Stock Compensation Plans – Everything You Need to Know
Renee Daggett - Thursday, April 20, 2017
If you are one of the rising number of employees receiving some form of stock compensation through your job, you know how confusing it can be to understand how exactly each type works, how each is different, and the tax considerations you need to be aware of. Even if you’ve been receiving this type of compensation for some time now, you might still feel in the dark about what to expect when it comes to the tax consequences. If you’re looking for a simple and straightforward summary of the main types of stock compensation and the characteristics and tax implications of each, look no further!
1. What are they? Rights to buy a certain number of shares of company stock at a pre-set price
2. How do they work? The employee can buy a certain number of company shares at a set price – the “exercise price” (the fair market value of the stock on the date the options are granted)
3. How are they taxed? This depends on whether the options are nonqualified or qualified:
i. Nonqualified: The difference between the value of the shares on the purchase date and the price you are paying is the “spread” and is included in your wages, with taxes withheld on it, in the year of purchase. This will be included in your W-2 at year end and needs to be reported as income on your tax return. When you later sell the stock, you have a capital gain for the difference between the selling price and the fair market value of the shares when you bought the stock (remember – you already paid tax on that amount, through your wages!).
ii. Qualified: When you buy the stock, you do NOT have to include the “spread” in your income, as long as the stock acquired through exercise is held for the LATER of one year following the day the stock was transferred/acquired or two years after the option was granted to you. If these rules are met, when you sell the stock, you report a capital gain for the difference between the price you paid (exercise price) and the sales price. So, you pay capital gains tax rates on the entire resulting gain, instead of paying part at ordinary income tax rates with nonqualified options.
Employee Stock Purchase Plans (ESPPs)
1. What are they? Plans that allow employees to purchase employer’s stock at a discount, usually through contributions made via payroll deductions
2. How do they work? The employee contributes to a stock purchase fund and, at certain points during the year, the employer uses the funds to purchase stock for him/her (at a discount)
3. How are they taxed? The taxation occurs upon the sale of the stock. The calculation of the amount of ordinary income vs. capital gain depends on whether the ultimate sale of the stock constitutes a qualifying or disqualifying disposition:
i. Qualifying: This applies if you sold the stock at least two years after the offering/grant date and at least one year after the purchase (exercise) date. The LESSER of the per-share company discount times the number of shares or the gross sales price minus the actual discounted price is included in ordinary income upon the sale of the stock/included in your W-2. Then, The difference between the sales price and your cost basis (the price you paid for the stock PLUS what was included on your W-2 as ordinary income) is reported as a capital gain/loss on your tax return.
ii. Disqualifying: If you did not meet the requirements for a qualifying disposition (above), the amount included in ordinary income/on your W-2 is the difference between the market price on the purchase/exercise date and the actual price paid for the stock. Then, the difference between the sales price and your cost basis (the price you paid for the stock PLUS what was included on your W-2 as ordinary income) is reported as a capital gain/loss on your tax return.
1. What are they? Stocks that are granted to an employee that are nontransferable and can be forfeited under conditions such as employment termination or inability to meet certain performance benchmarks
2. How do they work? The employee is granted shares over a period of time, according to a vesting schedule lasting several years, and also receives voting rights
3. How are they taxed?
i. Without 83(b) election: The entire amount of the stock – the fair market value on the vesting date – is included in ordinary income/reported on W-2 in the year of vesting. Once sold, the difference between the sales price and the fair market value on the vesting date should be reported as a capital gain/loss on the tax return.
ii. With 83(b) election: The value of the stock on the grant date, not the vesting date, is reported as ordinary income/taxed in the year granted. If the stock price is rising rapidly, this could greatly reduce the tax liability. Once sold, the difference between the sales price and the fair market value on the grant date should be reported as a capital gain/loss on the tax return.
Restricted Stock Units
1. What are they? Promises to grant a set number of shares of stock upon completion of a vesting schedule
2. How do they work? The employee is granted shares of stock after vesting and forfeiture requirements have been met, and does not have voting rights during the vesting period (since no stock has been issued)
3. How are they taxed? No actual stock is issued on the grant date, so no 83(b) election is allowed. The fair market value of the stock on the vesting date is reported as ordinary income/on the W-2 in the year of vesting, and once sold, the difference between the sales price and the fair market value on the vesting date is reported as a capital gain or loss.
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