San Francisco has almost become the heart of Silicon Valley these days. Twitter, Facebook, Yelp and many other lesser-known but no less dynamic companies are moving up to San Francisco and/or their employees are living the city life, while commuting down to Silicon Valley. Buses crowd the San Francisco streets and highway 101 shuttling employees back and forth between the most vibrant city in the Bay Area and the employers of Silicon Valley. Within San Francisco itself, we’ll soon have a new publically traded Twitter and a new Twitter HQ. The times, they are a changing: the city of flower power is becoming a city of stock option power.
In this blog post, we overview the types of stock options in the hopes of answering some basic questions from employees and employers about this innovative way to compensate employees. Note: if you have stock options or are a business considering granting them, please call us at 415-742-4249 or send us an email.
What are Stock Options?
Be advised that this is a summary, only, and please see the disclaimer below.
Incentive Stock Option (ISO) – A type of employee stock option with a tax benefit, when you exercise, of not having to pay ordinary income tax. Instead, the options are taxed at a capital gains rate.
Analysis – Although ISOs have more favorable tax treatment than non-qualified stock options (NSOs), they also require the holder to take on more risk by having to hold onto the stock for a longer period of time in order to receive the better tax treatment.
Incentive stock options are only available for employees and other restrictions apply for them. For regular tax purposes, incentive stock options have the advantage that no income is reported when the option is exercised and, if certain requirements are met, the entire gain when the stock is sold is taxed as long-term capital gains.
Non-qualified Stock Option (NSO or NQSO) – A type of employee stock option where you (the employee) pay ordinary income tax on the difference between the grant price and the price at which you exercise the option. NSOs are stock options which do not qualify for special tax treatments accorded to ISOs.
Analysis – Non-qualified stock options are frequently preferred by employers because the issuer is allowed to take a tax deduction equal to the amount the recipient is required to include in his or her income. If they have deferred vesting, then taxpayers must comply with special rules for all types of deferred compensation Congress enacted in 2004 in the wake of the Enron scandal known as Section 409A of the Internal Revenue Code.
When do I have to pay taxes on my options? NSOs result in a taxable transaction when you exercise the options and when you later sell the stock that you purchased. You don’t have to pay any tax when you’re initially granted those options.
Restricted Stock Units (RSU) – Compensation offered by an employer to an employee in the form of company stock. The employee does not receive the stock immediately, but instead receives it according to a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with the employer for a particular length of time. The restricted stock units (RSU) are assigned a fair market value when they vest. Upon vesting, they are considered income, and a portion of the shares are withheld by the employer to pay income taxes. The employee receives the remaining shares and can sell them at any time.
Analysis – RSUs are taxed differently than other kinds of stock options, such as statutory or non-statutory employee stock purchase plans (ESPPs). Those plans generally have tax consequences at the date of exercise or sale, whereas restricted stock usually becomes taxable upon the completion of the vesting schedule. Restricted stock plans are not eligible for capital gains treatment, and the entire amount of the vested stock must be counted as ordinary income in the year of vesting. The vested amount is typically included as part of the employees’ wages on their W2.
The amount that must be declared is determined by subtracting the original purchase or exercise price of the stock (which may be zero) from the fair market value of the stock as of the date that the stock becomes fully vested. The difference must be reported by the shareholder as ordinary income. However, if the shareholder does not sell the stock at vesting and sells it at a later time, any difference between the sale price and the fair market value on the date of vesting is reported as a capital gain or loss.
Section 83(b) Election
Shareholders of restricted stock are allowed to report the fair market value of their shares as ordinary income on the date that they are granted, instead of when they become vested, if they so desire. This election can greatly reduce the amount of taxes that are paid upon the plan, because the stock price at the time of grant is often much lower than at the time of vesting. Therefore, capital gains treatment begins at the time of grant and not at vesting. This type of election can be especially useful when longer periods of time exist between when shares are granted and when they vest (five years or more)
Method of making the election. Sec. 83(b)(2) stipulates that the Sec. 83(b) election must be made no later than 30 days from the date of the transfer. Regs. Sec. 1.83-2 requires the employee to file the election in the form of a written statement with the IRS office at which the employee regularly files his or her tax returns and attach a copy to the return. The employee must send a copy of the election to the employer; if the transferee of the property is not the employee, the employee must provide a copy of the election to the transferee. The statement’s required information is specified in Regs. Sec. 1.83-2(e).
Risks for the employee. The election under Sec. 83(b) carries at least two risks to the employee. One is that the property may not in fact appreciate but, rather, depreciate during the restricted period. In such case, the amount included in income when the employee made the election is not now deductible. Also, the employee can take a loss deduction only when he or she sells the stock, and the deduction will be subject to capital loss limitation rules. Employees will find themselves in the unenviable position of having reported ordinary income at the time of the award and paid the requisite income tax, followed by a capital loss upon its later disposition. Thus, if the employee is uncertain as to the growth or decline in value of the stock received, he or she might consider not making a Sec. 83(b) election.
A second risk is that, under Sec. 83(b)(1), no deduction is allowed to the employee if the stock is forfeited.
Employee Stock Purchase Plans (ESPPs) – A company-run program in which participating employees can purchase company shares at a discounted price. Employees contribute to the plan through after-tax payroll deductions, which build up between the offering date and the purchase date. At the purchase date, the company uses the accumulated funds to purchase shares in the company on behalf of the participating employees. The amount of the discount depends on the specific plan but can be as much as 15% lower than the market price.
Analysis – The rules that govern the taxation of proceeds from ESPPs can be quite complex in some cases, and only a simplified version of them is covered here. In general, the tax treatment of the sale of ESPP stock is governed by four factors: 1) The length of time the stock is held 2) The price the stock is actually purchased at, factoring in the discount 3) The closing price of the stock on the offering date 4) The closing price of the stock on the purchase date.
Participants who meet the holding requirements for qualifying dispositions will realize two types of taxable income (or losses), but none of it is reported until the year of the sale. The amount of the discount allotted in the plan (such as 15%) is reported as ordinary income. The remainder is classified as a long-term capital gain.
This type of disposition counts a great deal more of the sale proceeds as ordinary income. The seller must count the difference between the closing price of the stock as of the purchase date and the discounted purchase price as ordinary income.
IRS Circular 230 Notice
The Internal Revenue Service requires Safe Harbor LLP to inform the reader that any tax advice contained in this correspondence cannot be used for the purpose of avoiding penalties under the Internal Revenue Code or for promoting, marketing or recommending to another party any transaction or matter addressed.