If you’re an executive or other key employee with a larger company, you may receive incentive stock options (ISOs). ISOs receive tax-favored treatment but must comply with many rules. ISOs allow you to buy company stock in the future (but before a set expiration date) at a fixed price equal to or greater than the stock’s fair market value (FMV) at the date of the grant.
Therefore, ISOs don’t provide a benefit until the stock appreciates in value. If it does, you can buy shares at a price below what they’re then trading for, provided you’re eligible to exercise the options. Here are the key tax consequences:
You owe no tax when the ISOs are granted
You owe no regular tax when you exercise the ISOs
If you sell the stock after holding the options for at least one year and then holding the shares for at least one year from the exercise date, you pay tax on the sale at your long-term capital gains rate. You also may owe the NIIT.
If you sell the stock before long-term capital gains treatment applies, a “disqualifying disposition” occurs and any gain is taxed as compensation at ordinary-income rates. (Disqualified dispositions aren’t, however, subject to FICA and Medicare tax, including the additional 0.9% Medicare tax.)
Note: If you don’t sell the stock in the year of exercise, a tax “preference” item is created for the difference between the stock’s FMV and the exercise price (the “bargain element”) that can trigger the AMT. A future AMT credit, however, should mitigate this AMT hit. Plus, you may now be at lower AMT risk because of the higher AMT exemption and exemption phaseout range under the TCJA. Consult your tax advisor because the rules are complex. If you’ve received ISOs, plan carefully when to exercise them and whether to immediately sell shares received from an exercise or hold them. Waiting to exercise ISOs until just before the expiration date (when the stock value may be the highest, assuming the stock is appreciating) and holding on to the stock long enough to garner long-term capital gains treatment often is beneficial. But there’s also market risk to consider. In several situations, acting earlier can be advantageous:
Exercise early to start your holding period so you can sell and receive long-term capital gains treatment sooner.
Exercise when the bargain element is small or when the market price is close to bottoming out to reduce or eliminate AMT liability.
Exercise annually so you can buy only the number of shares that will achieve a breakeven point between the AMT and regular tax and thereby incur no additional tax.
Sell in a disqualifying disposition and pay the higher ordinary-income rate to avoid the AMT on potentially disappearing appreciation.
On the negative side, exercising early accelerates the need for funds to buy the stock, exposes you to a loss if the shares’ value drops below your exercise cost, and may create a tax cost if the preference item from the exercise generates an AMT liability.
The timing of ISO exercises could also positively or negatively affect your liability for the higher tax rates and the NIIT. See the Case Study "The TCJA provides tax deferral opportunity in certain circumstances" for additional information and, with your tax advisor, evaluate the risks and crunch the numbers using various assumptions to determine the best strategy for you.
Nonqualified stock options The tax treatment of nonqualified stock options (NQSOs) is different from that of ISOs: NQSOs create compensation income (taxed at ordinary-income rates) on the bargain element when exercised (regardless of whether the stock is held or sold immediately), but they don’t create an AMT preference item. You may need to make estimated tax payments or increase withholding to fully cover the tax on the exercise. Keep in mind that an exercise could trigger or increase exposure to top tax rates, the additional 0.9% Medicare tax and the NIIT.
Restricted stock is stock your employer grants to you subject to a substantial risk of forfeiture. Income recognition is normally deferred until the stock is no longer subject to that risk (that is, it’s vested) or you sell it. You then pay taxes based on the stock’s fair market value when the restriction lapses and at your ordinary-income rate. (The FMV will be considered FICA income, so it could trigger or increase your exposure to the additional 0.9% Medicare tax.) Under Section 83(b), you can elect to instead recognize ordinary income when you receive the stock. This election, which you must make within 30 days after receiving the stock, allows you to convert future appreciation from ordinary income to long-term capital gains income and defer it until the stock is sold.
The election can be beneficial if the income at the grant date is negligible or the stock is likely to appreciate significantly before income would otherwise be recognized. And with ordinary-income rates now especially low under the TCJA, it might be a good time to recognize income.
There are some disadvantages of a Sec. 83(b) election: First, you must prepay tax in the current year — which also could push you into a higher income tax bracket and trigger or increase your exposure to the additional 0.9% Medicare tax. But if a company is in the earlier stages of development, the income recognized may be small. Second, any taxes you pay because of the election can’t be refunded if you eventually forfeit the stock or you sell it at a decreased value. But you’d have a capital loss when you forfeited or sold the stock. Third, when you sell the shares, any gain will be included in net investment income and could trigger or increase your liability for the 3.8% NIIT.
RSUs are contractual rights to receive stock (or its cash value) after the award has vested. Unlike restricted stock, RSUs aren’t eligible for the Sec. 83(b) election. So there’s no opportunity to convert ordinary income into capital gains.
But they do offer a limited ability to defer income taxes: Unlike restricted stock, which becomes taxable immediately upon vesting, RSUs aren’t taxable until the employee actually receives the stock. So rather than having the stock delivered immediately upon vesting, you may be able to arrange with your employer to delay delivery. Also see the Case Study "The TCJA provides tax deferral opportunity in certain circumstances".
Such a delay will defer income tax and may allow you to reduce or avoid exposure to the additional 0.9% Medicare tax (because the RSUs are treated as FICA income). However, any income deferral must satisfy the strict requirements of Internal Revenue Code (IRC) Section 409A. Also keep in mind that it might be better to recognize income now because of the currently low tax rates.
Non Qualified Deferred Compensation Plans
Nonqualified deferred compensation plans pay executives in the future for services to be currently performed. They differ from qualified plans, such as 401(k)s, in several ways. For example, unlike 401(k) plans, NQDC plans can favor highly compensated employees, but any NQDC plan funding isn’t protected from the employer’s creditors.
Some major changes to the taxation of NQDC that had been included in original versions of the TCJA would have negatively impacted such compensation. Fortunately, those changes didn’t make it into the final version that was signed into law.
One important NQDC tax issue is that employment taxes are generally due once services have been performed and there’s no longer a substantial risk of forfeiture — even though compensation may not be paid or recognized for income tax purposes until much later. So your employer may withhold your portion of the payroll taxes from your salary or ask you to write a check for the liability. Or it may pay your portion, in which case you’ll have additional taxable income. Warning: The additional 0.9% Medicare tax could also apply.
Keep in mind that the rules for NQDC plans are tighter than they once were, and the penalties for noncompliance can be severe: You could be taxed on plan benefits at the time of vesting, and a 20% penalty and potential interest charges also could apply. So check with your employer to make sure it’s addressing any compliance issues.
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