The Tax Consequences of Employee Stock Options

Under the doctrine of constructive receipt, any transfer of property from an employer to an employee is considered to be compensation and is taxable on transfer. "Property" can take many forms, however, and the form often determines just how and when a particular kind of compensation is taxed. This is the case with employer grants of stock options which, as Karen Field of KPMG WNT said in her APA Congress workshop on Stock Options and Other Related Arrangements, come in various forms with various tax consequences.

In an unrestricted transfer of stock, for example, the employer simply gives the employee a certain number of shares, the value of which is included in the employee's income. FIT and FICA must be withheld--which may involve the sale of some of the stock or a separate payment from the employee to the employer, since no cash is being paid to the employee from which taxes can be withheld--and payment and withholding reported on the employee's Form W-2.

As Field noted, however, the tax consequences of other transfers of stock can be less straightforward. In a nonqualified stock option plan, for example, an employer gives an employee the right to purchase a certain number of shares at a certain price which is generally lower than the current fair market value (FMV) of the stock. When the employee exercises the option (buys the stock), the "spread" must be included in the employee's income, i.e., the difference between the FMV and what the employee actually paid for the stock, since that difference is in effect an employer-to-employee payment. Taxes must be withheld from the spread and the amount reported on Form W-2 in boxes 1, 3, and 5 and in box 12 with code V.

Incentive stock options (ISOs) add yet another layer of complexity, Field said. In an ISO plan, an employee is given the option to purchase stock at some future time for the FMV of the stock on the day the option is granted. In other words, if a share of stock is worth $5 on the day the option is granted, the employee pays $5 for the share even if on the day he or she exercises the option the FMV of the share has risen to $10. If the employee holds the stock for the required period (at least two years after the option is granted or one year after it is exercised), the spread between the FMV of the stock and the option price is not considered compensation.

Finally, employee stock purchase plans (ESPPs) allow employees to purchase shares of their employer's stock at a discount, the spread not considered compensation if the employee holds the stock for at least two years after the option is granted or one year after it is exercised. If the employee sells the stock too early (in what is known as a "disqualifying disposition"), the spread becomes taxable income. If the employee holds the stock for at least the minimum period, sales thereafter are treated as capital gains (or losses).

By Richard Vollmar, CPP