Taxpayers may have the right to earn deferred equity income as part of their overall compensation package, including Incentive Stock Options (ISO), Restricted Stock (RS) and Employee Stock Purchase Plans (ESPP).  Employees have many questions on the tax treatment of their equity awards including whether ordinary income, capital gains and/or alternative minimum tax (AMT) applies.  The goal for taxpayers is to seek preferred long term capital gains treatment, delay taxes when possible and obviously maximize profit on sale.

Stock Options:

Stock options remain a valuable tool to attract employees to startup companies, however, tax rules are complicated.  ISOs are deemed statutory stock options and may be entitled to preferential income tax treatment.  Upon exercise, taxpayers have two options:  sell the shares and pay tax on gain at ordinary rates or hold the shares, subjecting them to AMT.  When you exercise an ISO the spread between the market price and exercise prices goes untaxed if you don’t sell.  When you go to sell the shares, the entire profit (sales price over exercise price) is subject to favorable long term capital gains tax if sold more than two years after the grant date and one year after exercise.

Non qualifying distributions arise from qualified stock options if the sale occurs less than two years before the grant date or one year before exercise.  In this case, the spread between market price and exercise price will be subject to ordinary tax rates and income included on your W-2.   Otherwise, on exercise, the difference between the exercise price and market strike price is positive adjustment for AMT, meaning you may owe federal taxes on a portion of the award on Form 6251.  Taxpayers will receive IRS Form 3921, Exercise of ISOs confirming the amount to be included in AMT.  If you do owe AMT, you may be eligible for an AMT credit which will reduce your tax bill in a future year.  AMT can be avoided by staggering the exercise dates over several years or by exercising the options in earlier (after two) years while the spread is likely minimal.   Keep in mind that earlier exercise of options is risky as this requires your cash outlay to purchase shares not knowing if the share price will advance.

Stock options that are not deemed qualified are considered non-qualified and your company will tell which what type of stock option you have.  When you exercise non-qualified stock options, the difference between the stock and purchase price is treated as ordinary income.  This will be reported on your W-2 as income and subject to tax withholding and payroll taxes.  Subsequent appreciation will be taxed at capital gains rates, either short term or long term.

Employee Stock Purchase Plans:

ESPPs are a type of qualified statutory stock option whereby employees can purchase company stock, usually at a 15 percent discount.  The discount is taxable as wages on their W2 but is deferred until the employee sells the stock, thus affording preferred tax treatment. In the year of sale, taxpayers will report the amount of ordinary income and capital gain.  If the holding period is over one year and two years from the offering date, then favorable long term cap gains taxes will apply.  In the year of sale, employees will receive IRS Forms W-2 showing ordinary income, 1099-B reporting the sale and 3952 detailing the proper tax basis.

Employees enroll in the plan and shall designate how much will be deducted from their paychecks on an after-tax basis.  At the end of the offering period, money is used to buy the shares discounted from the market price or if there is a lookback period, back to the offering start date price.  If you leave company, you may want to sell the stock or find you have too much company stock to diversify.

Restricted Stock:

If you receive property for services, the fair market value is included in your income.  However, if there are restrictions on your rights, the income is recognized upon vesting, meaning there is no longer a substantial risk of forfeiture.  When the property right becomes vested you must include the current value of the property less the amount you paid for it (if any) in your income.  Dividends received on restricted stock are treated as wage income.  Your holding period for capital gains then begins on the date of vesting.

Recipients of restricted stock awards can choose to include the value of the property on the date of transfer instead of future vesting date.  You make this code section 83(b) election within 30 days of the transfer by filing notice with the IRS.  As later appreciated value is not included in your compensation at vesting you are betting that the stock will go up substantially and it makes sense to pay taxes now allocating more appreciation to capital gain. Tax basis for gain is the amount paid plus ordinary income included in your compensation.

When a company grants restricted stock units (RSU) or phantom stock, it gives the recipient the right to receive a payment in cash or shares if vesting conditions are met.  If the RSU is settled, the taxpayer recognizes ordinary income on Form W-2.  Unlike options, the recipient does not have to pay an exercise price for the stock.  If you immediately sell your stock units after settlement you will have to report the sale, though there will be little to no gain as the income was reported on your W-2.

Conclusion and Takeaways:

Reporting taxes on equity compensation causes confusion for employees, employers and tax practitioners alike.  The first step is for taxpayers to carefully read the offering plan to understand the type of plan (qualified/statutory or non-qualified) which will dictate the tax treatment.  Also keep in mind, there can exist disqualifying dispositions from statutory stock option plans if the required holding periods are not met.  Tax rules are complicated and it is possible to make a mistake self-reporting these types of transactions.