Equity-based compensation includes any compensation paid to an employee, director, or independent contractor that is based on the value of specified stock (generally, the stock or equity of the employer, which may be a corporation or a partnership). Examples of equity-based compensation include stock transfers, stock options, restricted stock awards, restricted stock units, stock appreciation rights, stock warrants, phantom stock plans, and other awards whose value is based on the value of specified stock. This article discusses the more common equity-based compensation awards: incentive stock options (ISOs), employee stock purchase plans (ESPPs), non-statutory (nonqualified) stock options (NQSOs), restricted stock awards (RSAs) and restricted stock units (RSUs).
Deducting Compensatory Stock-Based Compensation
A compensation deduction is allowed to an employer corporation for compensation paid to an employee or independent contractor through the grant of a stock option or issuance of other equity-based compensation. The amount and timing of the deduction are determined under Internal Revenue Code (IRC) Section 83 rules for compensation paid in the form of property.
Under the rules of Section 83, an employer corporation can deduct an amount equal to the amount includible in the gross income of the person who performed the services for the employer’s tax year, which includes the end of the tax year in which the person performing the services must include in gross income the compensation received. If the corporation transferring the property issues the appropriate forms to report the transaction to both the IRS and the recipient, properly completed, the recipient is deemed to have reported the income.
Tax Implications for ISOs and ESPPs
ISOs and ESPPs may be granted to employees only. Generally, the employer corporation does not receive a tax deduction at grant, exercise or sale. The employee will not recognize ordinary income at grant or exercise. However, in the year of exercise, the excess of the fair market value of the option over the exercise price is income to the employee for alternative minimum tax (AMT) purposes.
Provided that the employee sells shares after the ISO holding period requirements have been met, the employee will recognize long-term capital gains, taxed at preferential rates. To receive this favorable tax treatment, ISOs and ESPPs must be held the later of two years after grant date and one year after exercise.
For regular tax purposes, the tax basis in the stock is equal to the exercise price. For AMT purposes, the tax basis is increased by the income recognized upon exercise.
The disposition of a share of stock acquired by the exercise of an ISO before the applicable holding period expires is a disqualifying disposition to which statutory stock option treatment, described above, does not apply.
If there is a disqualifying disposition, Section 83 applies, and any income of the employee attributable to the disqualifying disposition is includible as compensation income received in the employee’s tax year in which the disqualifying disposition occurs and is taxed at higher ordinary rates. No amount is treated as compensation income for any other tax year.
The income attributable to the transfer is determined in accordance with the rules of Section 83(a), with no reduction for brokerage fees or other costs paid in connection with the disposition. This means that in the tax year in which the disqualifying disposition occurs, the individual must recognize compensation income equal to the stock’s fair market value at the time of exercise, less the exercise price.
This compensation income will be added to the ISO stock’s basis for determining the gain or loss on the sale or disposition of the ISO stock, thus making the stock basis equal to the fair market value at the time of exercise. This gain or loss is treated as short-term or long-term capital if applicable holding periods have been satisfied.
ISOs must be exercised within three months of termination of employment. This term is extended to one year for disability, with no time limit in the case of death. If the ISO is not exercised within three months of termination, the option is no longer an ISO and will be taxed as a NQSO. As a result, many companies will typically provide for a 90-day post-termination exercise period. This rule may have an impact to the corporation’s deferred tax asset for stock-based compensation.
There is a limit on the amount of ISO’s that can be exercised. An ISO will fail to be considered an ISO to the extent the aggregate fair market value of the stock with respect to an ISO exceeds $100,000. If the FMV (of the underlying stock) exceeds $100,000, the option is treated as a NQSO. This rule may also have an impact on the corporation’s deferred tax asset for stock-based compensation. Special rules additionally apply to a 10% shareholder.
For options granted under an ESPP, there is a $25,000 yearly limitation on the amount that an employee can purchase.
Compensation resulting from the exercise of an ISO or an ESPP, or from the disposition of stock acquired by exercising the option, is not considered compensation for social security, Medicare or FUTA tax purposes, and no federal income tax withholding is required.
The employing corporation must report as income in Box 1 of Form W-2 (a) the discount portion of stock acquired by the exercise of an ESPP option upon a qualifying disposition of the stock, and (b) the spread (between the exercise price and the fair market value of the stock at the time of exercise) upon a disqualifying disposition of stock acquired by the exercise of an ISO or ESPP option. Box 14 of Form W-2 may also include the amount of compensation related to ISO disqualifying dispositions with a code similar to “ISODD,” or for the amount related to the ESPP, as “ESPP.”
Form 3921 and 3922
In addition to issuing a Form W-2, an employer has an information reporting requirement following the exercise of either an ISO or ESPP. With respect to an ISO, IRC Section 6039 requires corporations to furnish Form 3921 to each employee on or before January 31 of the subsequent year. With respect to the exercise of an option under an ESPP, the transfer of stock to the employee is reported on Form 3922.
Tax Implications for NQSOs
NQSOs may be granted to employees, directors, and other service providers such as contractors and consultants. The employer corporation does not receive a tax deduction at grant, but is entitled to a tax deduction upon exercise, equal to the amount of ordinary income includible in the service provider’s income. The ordinary income to the service provider is the excess of fair market value of the option over the option price.
The income tax treatment of NQSOs is governed by IRC Section 83 rules for property transferred in connection with the performance of services. If a NQSO has a readily ascertainable fair market value when it is granted, then that value (less any amount that must be paid for the option) is included by the service provider as compensation income at grant. In the more typical situation where an option does not have a readily ascertainable FMV, then its value, less any amount that must be paid for the option, is taxed to the service provider at the time it is exercised, or as soon after exercise as the option property is transferable or not subject to a substantial risk of forfeiture. The employer corporation has a corresponding compensation deduction for the amount included by the service provider, in the same year that the service provider includes it in income.
IRC Section 83(b) and Treas. Reg. Section 1.83-2(a) permit a service provider to elect to include in gross income the excess (if any) of the fair market value of the property at the time of transfer, over the amount (if any) paid for the property, as compensation for services. IRC Section 83(b) election is allowed for NQSOs but not ISOs.
With the enactment of the Tax Cuts and Jobs Act (“TCJA”), new Section 83(i) allows qualified employees of a privately held company to elect to defer the income from the exercise of an NQSO or vesting of an RSU received in connection with the performance of services for up to five years, if the corporation’s stock is an eligible corporation. An eligible corporation cannot have any stock readily tradable on an established securities market during any preceding calendar year.
A detailed discussion of IRC Section 83(b) and 83(i) is beyond the scope of this article.
An employer must report to an employee the excess of the fair market value of stock received upon exercise of a NQSO, over the amount paid for the stock option, on Form W-2 in boxes 1, 3 (up to the social security wage base), and 5, and in Box 12 using the code “V.” For any non-employee service provider, the employer must report this income on Form 1099-NEC.
Other Types of Equity-Based Compensation
Restricted Stock Awards
An RSA is a grant of company stock in which the grant holder’s rights in the stock are restricted until the shares vest (or lapse in restrictions). Once the vesting requirements are met, the holder owns the shares outright and may treat them as any other share of stock in the employee’s account. Vesting periods for RSAs may be time-based (a stated period from the grant date) or performance-based (often tied to the achievement of corporate goals).
Upon granting of RSAs to employees or service providers, there is no tax unless the shares are vested at grant or the employee elects under Section 83(b) to be taxed at grant. Once vested, the fair market value of the vested shares, over the amount paid for the restricted stock, is compensation income to the holder (unless a Section 83(b) election was made at grant) and a deductible expense to the company. Generally, the amount paid for the restricted stock is $0. Federal income tax withholding and proper reporting by the corporation on Form W-2 or Form 1099 are required.
Restricted Stock Units
An RSU is a form of compensation issued by an employer to an employee in the form of company shares subject to a vesting plan and distribution schedule, after reaching certain performance goals or working for a particular length of time. The units are restricted because they are subject to a vesting schedule. Shares of the stock are issued after the vesting date.
Restricted stock units are taxed as ordinary income to a service provider upon vesting. The employer corporation is entitled to a deduction for the year in which the income is includible in the income of the service provider. Federal tax withholding and proper reporting by the corporation on Form W-2 or Form 1099 are required, where appropriate.
RSUs are not considered property for purposes of Section 83 since no actual property has been transferred, and therefore, an IRC Section 83(b) election cannot be made with respect to the grant of a RSU, but a Section 83(i) election is allowed.
Timing of Deduction to Employer Corporation
As previously discussed, a corporation would need to report any income that is required to be recognized by the employee or service provider. If the corporation issues the appropriate forms, properly completed, the recipient is deemed to have reported the income. Issues arise when the reporting forms are not provided by the corporation to the recipient and there is no evidence that the recipient included the items in gross income. In these situations, the corporation generally is not able to claim a compensation deduction.
Many corporations may fail to issue and file the proper forms reporting the compensation income to employees and/or independent contractors. Since current tax rules and case law support the position that a compensation deduction may be claimed by a corporation only in the year in which the compensation income is includible in the gross income of the service provider, regardless of whether the service provider reports the income to the IRS, it is important that the proper required reporting is made by the corporation to support any tax deduction associated with equity-based compensation.