Vesting stock options tax
In an economy driven by e-commerce, the use of employee stock options has become an increasingly significant component of many employees' compensation. In a June 13,article written by Gretchen Morgenson, the New York Times On the Web reported, for example, that the number of employees receiving stock options has now grown to about 10 million, up from about 1 million in the early 's. While options are many different types of stock option plans, most tax involve many of the same basic elements. From a tax standpoint, however, there are two fundamentally different types vesting stock options -- so-called qualified stock options or "Incentive Stock Options" "ISO's" and non-statutory or non-qualified options, sometimes referred to as "NSO's. For a more abbreviated discussion of the taxation of stock options, click here. Regardless of whether the plan is an ISO or NSO tax tax purposes, many plans will involve similar basic features. The employee stock be granted options to purchase company stock. These option grants will usually be tied to a schedule or set of other conditions, which will allow the employee to exercise the option i. Typically, the option will give the employee the right to purchase company stock at the fair market value of the stock at the time of the grant of the option. Thus, if the value of the stock rises between the grant of the option and the exercise of the option, the employee effectively gets to purchase the stock at a discount. It is also common tax plans to place significant restrictions on the stock that employees acquire through the exercise options the options. These restrictions can take many forms, although common restrictions might include a limitation on the ability to transfer the stock either for a stated period of time or so long as the employee remains an employee or requirements that the employee must sell the stock back to the company at the employee's cost if the employee leaves the company before a stated time interval. For tax purposes, stock option plans raise a number of questions. For example, is the grant of the option a taxable event? Is the exercise of the option taxable? If not, when is the transaction subject to tax? One key stock between ISO's and NSO's is that the timing of the taxable events may be different. In order to put the tax rules relating to stock options in a more vesting setting, the following discussion will consider the a hypothetical Stock Option Plan "the Plan". The Plan is set up by BigDeal. As to each option, one half will be ISO stock and one-half will be NSO stock. Employees receiving these options are entitled to exercise options with respect to 5, after the close of each year of service. After the second year of service, an additional 5, and so stock after each additional year until the options for the full 25, shares vest. Upon exercise, the stock acquired through BigDeal's Plan are subject to a number of explicit limitations and restrictions, including both broad limitations on the right to transfer the stock and a right of the Company to repurchase "unvested" shares at the option exercise price, if the employee leaves BigDeal. For this purpose, the term "vested" means that the stock is no longer subject to restrictions. As noted above, for tax purposes there are basically two types of stock options - ISO's and non-statutory options NSO's. Each type has its own set of tax rules. The basic treatment for ISO's is governed by I. Because the non-statutory option rules are the default, it is convenient to begin by discussing those rules. The tax treatment of non-statutory or non-qualified stock options is governed by the set of rules under I. Section 83 a 1 actually states this in terms of options that the fair market value of property received for services must be recognized "at the first stock the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier. In that event, the difference between the fair market value of the option and the option exercise price or other consideration paid will be taxable as ordinary income and will be subject to withholding. On vesting other hand, if the option has no readily ascertainable fair market value, the grant of the option is not a taxable event, and the determination of the tax consequences is postponed at least until the option is exercised or otherwise disposed of, even if "the fair vesting value of such option may have become readily ascertainable before such time. Whether an option has a readily ascertainable fair market value is determined under Tax. In basic terms, unless the option itself as distinguished from the stock is traded on an established market, an option will not usually be treated as having a readily ascertainable fair market value. There is a possibility, under Regs. Thus, in the case of options which themselves are not regularly traded, the grant of the option will not be taxable, and the tax consequences will be postponed at least until the option is exercised or otherwise disposed of. While the taxable income, determined at the time of exercise, will be treated as ordinary income subject to withholding, any additional appreciation in the value of the stock after a taxable exercise of the option may vesting for capital gain treatment, if the capital gain holding requirements are met. For example, in this situation, suppose that options to stock BigDeal. If, at the time of exercise, the fair market value of BigDeal. The foregoing analysis has assumed that the stock acquired through the exercise of the option is otherwise unrestricted property -- i. Here, in the case of BigDeal, there are restrictions on the transferability of the stock, and BigDeal. In this instance, the repurchase right effectively requires the employee to resell to BigDeal. In other words, because of the limitations on transfer and the presence of a substantial risk of forfeiture, the exercise of the BigDeal. It is also important to remember that under some circumstances, restrictions on stock transfer and vesting requirements may be waived by a company. At the same time, however, other, non-contractual restrictions, such as securities law provisions, may effectively preclude the shareholder from selling the stock. One potential advantage of making such an election is to cause all appreciation after that point to qualify for capital gain treatment and to start the running of the capital gains holding period, which would otherwise be delayed until the restrictions lapse and the stock becomes fully vested. Further suppose that because of the restrictions on the stock, all "unvested" shares are treated as subject to limits on transferability and a substantial risk of forfeiture i. Additional appreciation after that point could qualify for capital gain treatment if the stock tax retained for the requisite holding period, measured from that point onward. ISO plans have two potentially important advantages to employees, in comparison to non-statutory stock options. Second, if the stock is held until at least one year after the date of exercise or two years from the date the option is granted, whichever is laterall of the gain on the sale of the stock, when recognized for income tax purposes, will be capital gain, rather than ordinary income. If the ISO stock is disposed of prior to the expiration of that holding period, then the income is ordinary income. The basic requirements for an ISO plan are set out in I. Thus, there are two significant differences between ISO's and non-statutory options. Second, if the ISO holding period requirements are met, all gain will qualify for capital gain treatment. Second, all of the gain with respect to an ISO can be capital gain, if the ISO holding period requirements are met. While the exercise of an ISO does not cause any taxable event under the regular tax system, it does have consequences under the Alternative Minimum Tax AMT system. This "spread" tax treated as an AMT adjustment. The effect of this AMT adjustment is to cause the taxpayer to options AMT taxable income on the exercise of the option, when the stock acquired is substantially unrestricted or not options to a substantial risk of forfeiture. Regardless of when the AMT adjustment arises, it has several effects. First, the AMT adjustment -- the spread between the fair market value and the option price -- can become subject to Options, and AMT tax may have to be paid on that amount, even though the stock might be held for many years or ultimately sold at a loss. In addition, the basis in the stock, for AMT purposes only, becomes in effect the fair market value as of the date that the AMT adjustment arises. Vesting of this basis adjustment, when the stock is actually sold, there will be no AMT gain to the extent of the "spread" that was previously subject to AMT tax. Because the basis in the stock vesting be different for AMT and for regular tax purposes, the subsequent sale of the stock will generate gain or loss for regular tax purposes, even if it stock no gain for AMT purposes. Since the gain on the sale, determined for purposes of the regular tax, would also include the "spread" that was previously included in the AMT taxable income, there is a risk of double taxation, except for the AMT credit, as determined under I. In theory, the payment of AMT in the year of exercise creates a credit which then reduces the regular tax in the tax the stock is actually sold, since in that year, disregarding all other factors, the regular taxable income would be larger than the AMT taxable income, owing to the differences in the stock basis. This is, at least, the theory, in greatly simplified form. In practice, however, the extent to which there will be a significant risk of double stock depends upon the rather complicated calculation and operation of the AMT credit, a full discussion of which is beyond the scope of this article. For present purposes, a brief overview must suffice. When a taxpayer is subject to AMT liability in any taxable year, the amount of "adjusted net" AMT paid in that year is available as a credit against his regular tax liability in future years. This credit, however, will not reduce the regular tax below the tentative AMT in any year. Thus, after the credit is created, it may only be used in a subsequent year in which the AMT tax is lower than regular tax. For example, the credit generated from the AMT paid on the exercise of an ISO could, in theory, be used in the first year in which the AMT tax is lower than the regular tax, irrespective of what caused the difference. Of course, the converse is also possible -- namely, in the year in which the stock is sold, other AMT adjustments unrelated to the prior ISO could cause the AMT tax for that year to be the same or larger than the regular tax so that the credit would not be available that year but would carry over indefinitely. For example, in a year in which the ISO stock is sold, additional ISO exercises or other unrelated AMT adjustments could cause the AMT tax options be greater than regular tax and thus preclude tax of the earlier year's AMT credit. In reality, it sometimes requires very careful planning in order to be able to take advantage of the AMT credit. In addition, Congress has been considering a number of different proposals to provide further relief from the AMT, but the prospects for any change in the AMT are uncertain, at best. In situations such as BigDeal's, where the stock acquired under the option is not transferable and subject to a substantial risk of forfeiture -- i. Under such circumstances, the most important benefit of the ISO option is that all gain will be capital gain, if the requisite holding periods are met, but AMT considerations may reduce the value of that benefit. The actual tax savings that might tax from ISO treatment, under the such circumstances, can be difficult to predict, in part because they depend upon unknown and unpredictable variables relating to the market value of the stock, an individual's options situation, and other AMT adjustment events that affect the individual. While the rules for the two different types of stock options differ, both ISO's and non-qualified options afford employees the opportunity to convert what would otherwise be ordinary, compensation income into capital gain. Given the current capital gain rates, that advantage can be significant. Taking full advantage of this benefit, however, can require careful planning at the time of both the exercise and the subsequent sale of the stock. Careful AMT planning is essential. If you are reading this newsletter but are not on our mailing list, and would like to be, please contact us at While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services. You can search for information in options entire Authors Row section, or in the entire site. For a more vesting search, put your search word s in quotes. Typical Stock Option Plans Regardless of whether the plan is an ISO or NSO for tax purposes, many plans stock involve similar basic features. Non-statutory Stock Options The tax treatment of non-statutory or non-qualified stock options is governed by the set of rules under I. Incentive Stock Options ISO plans have two potentially important advantages to employees, in comparison to non-statutory stock vesting. Conclusion While the rules for the two different types of stock options differ, both ISO's and non-qualified options afford employees the opportunity to convert what would otherwise be ordinary, compensation income into capital gain.
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