Executive Bonuses Require Plans for Nonstatutory Stock Options

It’s that time of year when many executives receive their bonuses and when tax advice is needed on the best way to cash in on those bonuses—especially stock options.

Stock options are a right to purchase stock at a specified price. There are two types of stock options: statutory stock options, commonly referred to as incentive stock options, and nonstatutory stock options, also called nonqualified stock options.

A nonstatutory stock option is any option that doesn’t qualify as an incentive stock option under the Internal Revenue Code. Companies offer stock options to reward either their employees or independent contractors for providing services. The underlying stock price may fluctuate throughout the life of the option—specifically at the grant, exercise, lapse, and sale dates. Below are general tax rules and tax planning opportunities related to nonstatutory stock options.

Nonstatutory Stock Option Tax Rules

Grant date: There are no tax consequences on the date of grant unless the option has a readily ascertainable fair-market value, which are options actively traded on an established market. In practice, companies rarely issue traded options, especially privately held companies. Most employees or independent contractors receive options that don’t have a readily ascertainable value and thus generally report compensation income on the exercise date.
Exercise date: Recognize compensation income equal to the fair-market value of the stock at exercise less the exercise price (the amount paid for the stock). The exception is if the underlying stock is either subject to a substantial risk of forfeiture (i.e., must work for the company for a certain number of years) or has transferability restrictions (i.e., may not sell, assign, or pledge underlying stock). Compensation income is taxed as ordinary income at higher federal tax rates, with a top rate of 37%. Restrictions on selling stock due to blackout periods doesn’t constitute substantial risk of forfeiture. If compensation income is taxed at grant (i.e., has a readily ascertainable value), no additional income is taxed upon exercise.
Lapse date: Recognize compensation income at the lapse date, which is when stock is no longer subject to a substantial risk of forfeiture or has transferability restrictions. Compensation income is equal to the fair-market value of the stock at lapse date less the exercise price.
Sale date: The capital gain or loss realized equals the fair-market value at sale less basis. The basis equals the exercise price plus the compensation income previously realized. Capital gains are taxed at the lower capital gain tax rates up to 20%. An additional 3.8% net investment income tax may be imposed.

Tax Planning

For purposes of discussion, the focus is on options that are not actively traded on an established marked, where the taxable event occurs at exercise.

When to Exercise

Timing of when to exercise is critical. At the exercise date, the individual takes possession of the stock and must recognize compensation income as wages (employees) or nonemployee compensation (independent contractors). The goal is to reduce the amount of compensation income generated at exercise, since employees or independent contractors pay the highest tax rate up to 37% on compensation income.

A planning technique when the exercise price is low is to exercise nonqualified stock options on a date the fait-market value at exercise is close to or equal to the exercise price. Multiple factors such as stock price, tax rate, fair-market value at exercise, projected sales price and exercise price should be considered at this time to minimize the tax and maximize cash inflow.

Since nonqualified stock options generate wages for employees at exercise, the income is subject to payroll tax withholding. The issue is the wages are paid in kind as opposed to cash. Employees should address this with their employer on how their employer plans to withhold on these wages (i.e., receive net shares). After exercising, employees have a choice to either hold or sell the stock.

Hold or Sell

Employees or independent contractors who don’t have liquidity needs may want to hold onto the stock if the employee or independent contractor expects the stock price to increase. If the stock price goes up after the exercise date, the employee or independent contractor locks in the lowest amount of ordinary income. Any appreciation from this point forward is considered capital gain.

A possible strategy is to sell the stock in the exercise year and use the proceeds to purchase the same stock. The employee or independent contractor will have the cash to pay the tax on the compensation income and may benefit from any appreciation in the stock later. Alternatively, the employee or independent contractor may take a hybrid approach. Sell some of the shares and hold the rest to manage cash flow and risk.

If the individual anticipates the stock price will decline, then the employee or independent contractor should consider selling the stock. If the stock price goes down after exercise, the employee or independent contractor may pay tax on more income than the cash proceeds they receive when the stock is sold.

When the stock is subsequently sold for less than the fair-market value at exercise, the employee or independent contractor recognizes a capital loss, which can be used to offset other capital gains. To the extent capital losses exceed capital gains in the year of sale, the excess capital losses may only offset ordinary income up to $3,000 annually, with any unused capital losses carrying over to future years.

Lapse Date and Section 83(b) Election

After the individual exercises the option and purchases stock, the stock itself may still have restrictions. Due to these restrictions, they aren’t required to recognize compensation until those restrictions lapse. This exposes the individual to the possibility the stock price may increase from the exercise date to the lapse date. If the stock price increases, the individual will pay more tax than necessary.

Taxpayers may mitigate this risk by making a Section 83(b) election to treat the income as earned on the exercise date. Taxpayers must make the election within 30 days of transfer (exercise date).

There is a potential downside risk to making a Section 83(b) election. If an employee or independent contractor forfeits the stock (i.e., they leave the company), no deduction is allowed to recoup the income previously recognized due to the 83(b) election. However, the taxpayer may claim a capital loss on the amount the employee or independent contractor paid for the stock.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Alyssa Rausch is a senior tax manager in EisnerAmper’s private client services group. She has more than 15 years of experience in providing comprehensive tax compliance and advisory services to high net worth individuals, closely held businesses and their owners, S corporations, and partnerships.