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Taxation of stock options and restricted stock: the basics and beyond by G. Edgar Adkins, Jr.* Taxation of stock options and restricted stock: the basics and beyond 1 Contents Page Introduction 2 Incentive stock options 3 Nonqualified stock options 8 Restricted stock 10 Income tax withholding and employment taxes on stock options and restricted stock 15 Conclusion 16 This document supports Grant Thornton LLP’s marketing of professional services, and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the subject of this document we encourage you to contact us or an independent tax advisor to discuss the potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document may be considered to contain written tax advice, any written advice contained in, forwarded with, or attached to this document is not intended by Grant Thornton to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. © Grant Thornton LLP. All rights reserved. Taxation of stock options and restricted stock: the basics and beyond 2 Introduction The compensation mantra for many companies today is ―pay for performance.‖ As a result, companies often focus on equity-based compensation in order to align the interests of executives with those of the company’s shareholders. The most popular forms of equity-based compensation are stock options and restricted stock. It is not uncommon for these vehicles to compose a substantial portion of an executive’s net worth. Accordingly, it is important that executives fully understand the income tax treatment of options and restricted stock in order to maximize the after-tax value. This article presents the basic tax rules that apply to stock options and restricted stock, but also goes beyond the basics to discuss certain more complex issues and planning considerations. Throughout the article, we will refer to ―Jane,‖ an executive of a hypothetical company called ―Public Company,‖ in order to illustrate the various tax rules. We begin with a discussion of Jane’s incentive stock options. © Grant Thornton LLP. All rights reserved. Taxation of stock options and restricted stock: the basics and beyond 3 Incentive stock options Assume that Jane holds 1,000 incentive stock options (―ISOs‖). If Jane is like most executives, she is very pleased to hold ISOs due to their very favorable tax treatment. This favorable tax treatment is captured in the following points:  There is no income tax when:  Public Company grants the ISOs to Jane.  Jane exercises the ISOs.  There is income tax when Jane sells the stock. The following example illustrates the tax treatment of ISOs. Example 1 Jane exercises her 1,000 ISOs. She receives 1,000 shares of Public Company. Jane pays $10 per share for the stock (i.e., the exercise price is $10). Three years later, she sells the stock for $15 per share. As noted above, she pays no tax until she sells the shares. At that time, she has a capital gain of $5 per share, or $5,000 in total, calculated as follows: Sales price per share Minus exercise price per share (basis in the shares) Equals gain per share Times number of shares sold Equals total gain $15 -10 $5 x 1,000 $5,000 The gain is a long-term capital gain because Jane held the stock for more than one year.1 This very favorable tax treatment — the deferral of income recognition until the stock is ultimately sold — may seem too good to be true. In fact, there are situations in which such favorable tax treatment will not apply to ISOs. Disqualifying dispositions Specifically, an ISO loses its favorable tax treatment if there is a so-called ―disqualifying disposition.‖ A disqualifying disposition occurs whenever the stock that was acquired with an ISO is sold within: * G. Edgar Adkins, Jr., CPA, is a partner in the National Tax Office of Grant Thornton LLP in Washington, DC, specializing in the income tax aspects of compensation and employee benefits. He is Vice Chair of the AICPA’s Employee Benefits Tax Technical Resource Panel. 1 Section 1222(3). © Grant Thornton LLP. All rights reserved. Taxation of stock options and restricted stock: the basics and beyond 4  2 years after the ISO is granted, or  1 year after the ISO is exercised.2 If Jane sells the stock within either of the periods above, she will be required to report income in the year of the disqualifying disposition.3 Further, the income is ordinary income rather than a capital gain. The income amount is equal to the ―spread‖ on the exercise date (i.e., the difference between the fair market value of the stock on the exercise date and the exercise price).4 To illustrate this tax treatment, we will return to the prior example with a few changes in the facts. Example 2: As in Example 1, Jane exercises 1,000 ISOs and receives 1,000 shares of Public Company. The exercise price is $10 per share. At the time of exercise, the fair market value of the stock is $12 per share. Only six months later, Jane sells the stock for $15 per share. Jane has a disqualifying disposition because she sold the stock within one year after the ISO was exercised. As a result, Jane will recognize ordinary income in the year of the disqualifying disposition, calculated as follows: Stock value per share at exercise date Minus exercise price per share Equals spread per share (ordinary income) Times number of shares sold Equals total ordinary income $12 -10 $2 x 1,000 $2,000 In addition, Jane will report a capital gain upon the sale of the stock.5 The gain will be a short-term gain, because she has held the stock for less than one year. The amount of her capital gain is calculated as follows: Sales price per share Minus Jane’s basis in the stock: Exercise price per share Ordinary income per share, recognized as a result of the disqualifying disposition Total basis in the stock per share Equals capital gain per share Times number of shares sold Equals total capital gain (short-term) $15 $10 +2 - 12 $3 x 1,000 $3,000 In the example above, Public Company’s stock continues to increase in value. Of course, this is not always the case. Suppose that shortly after Jane’s exercise of the ISOs (when the stock value is $12 per share), the stock begins to decline in value. When the stock reaches $11 per share, Jane decides to sell it. Special tax treatment applies when the amount realized upon a disqualifying disposition is less than the Section 422(a)(1). Section 421(b); Reg. 1.421-2(b). 4 Public Company will obtain an income tax deduction equal to the amount of Jane’s ordinary income. Section 83(h); Reg. 1.83-6(a). 5 Public Company will not obtain any deduction related to Jane’s capital gain. 2 3 © Grant Thornton LLP. All rights reserved. Taxation of stock options and restricted stock: the basics and beyond 5 stock’s value at the exercise date.6 Jane will recognize ordinary income as a result of the disqualifying disposition.7 The amount is calculated as follows: Sales price per share Minus exercise price per share Equals ordinary income per share Times number of shares sold Equals total ordinary income $11 -10 $1 x 1,000 $1,000 Jane will not recognize any capital gain or loss, because her entire gain on the stock (i.e., the difference between the sales price and the exercise price) has already been recognized as ordinary income. Suppose that rather than selling the stock for $11 per share, Jane continued to hold the stock, and did not sell it until the value declined to $8 per share. Thus, in contrast to the example immediately above, Jane sells the stock for an amount that is less than the exercise price. In this situation, Jane has a loss of $2,000, calculated as follows: Sales price per share Minus exercise price per share Equals loss per share Times number of shares sold Equals total loss $8 -10 $2 x 1,000 $2,000 The loss is treated as a capital loss.8 Disqualifying dispositions are quite common for ISOs, because many employees sell the shares immediately upon exercise. However, an executive who believes the stock will continue to increase in value is well served to hold onto the stock in order to retain the favorable tax treatment for ISOs that was described earlier. Alternative minimum tax It is important that executives are aware of the tax ramifications associated with disqualifying dispositions. It is equally important that executives are aware of the impact that ISOs have on alternative minimum tax (―AMT‖). Otherwise, an executive may be very surprised to learn that he or she has an income tax liability as a result of exercising ISOs, despite the general rule that the exercise of an ISO is not a taxable event. This is the case because the spread upon exercise is a preference item for AMT purposes.9 To illustrate this concept, we return to the earlier examples. Example 3 Jane exercises 1,000 ISOs at an exercise price of $10 per share. At the time of exercise, the fair market value of the stock is $12 per share. Jane’s AMT preference amount upon the exercise is calculated as follows: Fair market value per share at exercise date Minus exercise price per share Equals spread per share at exercise date $12 -10 $2 Section 422(c)(2); Reg. 1.422-1(b)(2)(i); Reg. 1.422-1(b)(3), Example (3)(ii). Public Company will obtain a deduction equal to the amount of Jane’s ordinary income. 8 Reg. 1.422-1(b)(3), Example (3)(iv). Note that Public Company would not obtain any deduction in this scenario. 9 Section 56(b)(3). 6 7 © Grant Thornton LLP. All rights reserved. Taxation of stock options and restricted stock: the basics and beyond Times number of ISOs exercised Equals AMT preference amount 6 x 1,000 $2,000 Of course, this AMT preference item may or may not affect Jane’s actual income tax liability, depending on her overall tax situation. With proper planning, an executive can minimize the impact of ISO exercises on AMT. It is important that the executive recognize the danger of the AMT. Specifically, if an executive exercises a significant number if ISOs, at a time when the value of the stock has increased dramatically, he or she may have a substantial AMT liability. If the stock later plunges in value – before the executive sells the stock – the executive will have incurred a large tax liability on phantom (i.e., unrealized) gains. There are several strategies to minimize the AMT that an executive may consider, including those strategies which appear in Exhibit 1. Exhibit 1 Strategies to minimize the AMT liability associated with ISO exercises    Limit the number of ISOs exercised in any given year. o Calculate the amount of ISOs to exercise in a given year that will cause the regular tax and AMT to be equal amounts. o Do no exercise ISOs in excess of this amount, so that there is no AMT. Plan ahead. o Estimate how many ISOs can be exercised in each future year without triggering AMT. o Update the plan each year in the future to reflect changes in the stock value and other circumstances. Exercise ISOs as early in the year as possible, and then monitor the stock price throughout the year. o If the stock price decreases during the year, and the executive fees the decline may continue, then sell the shares. This results in a disqualifying disposition, but eliminates the AMT preference item. Thus, this technique avoids the payment of AMT on phantom income. o If the stock price increases, and the executive feels the stock will continue to increase in value, then consider holding the shares. In this situation, the executive may not be concerned about paying AMT on phantom income, because the increasing value of the stock indicates that the income will eventually be realized when the stock is sold. ISO limitations and requirements Executives may wonder why their employers do not issue more ISOs, given the very favorable tax treatment. The reasons that employers may limit the issuance of ISOs include the following:  The employer receives no income tax deduction for ISOs.10  There is a limit on the number of ISOs that an employer can issue to an employee. This limit is $100,000 per employee on the value of stock for which ISOs can first be exercised each year (i.e., an annual limit). For purpose of this rule, the stock value is measured at the date the options are granted.11 If there is a disqualifying disposition, then the employer will receive a tax deduction equal to the amount of ordinary income recognized by the executive. 11 Section 422(d). An employer can adhere to the rule through the vesting schedule that applies to the ISOs. For example, suppose Public Company grants 20,000 ISOs to Jane when the fair market value of the stock is $10 per share. The total stock value is $200,000 (20,000 ISOs times $10). Therefore, no more than 50 percent of the ISOs may become vested and exercisable in any given year, in order to adhere to the $100,000 limit. 10 © Grant Thornton LLP. All rights reserved. Taxation of stock options and restricted stock: the basics and beyond 7 Before leaving the discussion of ISOs, we turn our attention to a brief discussion of the requirements for ISO status, since it is quite possible that an executive will want to understand what makes an option an ISO. There are several requirements for an option to be an ISO, including the following:  The exercise price cannot be less than the fair market value of the stock at the time the option is granted.12  The option term (i.e., the period during which the option may be exercised) cannot exceed 10 years from the date the option is granted.13  The option is exercisable only by the executive, and cannot be transferred to anyone else except upon the executive’s death.14  At the time the option is granted, the executive cannot own stock possessing more than 10 percent of the total combined voting power of all classes of stock of the employer or of its parent or subsidiary corporation.15 This rule does not apply if certain conditions are met, as follows:  The option’s exercise price is at least 110 percent of the fair market value of the stock on the grant date, and  The option term does not exceed 5 years from the date the option is granted.16  The option plan must be approved by the employer’s stockholders within 12 months before or after the date the plan is adopted.17 Section 422(b)(4). Section 422(b)(3). 14 Section 422(b)(5). 15 Section 422(b)(6). 16 Section 422(c)(5). 17 Section 422(b)(1). 12 13 © Grant Thornton LLP. All rights reserved. Taxation of stock options and restricted stock: the basics and beyond 8 Nonqualified stock options In addition to her 1,000 ISOs, Jane holds 10,000 nonqualified stock options from Public Company. If an option does not meet the requirements for ISO status, then it is a nonqualified option.18 The tax treatment for nonqualified options is somewhat simpler but less favorable to the executive than ISOs. This treatment is summarized as follows:  Like ISOs, there is no income recognition upon grant.  Unlike ISOs, there is income recognition upon exercise.19 The income that is recognized upon exercise is treated as ordinary income. When the stock is sold later, the individual has a capital gain or loss. The income recognition for nonqualified options is illustrated by the following example. Example 4 Jane exercises her 10,000 nonqualified options. The exercise price is $10 per share, and the stock value on the exercise date is $15 per share. Jane sells the stock in Year 10 for $50 per share. Jane recognizes $50,000 of ordinary income in Year 1 when she exercises the options. The income amount is calculated as follows: Stock value per share on exercise date Minus exercise price per share Equals ordinary income per share Times number of options exercised Equals ordinary income $15 -10 $5 x 10,000 $50,00020 Even when an option does qualify as an ISO, the employer can treat it as a nonqualified option. Section 422(b). Reg. 1.83-7(a). 20 When Jane recognizes the income, Public Company will obtain a tax deduction equal to Jane’s income (i.e., $50,000). 18 19 © Grant Thornton LLP. All rights reserved. Taxation of stock options and restricted stock: the basics and beyond 9 When Jane sells the stock in Year 10, she will have a capital gain, calculated as follows: Sales price per share Minus Jane’s basis in the stock: Exercise price per share Ordinary income per share previously recognized Total basis in the stock per share Equals capital gain per share Times number of shares sold Equals total capital gain $50 $10 +5 - 15 $35 x 10,000 $350,000 The capital gain is a long-term capital gain, because Jane held the stock for more than one year. Employer loan to fund stock option exercise An employer sometimes extends a loan to an executive so that the executive has the cash to pay the exercise price of stock options. The loan does not change the tax treatment of the options that has been discussed above, unless the loan has certain characteristics. To illustrate, suppose Public Company gives Jane a loan to fund the exercise of her nonqualified options. Suppose further that the stock serves as security for the loan, and Jane is not personally liable to repay the loan. In this situation, Jane’s exercise of the options is ignored for tax purposes.21 This is the case because Jane has not taken on any personal risk that the value of the stock will decline. Therefore, there has been no transfer of stock for tax purposes. Jane should not report income upon the exercise. Jane will not report income until the loan no longer exists. It should be noted that if the loan is from a third party rather than from the employer, then the usual taxation rules apply.22 In other words, the special rules described in this paragraph apply only when the loan is from the employer. 21 22 Reg. 1.83-3(a)(2); Reg. 1.83-3(a)(7), Example (2). Palahnuk v. U.S., 97 AFTR 2d 2006-1433. © Grant Thornton LLP. All rights reserved.