One of the more popular ways that employers can compensate employees, besides traditional wages, is through the use of equity awards. These can come in many forms such as stock options, restricted stock, or partnership interests. The most common and popular form of compensation is stock options.
Generally speaking, there are two different types of stock options available – Incentive Stock Options (“ISO”) and Non-qualified Stock Options (“NQSO”). The specific plan document that governs the grant of the options will detail whether the options are ISO or NQSO, but typically an ISO is for executive level employees and NQSO are issued to rank and file employees as part of their overall compensation package. ISO and NQSO have very different tax treatments.
For recipients, the grant and exercise of an ISO does not have any effect on their income, but may have an effect on their Alternative Minimum Tax (“AMT”) calculation. The recipients do not recognize any income on the grant and only recognize income when the stock is sold. If the stock is held for longer than one year, then the stock is eligible for Long Term Capital Gains treatment, which currently maxes out at 20%, which is a lot lower than the maximum rate for ordinary income of 39.6%. In the event you do not hold the stock for at least one year, or two years after the offering date, the transaction becomes disqualified and is converted to ordinary income. The AMT addition for taxpayers that are subject to the AMT will result in the bargain element (difference between the grant price and the market price) as income in the year the options are exercised. Similarly, you will receive a downward adjustment in the year of sale.
For employers, since there is no compensation, there is no taxable event for the employer and no deduction is granted.
For recipients of an NQSO, there is a taxable event when the options are exercised, but not when they are granted. In the year that the NQSO are exercised, the recipient will pay tax on compensation (taxed at ordinary income rates and subject to FICA) for the difference between the grant price and the market value of the stock. This will be reported to the recipient on their W-2 and will have withholdings on it just like any other form of wage compensation. Your basis in the stock will be the grant price plus the compensation income you earned when they were exercised. As long as the options are held for one year or longer, the gain will be taxed as Long Term Capital Gains. Unlike ISO, there is no AMT adjustment.
For employers, a deduction will be granted for the compensation element that is reported on form W-2, which is the difference between the market price and the grant price. NQSO are more popular with employers for this reason – they are able to get a deduction for the grant of these options whereas ISOs have no taxable impact on their bottom line.
Other equity grants, such as restricted stock and partnership interests, are less common than the above and have many different tax treatments and planning considerations that need to be taken into account for both the recipient and the employer – that will have to wait until another day.
Edward McWilliams, CPA
Ed is a Partner in the firm’s tax and business advisory practice focusing on providing services to middle market private companies across different industries as well as to early stage startups. Ed has over a decade of experience providing tax and business consulting services to these companies of different sizes and across different industries, bringing a broad and diverse knowledge base and strategic solutions to the many complex issues that businesses face.