Posted Sun, September 30, 2018

Employers are routinely trying to find ways to keep top talent and to incentivize employees. Cash is great. But cash is cash, and it isn’t always available especially during the start-up or growth phase of a company. In addition, cash doesn’t have the potential for rocket type growth like stocks and stock options do.

Here are the employee stock options basics-

• Incentive Stock Options (ISOs)
• Non-qualified Stock Options (NSOs)
• Employee Stock Purchase Plans (ESPPs) also called Employee Stock Purchase Program
• Restricted Stock Units (RSUs)

Non-statutory is another name for non-qualified, and incentive stock options (ISOs) is another name for qualified.

Here are some common definitions used when discussing stock options and grants.

Grant / Offering Date
This is the date that the stock options are offered to the employees. This is especially important to understand when considering an 83b Election (more on that later). The stocks might or might not be readily available to the employee on this date. Grant = Offer = Award Date. Again, more office vernacular.

Vesting Date
This is the date that the stock is available to you by exercising your option.

Lapse Date
This is similar to the vesting date, and it is usually in connection with Restricted Stock Units (RSUs). Another way to look at this is when a stock is granted to you with restrictions, those restrictions eventually lapse allowing you to do whatever you want with the stock.

Fair Market Value
The stock price at the time of exercise or lapse date. Usually the closing price on that day although other computations such as daily average may be used depending on stock market volatility. This is also called the strike price.

Compensation Element
This is the difference between the fair market value of a stock and the exercise price, when exercised. This is typically reported on a W-2 with a Code V as taxable ordinary income, but not all employers do this, or do this accurately.

Underwater
A term used to refer to stock options where the option price is higher than the market price. For example, the company offers to sell you stock at $15 but it is trading for $12. If you wanted stock, you would be wise to buy it from the market rather than the company ($12 versus $15).

These are the most restrictive in terms of rules, and therefore the tax treatment is more favorable under IRC Section 421. There are a bunch of rules that don’t matter unless you are the employer attempting to make this stock option qualified.

The huge benefit of an ISO is that the taxable event does not occur at grant or exercise date. Rather, it is triggered only when the stock is disposed (sold). However, if the fair market value of the stock option exceeds $100,000 then it is re-classified as non-qualified.

If your disposition was qualifying, all discounts offered to the employee is treated as long-term capital gain rather than ordinary income. This can be huge- 20% capital gains rate (plus the net investment income tax) versus 39.6% ordinary tax rate. More on qualifying and disqualifying dispositions later.

You will receive a Form 3921 outlining your transactions giving you dates, prices, etc. You should keep this like gold including any other paperwork.

These are more common, and will normally generate ordinary income plus the possibility of capital gains. NSOs are the traditional stock options that employers offer outside of employee stock purchase plans and restricted stock units.

These are very common, and allow employees to purchase stock up to a 15% discount. This 15% is an IRS limit which prevents companies from providing a form of untaxable income through steep discounts. Depending on office vernacular employee stock purchase plans are sometimes referred to as employee stock purchase programs. Same thing, but Plan is the official use versus Program.

ESPPs can be qualifying under IRC Section 423 or non-qualifying. As you would expect, qualifying employer stock purchase plans have favorable tax treatment since you pay taxes at the time you sell not when you purchase the stock. Whether the ESPP tax treatment is ordinary income or capital gains depends on the holding period.

Similar to Form 3921, you will receive a Form 3922 providing important details such as dates, prices, etc. While this information might be about a current taxable event, you need to keep a Form 3922 plus any additional paperwork until you sell the stock. Therefore, you might receive a Form 3922 for a 2014 stock purchase, but not need to refer to it until 2018 when you sell it.

RSUs are not stock options per se, they are granted or given to the employee. This has become more popular since the IRS and SEC have changed the way stock options are reported. In the past, employers did not have to expense the cost of a stock option as compensation. This allows them to award or compensate executives (or least give the executive the option to be compensated) without showing this compensation as an expense until exercised. This created arbitrage in the company’s accounting records, and investors and creditors complained. In other words, companies were able to hide a financial obligation created by stock options yet provide instant stickiness for attracting and keeping top executives.

The biggest difference between RSUs and traditional employee stock options is that restricted stock units are taxed at the time of vesting and stock options are taxed at exercise (generally speaking). In other words, regardless if you want them, RSUs are granted, vested and taxed.

Restricted stock units are taxed as ordinary income. It is no different than your employer giving you a paycheck backed by cash or a paycheck backed by stock. Both have the same value in terms of taxable income. The fair market value at the vesting / lapse date will be used to determine the taxable income.

There are four scenarios when receiving RSUs in terms of handling the income and payroll taxes (note the word income and not capital gain)-

Net Issuance
The employer deducts the amount of stock from the grant to cover the related taxes, and issues the remainder. You will not receive a 1099-B from a broker since the stock withheld was never transferred to you. Your cost basis is the remaining stock at the fair market value on the vesting / lapse date.

Same Day Sale
You elect to have all the stock sold the same day as the vesting / lapse date. Your employer will withhold the amount necessary for taxes but you will receive a 1099-B from a broker for the entire lot of stock (this is different than net issuance above). Your cost basis is the entire lot of stock at fair market value.

Sell to Cover
You direct your employer to sell just enough stock to cover the taxes, and the remainder is issued to you. You will receive a 1099-B from a broker for the stock that was sold. Your cost basis for the stock that was sold is the same as the stock basis for the stock you retain.

Cash Transfer
You send a check to your employer for the taxes associated with the RSU grant. The stock is transferred to you. You will not receive a 1099-B from a broker unless you sell the stock you received.

Some things to note. Restricted stock units is a form of compensation, and is subjected to income taxes, social security taxes, and Medicare taxes. Yes, it is reported in Box 1, Box 3 and Box 5 of a W-2. The compensation is also subject to state and local taxation. However, not all employers are up to speed on this so take care when determining taxable ordinary income on a tax return.

Also, there is not a qualifying versus non-qualifying element within RSUs as compared to ISOs and ESPPs. The stock will always be considered ordinary income just like getting paid in cash (or peanuts according to some).