The Double Tax Trap Hidden in Your Stock Option Form 1099-B

You exercised company stock options, sold the shares, and received both a Form W-2 and Form 1099-B. The brokerage statement shows a large gain, so it may appear that the entire amount is taxable again as a capital gain.

That appearance can be wrong.

Part of the value may have already been treated as compensation and reported on Form W-2. If the tax basis reported on the stock sale is not properly reconciled with the compensation income, the employee may effectively pay tax twice on the same economic income.

This is one of the most important—and frequently overlooked—reporting issues involving employee stock options.

Why Stock Compensation Appears on Multiple Tax Forms

A single stock-option transaction can produce Form W-2 from the employer, Form 3921 for an incentive stock option exercise, Form 3922 for certain employee stock purchase plan transactions, Form 1099-B from the brokerage firm, exercise confirmations, and supplemental stock-plan reports.

Each document serves a different purpose. None should automatically be assumed to contain the complete tax answer. The employer may report compensation income. The brokerage firm reports the sale. The taxpayer and tax preparer must determine how the information fits together.

A Simplified Nonqualified Stock Option Example

Assume an executive exercises 5,000 nonqualified stock options with a $10 exercise price, a $50 stock value at exercise, and a $52 sale price shortly afterward.

At exercise, the difference between the $50 market value and the $10 exercise price is $40 per share. The total spread is $200,000. That amount is generally compensation income and may be included on the employee’s Form W-2.

The employee then sells the shares for $52 each, generating $260,000 of proceeds. Economically, the employee’s additional appreciation after exercise is only $2 per share, or $10,000.

But suppose the Form 1099-B or brokerage statement reflects only the original $10 exercise price as basis. It may appear that the employee has a $210,000 capital gain: $260,000 of proceeds minus $50,000 of reported basis.

That result would ignore the $200,000 already treated as compensation. The transaction may require a basis adjustment so the same $200,000 is not taxed once as wages and again as capital gain.

The IRS’s Instructions for Form 8949 explain the reporting and adjustment process for transactions in which the basis reported to the IRS requires correction.

Why the Brokerage Basis May Look Incomplete

Cost-basis reporting rules do not always require brokerage firms to incorporate compensation income arising from an employee stock transaction into the basis reported to the IRS.

The brokerage statement may provide supplemental information elsewhere, but that information is not always included in the primary Form 1099-B figures. The taxpayer may therefore receive one basis on Form 1099-B, another figure in a supplemental stock-plan statement, compensation income on Form W-2, and exercise information from the employer’s equity platform.

The correct treatment may require reconciling all four. This is not necessarily an error by the employer or brokerage firm. It is a consequence of different reporting obligations applying to different parties.

Incentive Stock Options Can Be Even More Complicated

Incentive stock options introduce additional issues because their treatment depends on how long the shares are held and whether the disposition is qualifying or disqualifying.

The employee should generally receive Form 3921 after exercising an ISO. The form reports the option grant date, exercise date, exercise price, fair market value at exercise, and number of shares transferred.

The IRS explains that Form 3921 should be retained to determine gain or loss when the shares are later disposed of and to evaluate the potential AMT consequences of exercising an ISO.

An ISO can have different implications under the regular tax and AMT systems. Following an exercise-and-hold transaction, the employee may need to track both regular tax basis and AMT basis. Those figures may not be the same.

When the shares are sold, the transaction can affect regular capital gain, AMT gain or loss, and the potential recovery of a prior minimum-tax credit. A brokerage statement generally does not perform the taxpayer’s complete dual-basis analysis.

A Disqualifying ISO Disposition Example

Assume an employee exercises 2,000 ISOs at a $15 exercise price when the shares are worth $60. The employee later sells the shares before satisfying the applicable ISO holding periods.

The spread at exercise is $45 per share. Depending on the subsequent sale price and other circumstances, some of the income may be treated as compensation and included on Form W-2. The sale will also appear on Form 1099-B.

If the wage income and stock-sale basis are not reconciled, the return could overstate the capital gain. If the compensation component is omitted, the return could understate ordinary income. The correct result cannot always be determined from Form 1099-B alone.

RSUs Can Produce the Same Basis Problem

Restricted stock units are not options, but they can create a similar reporting concern.

Suppose 1,000 RSU shares vest when the stock is worth $80. The $80,000 value is generally treated as compensation income, and the employee’s basis in the shares is ordinarily connected to that vest-date value.

If the employee later sells the shares for $83, the economic appreciation after vesting is generally $3 per share, or $3,000. If incomplete basis information causes the return to treat most or all of the $83,000 proceeds as gain, the same value may be taxed as both compensation and capital gain.

The Most Dangerous Assumption

The most dangerous assumption is that every tax document is independently complete.

Form W-2 may correctly report compensation. Form 1099-B may correctly report the information the broker is required to furnish. Form 3921 may correctly report the ISO exercise. Yet the tax return can still be wrong if those documents are not analyzed together.

Tax software does not necessarily recognize that two independently entered forms relate to the same shares. Accurate reporting depends on identifying the connection and applying the appropriate treatment.

Records Employees Should Preserve

  • Award agreements, grant notices, and vesting schedules
  • Exercise confirmations and trade confirmations
  • Forms 3921, 3922, W-2, and 1099-B
  • Supplemental brokerage statements
  • Records of shares sold to cover withholding
  • Prior-year AMT calculations
  • Documentation of mergers, stock splits, and other corporate actions

Employees who change employers should download their historical equity documents before losing access to the company’s stock-plan portal.

Common Stock-Compensation Reporting Mistakes

  • Reporting the Form 1099-B basis without reviewing supplemental information
  • Failing to connect W-2 compensation with the related stock sale
  • Losing Form 3921 before the shares are sold
  • Treating ISO, NQSO, and RSU transactions identically
  • Ignoring adjustments required on Form 8949
  • Failing to track regular and AMT basis separately
  • Combining tax lots with different exercise or vesting dates
  • Assuming shares sold to cover withholding require no further reporting
  • Entering every tax form independently without reconciling the transaction

Stock Compensation Requires Transaction-Level Reconciliation

An accurate return may require tracing the shares from grant through vesting or exercise and ultimately through sale. That includes determining what was already reported as compensation, whether the brokerage basis reflects it, which shares were sold, whether holding periods were satisfied, whether AMT applies, and whether more than one state has a connection to the income.

At Zagmout & Company CPAs, we help executives and employees reconcile equity-compensation documents and report stock transactions correctly. Our work considers the employer’s wage reporting, brokerage records, option documents, transaction history, and applicable regular-tax and AMT treatment.

How Zagmout & Company CPAs Can Help

Exercised or sold company stock? Zagmout & Company CPAs helps executives accurately reconcile Forms W-2, 3921, and 1099-B so compensation income, cost basis, and AMT treatment are evaluated together.

SCHEDULE YOUR FREE CONSULTATION

Disclaimer: This article is for general informational purposes only and does not constitute accounting, tax, legal, financial, or investment advice. The application of these matters depends on individual circumstances and should be evaluated with qualified professional advisers.

Your RSUs Were Withheld at 22 Percent. Your Tax Rate Wasn’t.

Restricted stock units frequently create an unpleasant surprise: taxes were withheld when the shares vested, but the employee still owes a substantial amount when the income-tax return is filed.

The problem is usually not that the RSUs escaped taxation. The problem is that the amount withheld may be considerably lower than the employee’s actual marginal tax rate. For a highly compensated employee, the difference can reach tens of thousands of dollars.

RSUs Are Generally Taxable When They Vest

A restricted stock unit represents an employer’s promise to deliver shares or their cash equivalent after specified vesting requirements are satisfied. Unlike certain restricted-stock awards, RSUs generally are not taxable when granted. The taxable event commonly occurs when the units vest and the shares are delivered.

The fair market value of the vested shares is generally treated as compensation and included on the employee’s Form W-2. The income is subject to federal income tax and applicable payroll taxes.

For example, assume an executive receives 4,000 shares when the company’s stock is worth $75 per share. The vesting event creates $300,000 of compensation income: 4,000 shares multiplied by $75.

The executive may not receive $300,000 in cash. The employer may retain or sell a portion of the shares to cover withholding. Seeing fewer shares delivered can create the impression that the tax obligation has been fully satisfied. That is not necessarily true.

Why 22 Percent Withholding Can Be Misleading

Employers may treat RSU income as supplemental wages. Under the federal supplemental-wage withholding rules, an employer may, when the applicable requirements are met, withhold federal income tax at a flat 22% rate on supplemental wages up to the relevant threshold.

The mandatory rate on supplemental wages exceeding $1 million during the calendar year is generally 37%. The detailed rules and available withholding methods are discussed in the IRS’s current Publication 15.

The withholding rate is not necessarily the employee’s ultimate income-tax rate.

Suppose an executive has $350,000 of salary and bonus income, a $300,000 RSU vest, married-filing-jointly status, a spouse with additional compensation, and federal withholding on the RSUs at 22%.

The employer might withhold $66,000 of federal income tax from the RSU vest. But some or all of that income may fall within a higher marginal federal bracket when the couple’s complete return is prepared.

If the relevant income were ultimately taxed at a marginal rate of 35%, the difference between a 35% rate and 22% withholding would be $39,000. This simplified illustration is not a calculation of the couple’s actual liability. It demonstrates the central problem: withholding is merely a prepayment. It is not a determination of the tax ultimately owed.

Multiple Vesting Dates Can Hide the Problem

Many executives receive RSUs that vest quarterly, monthly, or on several dates throughout the year. A single vest may not appear alarming, but the combined annual value can be significant.

Consider an employee with four quarterly vests: $75,000 in March, $90,000 in June, $110,000 in September, and $125,000 in December. The employee has received $400,000 of additional compensation during the year.

The cumulative amount may affect federal brackets, state income taxes, estimated-tax requirements, Additional Medicare Tax, income-sensitive deductions and credits, and the consequences of selling retained shares. A December vest is particularly important because little time may remain to address an underpayment before year-end.

Bonuses and Stock Compensation Compound the Exposure

RSU recipients frequently receive annual bonuses, performance compensation, nonqualified stock options, employee stock purchase plan shares, retention payments, deferred compensation, or capital gains from selling employer stock.

Each item may appear adequately withheld when viewed independently. Collectively, they may push the employee into a higher marginal bracket and create a significant payment obligation. The risk is even greater in a dual-income household where both spouses receive bonuses or equity compensation.

Payroll departments generally withhold according to standardized rules. They do not prepare a joint household tax projection incorporating the spouse’s income, investments, business income, capital gains, deductions, or estimated payments.

Selling Shares Does Not Eliminate the Vesting Income

Another common misunderstanding is that selling RSU shares immediately after vesting somehow avoids the taxable compensation. The vesting income has generally already occurred. Selling the shares creates a separate transaction.

Assume an employee receives 1,000 shares at vesting when the stock is worth $80. The employee generally has $80,000 of compensation income and an $80-per-share tax basis.

If the shares are later sold for $86, the additional $6 per share may create a capital gain. If they are sold for $72, the employee may have a capital loss. Selling immediately can reduce exposure to later price changes, but it does not reverse the original compensation income.

State Taxes Create Another Layer of Risk

Employees who live or work in more than one state may face additional complexity. RSU income may need to be allocated based on where the employee performed services during the applicable grant-to-vest period.

This becomes especially important when an employee relocates, works remotely from another state, transfers between offices, or moves shortly before a large vest. Changing residency before vesting does not necessarily eliminate the former state’s potential claim to the income.

Common RSU Tax Mistakes

  • Assuming shares withheld for taxes fully satisfy the liability
  • Confusing the withholding rate with the final tax rate
  • Forgetting to include a spouse’s income in the projection
  • Ignoring future vesting dates or a large annual bonus
  • Treating each vest as an isolated event
  • Overlooking state sourcing after a move
  • Selling shares without preserving vest-date information
  • Failing to review the basis reported by the brokerage firm
  • Waiting until tax-return preparation to discover the shortfall

The Tax Projection Should Come Before the Surprise

An equity-compensation projection should consider the complete household tax picture, including expected salary, bonuses, RSU vesting, stock sales, investment income, deductions, withholding, estimated payments, and state residency.

At Zagmout & Company CPAs, we work with executives and other highly compensated employees to evaluate the tax consequences of RSU vesting and related stock transactions. This may include projecting the annual liability, reviewing withholding, assessing estimated-payment exposure, and coordinating the information required for accurate tax-return reporting.

How Zagmout & Company CPAs Can Help

Have RSUs vesting this year? Zagmout & Company CPAs helps executives evaluate projected income, withholding, estimated payments, and multistate exposure before an underpayment becomes a filing-season surprise.

SCHEDULE YOUR FREE CONSULTATION

Disclaimer: This article is for general informational purposes only and does not constitute accounting, tax, legal, financial, or investment advice. The application of these matters depends on individual circumstances and should be evaluated with qualified professional advisers.

The AMT Trap: How Many ISOs Can You Exercise Before the Tax Bill Arrives?

Incentive stock options can create substantial wealth. They can also generate a substantial tax bill before you have received any cash from selling the shares.

This surprises many employees because exercising an incentive stock option, or ISO, generally does not produce ordinary taxable income under the regular federal income-tax system. But the same transaction may produce income under the alternative minimum tax system.

The result can be a tax liability based on income that exists only on paper.

Before exercising ISOs, the important question is not simply whether the company’s stock price will increase. It is: How many options can you afford to exercise after accounting for the purchase price, alternative minimum tax, estimated payments, and the risk of continuing to hold the shares?

There is no universal answer. The number must be determined using the taxpayer’s complete projected tax situation.

Why Exercising ISOs Can Trigger AMT

When an employee exercises an ISO and continues holding the shares, the difference between the stock’s fair market value and the exercise price is generally included in alternative minimum taxable income. This difference is commonly called the bargain element or spread.

For example, assume an executive has 20,000 vested ISOs with an exercise price of $5 per share and a current fair market value of $45 per share. Exercising all the options requires $100,000 to purchase the shares.

The spread is $40 per share: $45 fair market value minus $5 exercise price. Exercising all 20,000 options would create an $800,000 AMT adjustment.

The executive has not sold the shares and has not received $800,000 in cash. Nevertheless, that amount may enter the AMT calculation for the year of exercise. The executive must therefore consider both the cash needed to acquire the shares and the potential tax resulting from the AMT adjustment.

The IRS reports ISO exercises on Form 3921, which provides the grant date, exercise date, exercise price, fair market value at exercise, and number of shares transferred. Those figures are critical to determining the potential AMT adjustment.

Why There Is No Simple AMT-Free Number

Employees often ask how many ISOs they can exercise without triggering AMT. Unfortunately, the answer cannot be determined from the option statement alone.

The calculation may be affected by filing status, salary and bonus income, a spouse’s income, RSU vesting, investment income, capital gains, deductions, state income taxes, other AMT preference items, prior-year minimum-tax credits, earlier exercises, and expected year-end income.

Two employees with identical option grants may have dramatically different tax consequences. Consider two executives who each exercise ISOs producing a $300,000 bargain element. One is single and earns $600,000. The other is married, earns $250,000, and has a spouse who temporarily stopped working.

The same transaction may produce different AMT results because their regular tax liabilities, AMT exemptions, exemption phaseouts, deductions, and household income are different. That is why relying on a coworker’s experience can be dangerous.

The Exercise-Date Stock Price Matters

The AMT adjustment is generally based on the stock’s fair market value when the options are exercised—not its value on December 31.

Suppose an employee exercises options when the stock is worth $70 per share. By year-end, the shares are worth only $35. The employee may still face an AMT calculation based on the $70 exercise-date value even though the investment has lost half its value and no shares were sold to fund the tax.

Depending on the circumstances, selling some or all of the shares before year-end may change the treatment. However, that decision can create a disqualifying disposition, affect the character of the income, and alter the employee’s investment position. Waiting until tax-return preparation may eliminate available planning alternatives.

Exercise and Hold Versus Exercise and Sell

An ISO transaction may involve exercising and retaining the shares, immediately selling them, selling enough shares to cover costs, exercising only a portion, exercising over several years, or holding long enough to pursue a qualifying disposition.

Each alternative can produce a different combination of ordinary income, capital gain, AMT, minimum-tax credit, cash requirements, market exposure, and concentration risk.

A strategy that minimizes this year’s tax may increase investment risk. A strategy that pursues long-term capital-gain treatment may require the employee to hold a concentrated position while using personal cash to pay the exercise price and AMT. Tax treatment should not be analyzed in isolation.

Paying AMT Does Not Automatically Mean the Strategy Failed

AMT generated by an ISO exercise may create a minimum-tax credit that can potentially be used in future years. However, the credit is not necessarily refunded in full when the shares are sold.

Recovery can take several years and depends on the relationship between the taxpayer’s regular tax and tentative minimum tax in each subsequent year. A large AMT payment can therefore become a significant amount of capital tied up with the government.

Common ISO Exercise Mistakes

  • Exercising based only on the cash required to purchase the shares
  • Ignoring AMT because no shares were sold
  • Exercising shortly before year-end without a tax projection
  • Assuming the employer will withhold enough tax
  • Using a coworker’s exercise strategy
  • Exercising all vested options in one year without comparing alternatives
  • Holding shares exclusively for tax reasons despite excessive concentration
  • Failing to retain Form 3921
  • Missing estimated-tax or safe-harbor requirements
  • Assuming an AMT credit will be recovered immediately

Model the Transaction Before Exercising

An ISO exercise should be modeled before the employee commits the cash and acquires the shares. A proper projection may need to compare several exercise amounts and stock-price scenarios under both the regular tax and AMT systems. It should also consider estimated payments, existing withholding, state taxes, liquidity needs, and the consequences of a later sale.

At Zagmout & Company CPAs, we help executives and employees evaluate equity-compensation transactions before they exercise or sell. The objective is not simply to calculate a tax bill after the transaction has occurred. It is to identify the exposure while the client still has choices.

How Zagmout & Company CPAs Can Help

Considering an ISO exercise? Zagmout & Company CPAs helps executives evaluate the potential regular-tax, AMT, cash-flow, and estimated-payment consequences before the transaction is completed.

SCHEDULE YOUR FREE CONSULTATION

Disclaimer: This article is for general informational purposes only and does not constitute accounting, tax, legal, financial, or investment advice. The application of these matters depends on individual circumstances and should be evaluated with qualified professional advisers.

5 Things You Should Know About Incentive Stock Options


Incentive stock options (ISOs) are a form of compensation package awarded to key employees as a reward for achieving specific milestones, a vehicle to retain top employees, and an opportunity to share in the company’s success and align employees’ interest with the interest of the company.

ISOs can be a lucrative long-term compensation benefit, and a source of wealth accumulation, especially if you work for a high growth company with a rising stock price. Because ISOs may be highly valuable, there are special tax and financial components that are worth studying.

1 – What is an Incentive Stock Option?

An incentive stock option gives you the right to purchase shares of your company at a predetermined price during a predefined time frame.

You are given – or “granted” – a certain number of ISOs allowing you to buy – or “exercise” your options during a specific time frame – or when you are “vested”.

2 – What is the process of receiving ISOs?

When you are awarded ISOs from your company in a form of an option grant, normally, you will have to “accept” the option before it becomes official.

Your company, or your HR department will provide you with several documents which may include the stock option plan, the plan prospectus, and specific stock grant details. It is wise to read through the documents as they provide you with details about your rights, obligations, restrictions, and limitations.

The option grant letter will also provide you a vesting schedule. The vesting schedule specifies the time frame when you can exercise your stock options.

For example, a 12,000 ISOs with a monthly vesting of 1,000 ISO. Or a 5-year plan with a 20% vesting per year. This type of vesting schedules is designed to reward employees for staying with the company for a longer period, and it is also used as a retention tool to retain top employees. The stock option plan also details forfeiture provision should you leave the company before your ISOs vest.

3 – How do you exercise your Incentive Stock Options?

There are 3 strategies you can employ to exercise your ISOs. The approach you choose will depend on several factors such as: your cash flow position, short- and long-term financial goals, and your tax situation.

Exercise strategy 1 – Cash upfront

The simplest and easiest way to exercise ISOs is by paying with cash. When you exercise, you must deliver the cash to pay for the exercise cost of acquiring your company’s stocks. This is the best strategy if you are bullish on your company’s outlook, have the cash to exercise the ISOs, and want to maximize the number of shares you own.

In this example, you were granted 5,000 shares at an exercise price of $10 per share. You could choose to exercise all or portion of the 5,000 shares. Exercising all shares will require you to invest $50,000 of cash up front.

Exercise strategy 2 – Sell enough of ISO to cover exercise cost

You can convert by selling 1,000 share @ $50 each, you will receive $50,000. That is enough to pay for all your 5,000 shares leaving you with 4,000 remaining shares.

Exercise strategy 3 – Cashless Exercise

A cashless exercise can be designed in a way that:

  • Can cover only the exercise cost of shares you need to purchase
  • Can cover the exercise cost plus tax liability due on the exercise and the sale of stocks

4 – When Should I exercise my Incentive Stock Options?

Evaluating the pros and cons of exercising stock options is a topic where a financial expert can be invaluable.

Like most things in life, the decision to exercise is a judgment call. It is based on whether you need the money now, pay for kids’ education, supplement you income, or lowering your taxes now vs later. Another factor is your confidence in your company’s ability to grow and the share price to continue to rise, or the need for diversification since most ISO recipients tend to have a lion’s share of their wealth tied to their companies’ stocks.

You are considered an insider, an executive with inside knowledge of the company’s strategic plans and outlook, you may only be able to exercise within a specific time called trading window. If you are not sure of your status, you may want to consult your legal department before you exercise your ISOs or sell your common stocks.

5 – What are the tax implications of Incentive Stock Options?

There are two main tax possible outcomes related to the exercise. The tax treatment may be either a qualifying distributions or disqualifying distributions.

Qualifying distributions may help minimize your tax liability by adhering to a special holding period prior to the final disposition of stocks.

These requirements are:

  • No disposition of stocks before the later of the following two dates:
    • One year after the date you exercise your ISOs
    • Two years after the date your employer granted the ISOs to you

A qualifying distribution entitles your profit to be treated as a long-term capital gain, which is taxed at a lower rate than ordinary income, which tends to be higher than long-term capital gain rate.

Disqualifying distributions occur when you exercise ISOs in a way that does not meet the rules of qualifying distributions. Example of such transactions that causes your ISOs to be a disqualifying distribution:

  • Not satisfying the special holding period (listed above)
  • A gift to someone other than spouse
  • Using shares to exercise another incentive stock option
  • Transferring your shares to an irrevocable trust

Certain events do not give rise to a disqualifying disposition:

  • An exchange of shares that is part of a tax-free reorganization of the corporation that issued the shares
  • A transfer that occurs as a result of death
  • A pledge or hypothecation (meaning, using the stocks as a collateral)
  • A transfer of stocks into joint tenancy
  • A transfer to a spouse (or to a former spouse in connection with a divorce)

Not all disqualifying distributions are bad; sometimes it is beneficial to cause a transaction to be a disqualifying disposition. This can benefit you in case of a possible drop in stock price. In this case it may be a planning opportunity to avoid AMT tax!

Alternative Minimum Tax (AMT)

The alternative minimum is a parallel tax system to the regular tax system that was originally enacted to ensure that high-income taxpayers pay at least a minimum amount of tax if they benefit from certain deductions and other tax preference items.

ISOs fall under this parallel tax system where the spread between the exercise price and fair market value FMV is considered as a taxable income, although no cash is received (phantom income).

However, there are opportunities where you can exercise just enough ISOs to stay under the AMT radar. Sometimes it is beneficial to pay the AMT tax which will result in an AMT credit in future years.

In the event you are subject to Alternative Minimum Tax from the exercise of your ISO, you will need to file Form 6251 with your Form 1040.

Conclusion

Incentive stock options is a power wealth accumulation tool if you are a lucky recipient. They also can be a source of potential complication in the absence of a proper tax and financial planning.

How Zagmout & Company CPAs Can Help

Zagmout & Company CPAs helps executives evaluate ISO exercises across the regular-tax and AMT systems, including potential cash-flow, estimated-payment, and future disposition consequences before action is taken.

SCHEDULE YOUR FREE CONSULTATION

Disclaimer: This article is for general informational purposes only and does not constitute accounting, tax, legal, financial, or investment advice. The application of these matters depends on individual circumstances and should be evaluated with qualified professional advisers.

ESPP Taxation: What You Need to Know

Many large employers offer an Employee Stock Purchase Plan (ESPP) as part of your compensation package. These plans are offered as an employment incentive, giving you an opportunity to share in the growth potential of your company’s stock.

You may be wondering what this means to you and whether this option is worth taking advantage of. In general, an ESPP is an excellent offering that gives employees the ability to purchase shares of a company’s stock. Still, there are some nuances to be aware of—especially as it relates to taxation.

By having a better understanding of what ESPPs are and how they work from a tax perspective, you can make the right decision for your own unique investing and financial needs.

What is an Employee Stock Purchase Plan?

Specifically, an ESPP refers to a benefit plan that allows employees to purchase shares of their employer’s stock easily and conveniently. Perhaps the biggest advantage of this type of plan is that these shares can be purchased using after-tax payroll deductions. Shares are also typically offered at a hefty discount of up to 15% of the actual market price. For employees taking part, these plans offer an excellent opportunity for employees to stake their own claim in a company’s short- and long-term success.

Understanding Qualified vs. Nonqualified Plans

For tax purposes, it is important to understand that there are two different kinds of ESPPs out there: qualified and non-qualified. Each has its own important rules and stipulations to follow, so you’ll want to be aware of which option your employer is offering.

Qualified ESPPs

A qualified ESPP (which is also the most common type) has to be approved by a shareholder vote before it can be implemented. From there, every employee participating in the plan has equal rights. There are also limits on offering periods and discounts on this type of plan; specifically, offering periods must be 27 months or less, and stock discounts to employees may not exceed 15%.

With qualified ESPPs, participating employees may also be subject to income tax or capital gains tax on their earnings here. In most cases, participants will pay income tax on either the discount offered based on the offering date price or the total gain between purchase and sale price(whichever is lower).

Nonqualified ESPPs

A nonqualified plan operates a bit differently. While these ESPPs are not as common as qualified plans, it is still worth being aware of the rules and tax regulations surrounding these plans. The main thing to be aware of is that with a nonqualified plan, it is possible for an employee to be subject to both income tax and capital gains tax.

Specifically, participants pay income tax on the difference between their original purchase price and the market price for that day. Likewise, employees may also owe a capital gains tax on the difference between the purchase price and final sale price.

With all this in mind, it’s easy to see why a qualified ESPP is typically the more ideal option for employees. In general, participants will pay less in taxes on their earnings from these shares with a qualified plan than they would with a nonqualified plan. Regardless of the type of ESPP you may participate in, being aware of these tax rules can help you make more informed investing decisions.

Other ESPP Tax Considerations

In addition to different taxation rules for qualified vs. nonqualified plans, ESPPs are also subject to some other complex tax rules. There are many factors that come into play when determining how an ESPP will be taxed, including:

  • how long the stock has been held
  • the original purchase price of the stock
  • the closing price of the stock on the offering date
  • the final closing price of the stock when purchased

In general, stocks purchased using an ESPP will be taxed at a lower rate when it is held for at least a year or two after purchase. Stocks sold prior to this may be taxed at a higher rate.

The Bottom Line on Employee Stock Purchase Plans

If your employer offers an ESPP, whether it be a qualified or nonqualified plan, this is certainly a benefit worth exploring further. Just make sure you fully understand your own tax requirements and potential tax burdens. Even though these plans allow you to purchase shares of a company with after-tax payroll deductions, there are still important nuances to be aware of that could affect your bottom line.

If you have any questions regarding this article, or if you need further assistance regarding your unique financial or tax situation, send us an email at info@zagmoutcpas.com, or call us at (312) 239-3716.

To learn more, visit Zagmout & Company CPAs at www.zagmoutcpas.com.

Disclaimer:

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.

Restricted Stock Units (RSU) – What You Should Know

As a key employee of your company, your compensation is often tied directly to the performance of the company. As a part of your compensation you may receive stock options known as restricted stock units (RSU) instead of a cash payment or bonus.

What are Restricted Stock Units?

One of the biggest mistakes young people make after securing their first jobs is getting careless with their spending. While it’s true that you may be making more money now than you have at any other point in your life, this isn’t a free pass to start spending with reckless abandon.

If you don’t already have a budget in place, now is the time to create one using one of the many free apps available. Ideally, you should be allocating at least 10% of your salary to savings. From there, your other essential expenses should total no more than 50% of your income. As you review your budget, take some time to notice where you’re spending more money than you’d like (dining out or entertainment, for example) and cut back.

Are Restricted Stock Units Taxable Income?

Restricted stock units (RSU) are considered to be taxable income. While there is no taxable event at the time the shares are granted, once the shares vest, and you take possession of the shares, this becomes ordinary income to you. The share value will be equal to the fair market value of the shares at the time they vest. The amount of income you receive is included in your W-2 and taxes are withheld based on your withholding elections. This may or may not be enough to cover the entire tax burden for the year. You will want to ensure that you are prepared to pay any additional tax liability that may not be covered by withholding.

For example, based on our example above, let’s say that the 1,000 shares that vest in year one, have a fair market value of $20 per share. The compensation included on your W-2 for the year would include the additional $20,000 in income.

Once you own the shares, the next taxable event will be upon the sale of the shares. If you hold the shares for less than a year, you would be subject to short-term capital gains tax rates equivalent to your ordinary income tax rate.

If you hold the shares for a period greater than one year, you would be subject to long-term capital gains tax rates capped at a maximum of 20%.

As the shares are not considered tangible property to you prior to vesting, they would not qualify for the Internal Revenue Code (IRC) 83(b) election. This election would allow an employee to pay tax on the share prior to vesting. This would be beneficial if the share price at the time of the grant was lower than at the time the shares would vest.

Are Restricted Stock Units the Same as Stock Options?

Stock options are different from restricted stock units in that they typically give the employee the right to receive the shares, even though they would not be required to do so.

Restricted stock units on the other hand, typically provide the employee with a predetermined number of shares over a set number of years that they remain with the company.

Restricted stock units can be a win-win for both the employer and employee of a company. The employer does not have to provide an upfront outlay of cash as compensation to the employee and provides an incentive for the long-term. The employee receives the benefit of the shares which will hopefully increase in value and help tie their compensation to the performance of the firm.

Having a strategy for the vesting of restricted stock units is crucial to avoid any financial pitfalls associated with the potential tax liability when the shares are received and subsequently sold.

How Zagmout & Company CPAs Can Help

Zagmout & Company CPAs helps executives evaluate RSU vesting, withholding, stock sales, estimated payments, and multistate tax exposure as part of the complete household tax picture.

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Disclaimer: This article is for general informational purposes only and does not constitute accounting, tax, legal, financial, or investment advice. The application of these matters depends on individual circumstances and should be evaluated with qualified professional advisers.

Equity Compensation Benefits: Life after the IPO

Equity compensation benefits allow employees to share in the profits and successes of the company in which they work. They encourage retention and give workers a direct interest in increasing company profits and the bottom line. This type of benefit is sometimes used to supplement below-market salary rates, but they can also simply be a bonus to a standard market-based salary as well.

While many employees are inclined to their interest sit for a long period of time, you can miss out on earnings opportunities if you do not take action. However, maximizing the value of this asset depends on a wide variety of factors that you must consider before you make any major changes. Good planning can help you get the most out of your equity compensation benefits.

In addition, equity compensation is used both for private companies and publicly traded employers. When a private company switches to a public company, equity compensation benefits can take a substantial loss.

Equity Compensation and the IPO

Equity compensation plans can exist before an IPO (Initial Public Offering). However, they must undergo substantial changes when a company goes public. For example, restrictions on transferring the stock (that are pretty common in private companies) must be revised or deleted entirely. The IPO might also trigger additional changes that affect items such as stock bonuses, stock appreciation rights, restricted stock units, and more.

Keep in mind that an IPO does not necessarily mean that employees have to sell their stocks back or that they have to make any changes to their holdings at all. However, many companies make the decision to do a “reverse stock split” just before they go public. In that type of situation, the total number of shares will go down—sometimes significantly. These adjustments are necessary to reach a per-share value that equals the desired IPO price.

For employees holding equity, this change can result in a huge decrease in the value of their initial holdings. That means that even if the employee makes no changes to their holdings, it may suddenly be worth significantly less than before the IPO.

What an IPO Means for Selling Equity Compensation Benefits

Private equity compensation holdings often have a wide variety of restrictions. In some cases, you cannot sell at all. In other situations, you are restricted to selling during a particular window or only after holding the assets for a specific period of time.

If the company has just gone through an IPO, you may not be able to make any changes for a period of time after the IPO. These “lock-up” or “blackout” periods are commonly in the range of about six months, but they can be longer or shorter.

Choosing the Right Time to Sell

If you have the option to sell before a looming IPO, you may want to seriously consider taking action. Talk to a tax professional about your unique situation so they can help you work through the best options based on your rights as an equity holder.

How Zagmout & Company CPAs Can Help

Zagmout & Company CPAs helps executives evaluate the tax consequences of equity compensation before and after an IPO, including withholding, estimated payments, stock sales, and multistate reporting.

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Disclaimer: This article is for general informational purposes only and does not constitute accounting, tax, legal, financial, or investment advice. The application of these matters depends on individual circumstances and should be evaluated with qualified professional advisers.

What is an 83(b) Election? Advantages and Potential Pitfalls

The 83(b) election, named after the provision in the Internal Revenue Code that permits this strategy, allows an employee or founder of a business a special option to prepay the tax on the total restricted stock’s fair market value at the time the equity is granted instead of the time when the equity is vested; thus paying taxes on a total equity on a lower valuation (assuming the value of the stock increases over time)

The Pros and Cons of the 83(b) Election

When a founder or an employee receives equity compensation, that stake is subject to ordinary income tax. However, the equity granted often does not vest until sometime later, based on a preset vesting schedule. E.g., 25% vests annually starting on the 1st work year anniversary.

Under normal situation, the income tax obligation is not triggered until the equity vests. By the time the equity vests, it is often worth much more than it would have been worth when the equity was issued. The result is that the founder or employee will end up paying a significantly higher tax on the vesting date compared to the date that they first received the stake. The 83(b) election allows founders and employees to choose to incur the tax burden right away, instead of waiting.

If you expect your restricted stocks to increase in value between the grant date and the vesting date, then you may wish to accelerate the recognition of tax on your equity. Any appreciation from that point on is treated as capital gains at the date of sale, which is taxed favorably if the equity is held for at least one year. This acceleration can occur if you timely make an 83(b) election with the IRS.

However, if the 83(b) election is not made, and the stock price increases, then you will end up paying ordinary tax on a higher valuation on each vesting date period. If the value of the shares have significantly increased in that first year and over the next vesting period, then the difference in tax can be substantial.

When does it not make sense to make the 83(b) election?

The 83(b) elections is an irrevocable election; the IRS does not allow for an overpayment claim if you make the 83(b) election and the equity value decreases or the company becomes bankrupt.

Although the election makes sense if you believe in the fundamentals of the company, and believe the value of the company to continue increasing. There are situations where the election does not work to your advantage, including the following:

  • If you expect the value of the stock to go down, then it would make sense to wait until your equity vests then recognize ordinary income. If you already made the election and the value went down, you would have paid more taxes than necessary.
  • If you expect to leave the job before vesting, or to meet applicable milestones.

Additional considerations:

  • The 83(b) election must be filed within 30 days of receipt of the property.
  • An 83(b) election is generally irrevocable once made.
  • 83(b) elections should be filed by certified mail with return receipt requested as the burden is on the person filing the election to prove the timely filing of the election.
  • Please consult with your financial or tax adviser if you have questions regarding how an 83(b) election will impact you.

A Practical Example of an 83(b) Election

Imagine that an employee or a founder gets 500,000 shares of a company, but he or she receives these shares over a four-year vesting period, with 25 percent of the shares vesting on the first four anniversaries of the issuance date, in exchange for their services. If an 83(b) election is filed, then the fair market value of all 500,000 shares is treated as compensation income to the founder or employee at the time of grant

However, if the 83(b) election is not filed, then the first 25% or 125,000 shares vest after one year, and ordinary income would be recognized, if the value of the shares have significantly increased in that year and over the next four years, then the difference in tax can be substantial.

For the purpose of this example, let’s assume the shares have a value of $0.02 when granted, $0.50 at the end of year one, $1 at the end of year two, $2 at the end of year three, $3 at the end of year four, and the ordinary tax rate is 35%.

  • If the employee or founder timely makes an 83(b) election, then he or she will pay ordinary income tax on $10,000 ($0.02/share * 500,000 shares) at grant, and the total ordinary income tax owed is $3,500 (35% * $10,000)
  • However, if the election is not made, then the total taxes paid is a whopping $284,375 in ordinary income tax on the receipt of the shares:

When and How to File for an 83(b) Election

You must file for an 83(b) election within 30 days of your receipt of the restricted stock or stock option exercise. The 30 days is measured by the date on which your election is mailed to the local IRS office in your area. When the 30-day deadline falls on a weekend or holiday, the deadline extends to the next business day.

83(b) elections should be filed by certified mail with return receipt requested as the burden is on the person filing the election to prove the timely filing of the election.

There is no official form to make an 83(b) election. Some companies have created their own forms that you can use, but many companies do not provide this type of resource. Instead, the IRS recommends that you provide some specific language to make the election that would satisfy the IRS requirements.

How Zagmout & Company CPAs Can Help

Zagmout & Company CPAs helps founders and employees evaluate whether an 83(b) election applies, the tax exposure created at transfer, and the consequences of the irrevocable 30-day decision.

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Disclaimer: This article is for general informational purposes only and does not constitute accounting, tax, legal, financial, or investment advice. The application of these matters depends on individual circumstances and should be evaluated with qualified professional advisers.