The Tax Ramifications of Nonqualified Stock Options

A company may offer stock options to their employees in an effort to encourage them to take a vested interest in their business and eventually reap the rewards of the company’s success. In general, there are two common types of compensatory stock options that employers can grant employees: Statutory (also known as incentive stock options or “ISOs”) and Nonstatutory (“NQSOs”). Both types of options are financial instruments that provide the employee the opportunity to purchase shares in the company of the employer, under certain conditions.

Incentive Stock Options

ISOs are generally not taxed to the employee as normal compensatory benefits even though they are compensatory in nature. Because ISOs are granted this special tax treatment, there are numerous qualification requirements that an ISO option program must satisfy. In addition, the employer is denied any compensation deduction related to these options transactions and ISOs may trigger AMT tax. NQSOs, however, generally follow a pattern of taxation common to many other employer-provided compensatory benefits; they trigger gross income to the employee at some point in time and likewise produce compensation deduction to the employer. This article addresses the tax treatment of NQSOs.

Nonqualified Stock Options

NQSO’s are a form of employee compensation benefit that are subject to their own unique rules. Generally, NQSO’s are taxable to employees and deductible as compensation by the company at the same time. The issue is when is the income triggering event? Is it upon grant, exercise, or some other date?

In general, a NQSO is taxable at the time of grant only if the option has a readily ascertainable fair market value. In order to have a readily ascertainable fair market value and thus taxable at grant, the option would generally have to be actively traded on an established securities market.

If the fair market value is not ascertainable, the option is then taxed at date of exercise, so long as there are no significant restrictions on, or a substantial risk of forfeiture of the stock received.

When an option is taxed upon exercise, the difference between the fair market value of the stock on the exercise date and the per share exercise cost is taxed to the employee as compensation.

This income is reportable as wages on Form W-2 and is deductible by the company. Any further appreciation will be subject to capital gain taxation.

If the stock obtained through the exercise of NQSO’s is subject to significant restrictions or a substantial risk of forfeiture, income is recognized only when the stock is no longer subject to the restrictions or risk of forfeiture. It is not a taxable event upon grant or exercise. Although this would seemingly be considered favorable from a tax perspective as income tax is deferred until such time as the risks or restrictions terminate, in actuality it may be a negative. Deferral results in ordinary income taxation instead of capital gain treatment on all subsequent appreciation from the date of exercise. Long-term capital gain tax rates are more favorable and short-term capital gains may offset capital losses. In addition, payroll taxes will be reduced if the income recognition event occurs at a lower fair market value point.

Section 83(b) Election

The best result for an employee who is granted options that will quickly increase in value is to recognize the ordinary income element as soon as possible. After the initial ordinary income tax event, future appreciation is subject to capital gains treatment. If the stock acquired is held long-term the very favorable long-term capital gains rate applies.

There is an opportunity available to employees, known as a “Section 83(b) Election.” When properly made, this election results in acceleration of ordinary income so that more of the gain can ultimately qualify as long-term capital gain. The Section 83(b) Election must be made by the employee within thirty days of exercise of the NQSO. The election is made by filing a signed statement with the Internal Revenue Service Center where the individual’s return will be filed and attaching a copy of the statement to the tax return for the year of election. Once the election is made the employee includes the ordinary income portion of the award in taxable income. Any subsequent appreciation in value of the stock will be capital gain.

In Summary

NQSOs are an excellent mechanism for companies to compensate employees and encourage them to take a vested interest in their business. If the NQSO has a readily ascertainable fair market value, it is taxable to employee and deductible to employer at time of grant. If there is no readily ascertainable fair market value, the option is taxable at time of exercise. If however, the stock obtained through the exercise is subject to restrictions or risk of forfeiture then the option is not taxed until a later date. This deferral of tax can be unfavorable because it can potentially result in ordinary income taxation at a higher rate than capital gain taxation. A remedy for this potentially unfavorable treatment is a Section 83(b) Election.

Accordingly, when companies are structuring their employee compensation packages, the tax implications of offering NQSOs should be analyzed as there could be a significant impact to both the employee and the employer.