Capital gains tax on restricted stock awards

Upon selling the vested shares, the employee will recognize a capital gain or loss on the difference between the sale price and his or her basis in the shares. The tax treatment will depend on how long the employee holds the shares before disposition. If the employee holds the shares for more than one year and the price exceeds the tax basis of the shares, the gain will be taxed as a long-term capital gain. If the employee holds the shares for one year or less, the gain will be taxed as a short-term capital gain. The employee may also be subject to state and local taxes on the gain depending on where the individual works and resides.

10.6.2.2 IRC Section 83(b) elections on restricted stock awards

An IRC Section 83(b) election enables an employee to pay income tax on the fair market value of property such as a restricted stock award on the date it is transferred (e.g., the date it is granted) rather than on the vesting date, as required under the normal rule of IRC Section 83(a). Thus, an IRC Section 83(b) election effectively means that the employee ignores the substantial risk of forfeiture provision in an award or believes that the risk of forfeiture is not significant. An IRC Section 83(b) election does not, however, change the requirement that the employee satisfy the vesting condition. If the employee fails to satisfy the vesting condition, the award will still be forfeited.
Any appreciation in the restricted stock after the grant date will be taxed as a capital gain (either long- or short-term) instead of as ordinary income with the capital gains holding period commencing at the date of grant instead of the vesting date. The employer will be required to withhold applicable taxes at the grant date, and the employee will have to make arrangements with the employer to satisfy the withholding requirements. The result of this election for stock that appreciates in value after the grant date is a reduction in the taxes that the employee incurs. Conversely, if the stock declines in value, the employee is limited to a capital loss upon sale of the stock.
Employees should be aware that an IRC Section 83(b) election is not without risk. For example, if the employee does not satisfy the vesting condition, the award will be forfeited and the employee will not be allowed an ordinary loss (but may recognize a capital loss) with respect to any amounts actually paid for the stock but not on the income recognized under the IRC Section 83(b) election. The employee also bears the risk of a market decline between the grant date and the vesting date.
An IRC Section 83(b) election must be filed no later than 30 days after the grant of the restricted stock award and, once filed, is irrevocable. The election must be filed with the IRS service center where the employee normally files his or her tax return. The employee no longer must attach a copy to the tax return for the taxable year in which the election is made.

10.6.2.3  Dividend treatment on restricted stock awards

If dividends are paid on restricted stock during the vesting period, the dividend income will be treated as compensation income and will be subject to the reporting and withholding rules described in SC 10.6.2.1 (i.e., ordinary income to the employee). Once the restricted shares are vested, the dividends will receive normal dividend treatment and will not be subject to the withholding rules that apply to compensation income. If the employee makes an IRC Section 83(b) election, dividends received on the restricted stock will be treated as regular dividends during the vesting period. Employers should coordinate with their transfer agent and/or stock-plan administrator to avoid duplicate or incorrect reporting of dividends on restricted stock.

10.6.3  Restricted stock units - tax implications to employees

Similar to restricted stock, an RSU is an incentive designed to reward an employee with employer stock provided the specific vesting condition is met. However, unlike restricted stock, an RSU is merely a promise to deliver stock at some future date as defined by the terms of the award. There is no transfer of shares on the grant date and no asset for employees to establish either legal or economic ownership of during the vesting period. Employees do not have voting or dividend rights until the shares are transferred and there is no opportunity to make an IRC Section 83(b) election at the grant date because RSUs constitute a promise to deliver property in the future – not an actual transfer of property at the grant date.
After an RSU becomes vested, the number of shares under the vested RSU is transferred to the employee on a fixed date or a fixed event (often on the vesting date). IRC Section 83(a) provides that the employee will have compensation income on the transfer of vested shares equal to the FMV of the stock on the transfer date less any amount paid by the employee.
Under IRC Section 409A, RSUs are considered deferred compensation and must comply with IRC Section 409A or result in an additional 20% federal tax penalty to the recipient, additional underpayment penalties, and an acceleration of taxation to the vesting date. Refer to SC 10.10 for further discussion of IRC Section 409A.
RSUs that are settled at the time of vesting must be structured to either comply with IRC Section 409A or satisfy the short-term deferral exception. Some RSU plans have a deferral feature, under which the employer delivers the shares in a year later than the year of vesting or allows employees to voluntarily postpone receipt of the shares past the vesting date. Any deferral beyond the vesting date must comply with the IRC Section 409A rules.
There are a number of non-US jurisdictions that tax restricted stock at the grant date rather than the vesting date. Multinational companies that wish to convey a similar economic benefit while deferring tax until the actual receipt of the shares should consider granting RSUs rather than restricted stock. Prior to granting restricted stock and/or RSUs, multinational companies should review the tax laws of each jurisdiction.

10.6.3.1 Dividend equivalents on RSUs

Typically, employees do not receive voting or dividend rights on RSUs until delivery of the shares. However, an employer may choose to pay dividend equivalents on its RSUs prior to vesting or deliver the cumulative dividend equivalents on the vesting date. Dividend equivalents, if paid, will be treated as compensation income and are subject to the normal reporting and withholding rules for compensation.

10.6.4 Stock options - tax implications to employees

In the US, two types of stock options are generally offered to employees: nonqualified stock options and incentive stock options (ISOs). Nonqualified stock options are extremely flexible, allowing the employer to grant options to employees and non-employees, and set the term of the options for periods of more than ten years. However, nonqualified stock options generally result in the employee's taxable income being included on the option's exercise date. ISOs, on the other hand, are generally not taxable to the employee until the underlying common stock is sold, but they must meet certain statutory requirements in order to qualify for such favorable tax treatment.
IRC Section 409A somewhat limits the flexibility of nonqualified stock options. Under IRC Section 409A, a nonqualified stock option must meet the following requirements: (1) be granted on stock that is "service recipient stock," (2) have an exercise price that is (or could be at some point in the future) at least equal to the stock's fair market value on the grant date, and (3) not defer the employee's income tax to a date after exercise of the option. If these criteria are not met, the option generally will be considered to be deferred compensation and therefore will be subject to the provisions of IRC Section 409A, including the potential for a 20% penalty tax (refer to SC 10.10 for additional information). A dividend equivalent right provision may also cause the nonqualified stock option to fail to meet the criteria. ISOs, qualified ESPPs, and restricted stock awards (but not RSUs) are specifically excluded from the definition of deferred compensation under IRC Section 409A.

10.6.4.1 Nonqualified stock options - tax implications

In general, most nonqualified stock options granted to employees do not have a readily ascertainable fair market value. Thus, the employee is not deemed to have received compensation for tax purposes on the grant date. Such options will be taxed at exercise, assuming the options are vested at that time. If the options are not vested at the time of exercise (i.e., “early exercise”), the employee would normally be taxed at the time those shares subsequently vest, similar to restricted stock awards (SC 10.6.2). However, an employee could make an IRC Section 83(b) election in this situation (SC 10.6.2.3), thereby including the value of the unvested shares (less the option exercise price) in taxable income when the option is exercised.
Like the US, most foreign jurisdictions tax stock options at the time of exercise. However, some foreign jurisdictions tax the employee at a time other than the exercise date, for example, at grant or at the time of vesting. Some jurisdictions allow the employee's tax to be deferred until the stock is sold, so long as certain conditions are satisfied (similar to what is allowed by the rules governing ISOs in the US; see SC 10.6.4.2). Multinational companies should understand the tax rules that apply to option awards to employees in all of their jurisdictions to understand the effect on employee behavior and the company's compliance obligations.
If an employee purchases shares or exercises an option using a loan from the employer and the employee is not required to repay all or part of the loan or if the loan is not adequately secured, the purchase or option exercise generally is not treated as a transfer of the underlying shares for tax purposes. Rather, it is treated as a new option or an extension of the existing option to purchase the shares and the taxable transfer is delayed until the loan is repaid. If the transaction is treated as a purchase of the shares and the loan is forgiven, the forgiven debt should be treated as compensation and subject to income and employment taxes. The employer must withhold taxes on the value of the forgiven debt and report the amount as compensation income. Further, if in making a loan the employer does not charge interest at the prevailing rate, interest will be imputed and the employee will be liable for income tax and applicable employment tax on the imputed income. However, in the case of below-market loans, the employer will not be required to withhold employment taxes and report the amount of the imputed income if the underlying value of the loan is $10,000 or less.
Not only might a loan feature result in additional unintended tax consequences for the employee and employer, it also presents potential corporate-governance issues. The Sarbanes-Oxley Act places restrictions on direct and indirect personal loans to certain executives. Under Section 402 of the Sarbanes-Oxley Act, "Enhanced Conflict of Interest Provisions," it is unlawful for a company to directly or indirectly provide credit or arrange for the extension of credit in the form of a personal loan to or for any director or executive officer. Employers should also consider whether their cashless-exercise program may be affected by this rule (refer to SC 3.3.7 for more information on this type of program). Loans can also result in a number of accounting issues as described in SC 2.3.

10.6.4.2 Statutory stock options - tax implications

There are two kinds of statutory stock options: ISOs and options that are granted under a qualified employee stock purchase plan ("ESPP"). Like nonqualified stock options, both types of statutory stock options are contractual promises that permit an employee to acquire the employer's stock on a future date under terms established on the grant date. However, because ISOs and ESPPs meet specific IRS requirements, they are not taxed on either the grant date or the exercise date (or purchase date in the case of qualified ESPPs). Instead, employees are taxed when they sell their shares. If the employee completes a qualifying disposition, whereby the employee sells the stock at least two years after the grant date and one year after the date of exercise or purchase (the statutory holding period), the employee will recognize a greater capital gain and less ordinary income on the sale of the stock. If the employee sells the stock before the statutory holding period ends, the sale will be a disqualifying disposition and the employee will recognize more ordinary income, which is taxed at a higher rate. Employment taxes (FICA) will not be due for either ISOs or ESPP shares.

10.6.4.3 Incentive stock options - tax implications

In addition to complying with the statutory holding-period requirement, an option must also satisfy the following conditions in order to qualify as an ISO:
  • ISOs may be granted only to employees. For purposes of the ISO rules, the term "employee" has the same meaning as it does in the withholding tax rules of IRC Section 3401(c). Thus, outside directors and other independent contractors may not be granted ISOs.
  • ISOs plans may not last longer than ten years and an option exercise period cannot be longer than 10 years from grant. Options under the plan must be granted within ten years from the date that the plan is adopted or approved by shareholders, whichever is earlier. Although the term of the plan is ten years, all ISOs may have up to 10 years for exercise, so that even an ISO granted in the ninth year of a plan may have a ten-year term (5 years for a 10% shareholder).
  • ISOs must have a FMV exercise price. The exercise price cannot be less than 100% of the fair market value of the stock at the grant date (110% in the case of options that are granted to shareholders that hold 10% of the company's stock). A reasonable, good-faith method may be used to determine the fair market value. If it is determined that the exercise price is less than the fair market value of the stock on the grant date, the option cannot be treated as an ISO and will be considered a deferred compensation arrangement subject to IRC Section 409A.
  • ISOs must be exercised within three months of an employee's termination. If termination results from disability, ISO treatment may continue up to one year following termination. If an employee dies and the ISO is transferred by bequest or inheritance, the option may continue to be treated as an ISO for its full term. An ISO can specify a shorter exercise period if desired.
  • Only a limited number of ISOs may be granted. Not more than $100,000 worth of ISOs, valued at the grant date, may become exercisable in any year for an individual employee. Any stock options granted that exceed the $100,000 vesting limit will be treated as nonqualified stock options. This limit applies on an aggregate basis to all ISO plans of the employer, its parent, and subsidiaries awarded to an individual employee. While the assessment is initially made at the time of grant, it should be re-assessed as needed, for example if a change in control accelerates vesting of ISOs.
  • The ISO plan must be approved by the company's shareholders within one year after the plan is adopted. The approved plan must specify the aggregate number of shares that can be issued and the eligible class or classes of employees that may participate in the plan.
  • ISOs may only be granted on the employer's stock. ISOs cannot involve a partnership interest.
  • ISOs cannot be transferred. The option agreement should specifically state that the ISOs cannot be transferred, other than through a will or by the laws of descent.
If an employee sells the shares obtained from the exercise of the option through a qualifying disposition, the individual will pay only long-term capital gain taxes on sale proceeds that exceed the option's exercise price. Although an employee does not recognize taxable income until the shares are sold or otherwise disposed of, the employee will have to make an adjustment to reflect the alternative minimum tax (AMT) in the year of exercise. The excess of the fair market value of the shares at exercise over the exercise price is included in the calculation of the taxpayer's AMT as a tax adjustment item. This adjustment is not required if the shares are sold in the same year as the option is exercised.
If an employee fails to meet the statutory holding-period requirements (i.e., if the employee sells the shares within two years after the grant date or one year after the exercise date including via a net share settlement), the ISOs will be deemed as having been disposed of in a disqualifying disposition. In a disqualifying disposition, the exercise of the option will be treated as though the option was a nonqualified stock option. Even though employment taxes will not be due, ordinary income tax will be imposed on the stock's fair market value on the exercise date less the exercise price.
If the amount realized on the sale exceeds (or is less than) the sum of the amount paid for the shares and the amount of income recognized on the disqualified disposition, the gain (or loss) is determined under the rules of IRC Section 302 or 1001, as applicable.
The employer is not required to withhold income tax on any portion of the ordinary income or capital gain that is triggered upon disposition; however, the employer is required to report the compensation income on the employee's Form W-2.

10.6.5 Employee stock purchase plans - tax implications

ESPPs allow employees to purchase company stock (usually via a payroll deduction) at a discount that does not exceed 15%. For purposes of federal income tax, this discount does not result in immediate compensation, provided that the statutory holding period requirements and the requirements of IRC Section 423 are met. For a plan to qualify as an ESPP, it must meet the following requirements:
  • ESPPs may only be offered to employees of the employer or related corporations.
  • ESPPs must be granted to all employees on an equal basis.
  • ESPP shares may be purchased only by an individual who is an employee from the grant date to three months before the purchase date.
  • An employee who has voting power that is greater than 5% may not participate in the plan.
  • Certain employees may be excluded from participating in an ESPP, including
    • Employees who have been employed for less than two years.
    • Employees who customarily are employed 20 hours or less per week.
    • Employees who customarily are employed no more than five months in a calendar year.
    • Highly compensated employees, as defined in IRC Section 414(q).
Because ESPPs must be granted to all employees of US companies to qualify for favorable treatment under IRC Section 423, multinational companies should generally be careful not to exclude those employees who work for overseas branches or representative offices of US companies.
ESPPs must also comply with the following conditions:
  • The plan is approved by the shareholders of the company within 12 months before or after the plan is adopted.
  • The plan designates the aggregate number of shares that may be issued.
  • The awards granted under the ESPP are in the stock of the employer.
  • The term during which a participating employee has the option to purchase the employer's stock cannot exceed 27 months, unless the option price is not less than 85% of the stock's fair market value at the time that the option is exercised.
Further, an employee cannot accrue a right to purchase more than $25,000 (valued at the grant date) of stock each year under any ESPP of the employer, its parent company, and subsidiary corporations.
If the ESPP designates a maximum number of shares that may be purchased by each employee during the offering, or establishes a fixed formula to determine that number (such as $25,000 divided by the fair market value of the stock on the first day of the offering period), the first day of the offering period is deemed the "option grant date." Establishing this date is critical to avoiding issues under IRC Section 409A. If no maximum is set, the option grant date for purposes of establishing the minimum exercise price is deemed to be the exercise date.
In the case of a qualifying disposition, if an option has an exercise price that takes advantage of the IRC Section 423 discount feature, the employee must include in ordinary income, at the time that the stock is disposed (assuming that the statutory holding-period requirement is met), the lesser of the following two amounts:
  • The amount of the fair market value of the shares at the time of the disposition or the employee's death that exceeds the exercise price of the option.
  • The amount of the stock's grant-date fair market value that exceeds the option's exercise price.
Any additional gain upon selling the stock should be treated as a long-term capital gain.
If the stock is sold through a disqualifying disposition, the employee will recognize ordinary income that is equal to the difference between the purchase date fair market value and the purchase price. This amount is considered ordinary compensation income in the year of sale even if no gain is realized on the sale. The difference between the proceeds of the sale and the employee's basis in the stock will be treated as a capital gain or loss. Ordinary income that the employee recognizes upon a disqualifying disposition of ESPP shares constitutes taxable income and should be reported by the employer on the employee's Form W-2; however, taxes do not have to be withheld.
Unlike ISOs, ESPPs provide that even in a qualifying disposition some amount of ordinary income will be recognized at the time of sale. However, the amount of ordinary income in a qualifying disposition is generally lower than the amount of ordinary income in a disqualifying disposition.
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