Stock Options Received as Compensation – Tax Treatment
Are you providing compensation to employees in the form of stock options? Unlike paying your employees a standard salary or hourly rate, stock options are treated differently in the tax code. As a business owner, it’s important to be aware of these differences to not only offer competitive compensation packages to employees but also to maximize your tax deductions. In this article, we’ll cover the common types of stock options, the tax treatment, and other important considerations.
Types of Stock Compensation
Stock options fall into three main categories: restricted, statutory, and non-statutory. Let’s explore each of these categories in more detail.
Restricted Stock Units (RSUs)
This type of stock option usually comes at no cost to the employee. The company will determine the amount each RSU is worth and the vesting period, which is usually three to five years.
Statutory Stock Options
Statutory stock options come in two common forms: incentive stock options (ISOs) and employee stock purchase plans (ESPPs). These types of stock compensation allow employees the option to purchase shares of stock at a future date for a specified price.
ISOs are more common for employee compensation packages because of the rules that apply. For example, the stock is non-transferable and expires after ten years. On the other hand, ESPPs are handled through a payroll election, reducing an employee’s net pay for the discounted stock price.
Non-Statutory Stock Options
Non-statutory stock options, known as NSOs, are the catch-all category for stock options. If the stock option doesn’t qualify as an ISO or ESPP, it will be considered an NSO. NSOs are broader and can cover independent contractors in addition to employees. The individual is given the option to purchase shares at a future date for a specific price.
Stock Option Tax Treatment
Each stock option has different tax treatment for businesses and employees. Let’s explore these differences in more detail.
Restricted Stock Units
Restricted stock units do not require employees to pay for the stock. As a result, the fair value of the stock on the vesting day becomes taxable income, which will be reported in W-2 Box 1, 3, and 5. Since employees are reporting the stock options as income, you can take a business deduction to lower your taxable income.
Statutory Stock Options
Statutory stock options require the employee to pay the strike price to acquire shares. However, there are tax treatment differences between ISOs and ESPPs. ISOs do not give way to an employer deduction since the employee is paying for the units. Employees will pay income tax when the stock is sold at the difference between the strike price and the price sold. Here’s a chart that will help you determine if you trigger a tax event.
ESPPs are reported on Form 3922, Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423(c). However, there is no income when the options are granted or exercised. In the year of the sale, taxable income is reported in Box 1 of the W-2 for the discounted amount. As a result, employers are able to take a deduction for the amount added back to employee taxable income.
Non-Statutory Stock Options
Non-statutory stock options give employees the ability to purchase shares at the strike price. The discount is added to W-2 Box 1, 3, and 5. Employers are able to take a deduction for the spread added back to employee taxable income.
Elections and Other Considerations
Here are a few more elections and other considerations to keep in mind as you build your stock option compensation package.
83(b) Election
A Section 83(b) election is used to shift the income inclusion from the vesting date to the exercise date, which includes the fair value of the stock in taxable income earlier than it normally would. It might make sense to pay tax on the fair value on the exercise date before the stock appreciates. However, this will result in a lower basis on future stock sales.
Net Unrealized Appreciation
If an individual holds stock options in their 401(k), it might be worth considering net unrealized appreciation treatment. In this situation, stock in a 401(k) is rolled over to a non-retirement account, like a brokerage account. The individual is then able to sell the stock out of the brokerage account, unlocking long-term capital gain tax treatment with no holding period requirement.
Qualified Equity Grants
A qualified equity grant allows qualified employees to defer the taxation of stock options for up to five years from the vesting date. To take advantage of this rule, your company must have a written plan and provide stock options to at least 80% of U.S. employees. This election is made by attaching a statement to the tax return for the year the election is made and providing a copy to the employer.
Summary
Does it sound like your compensation package could benefit from offering employee stock options? If so, it’s important to be aware of the tax treatment to maximize your deductions. For more information, reach out to Kislay Shah CPA PC at or 646-328-1326.