Equity Compensation in brief Frequently Asked Questions What is a stock option? It is the right to purchase stock at a specified price. Why are stock options used? Stock options provide a performance-based incentive to an employee on a tax-advantaged basis. Further incentives can be created with the use of a vesting schedule which will require future performance by an employee before an option is earned. What are the two types of stock options? Stocks options either qualify as incentive stock options, or they are nonqualified stock options. Frequently Used Terms Exercise Paying the exercise (or strike) price of the stock option and taking possession of the stock. Exercise Price Also known as the strike price, it’s the amount the employee must pay to exercise the option. Grant The transfer of the stock option to the employee. Spread The difference between 1) the fair market value of the stock on the date the stock option is exercised and 2) the exercise price. Vesting Schedule The dates on which the stock options are no longer subject to a risk of forfeiture. Incentive Stock Options (ISO) Employee Taxation • At grant of option – NO. • At exercise of option – NO. • Upon sale of stock – YES. The employee is taxed on the gain at the long term capital gains rate. The gain is gross proceeds minus tax basis, where “gross proceeds” is the sale price of the stock and “tax basis” is the price the employee paid for the stock (i.e., the exercise price). Example: On January 1, 2007, Employee is granted the option to purchase 1,000 shares of XYZ, Inc., at $20 per share. On February 1, 2009, when XYZ, Inc. is trading at $35, Employee exercises 1,000 shares for $20,000. On March 1, 2010, when XYZ is trading at $45, Employee sells the 1,000 shares of XYZ. 01/01/2007 Grant: 1,000 shares XYZ @ $20/share 02/01/2009 Exercise: 1,000 shares XYZ @ $20/share when stock is trading @ $35/share 03/01/2010 Sale: 1,000 shares XYZ @ $45/share $45,000 Gross Proceeds $45,000 Minus: Tax Basis $20,000 Equals: Long-term Capital Gain $25,000 $20,000 Alternative Minimum Tax (AMT) Although the difference between the fair market value at exercise and the exercise price is not taxable for regular tax purposes, it is taxable for AMT purposes. A credit is available to offset future regular income, and will probably be used in the year the stock creating the AMT liability is sold. Incentive Stock Options (ISO) ISO Requirements If any of these requirements is not met, the option is a Non-qualified Stock Option (see below). • The shares of stock purchased may not be sold within: - 2 years of the option grant; and, - 1 year of the transfer of the share of stock to the employee • An ISO is not transferable during life. • The employee cannot own more than 10% of the corporation’s voting power at the time of grant. • The FMV of stock subject to the ISO cannot exceed $100,000 in any year, determined at the time of grant. • Participants must be employees, and ex-employees have 3 months to exercise. Employee’s Estate and Heirs • The tax treatment for an estate or heir is the same as it is for an employee, except that there are no ISO holding period or employment requirements, and the ISO receives a step-up in basis. Employer • There is no employer income tax deduction. If the ISO is later disqualified (e.g., by selling stock within one year of exercise), then a compensation deduction may be available under the Non-qualified Stock Option rules. Transfer Taxation and Charitable Giving • An ISO cannot be transferred during life. • An ISO may be transferred at death, and the valuation for estate tax purposes is based on a formula. Non-Qualified Stock Options (NSO) Employee Taxation • At grant of option – NO. • At exercise of option – YES, unless the stock is not vested. The excess of the fair market value (FMV) at the date of exercise over the exercise price is treated as compensation to the employee. • Upon sale of stock – YES. The employee is taxed on the gain measured by gross proceeds minus tax basis, where “gross proceeds” is the sale price of the stock. “Tax basis” is the price the employee paid for the stock plus the income reported at exercise (e.g., the exercise price plus spread at exercise). Example: On January 1, 2007, Employee is granted the option to purchase 1,000 shares of XYZ, Inc., at $20 per share. On February 1, 2009, when XYZ, Inc. is trading at $35, Employee exercises 1,000 shares for $20,000. On March 1, 2010, when XYZ is trading at $45, Employee sells the 1,000 shares of XYZ. 01/01/2007 Grant: 1,000 shares XYZ @ $20/share 02/01/2009 Exercise: 1,000 shares XYZ @ $20/share when stock is trading @ $35/share $20,000 03/01/2010 $45,000 Sale: 1,000 shares XYZ @ $45/share FMV at Exercise $35,000 $20,000 Minus: Exercise Price Equals: Ordinary Income $15,000 Gross Proceeds Minus:Ordinary Income $15,000 $20,000 Exercise Price Tax Basis: Equals: Long-term Capital Gain $45,000 $35,000 $10,000 Non-Qualified Stock Options (NSO) NSO Requirements • If an option is not an ISO, it is an NSO. • An ISO may become a NSO if it fails to meet the ISO requirements after grant. Employee’s Estate and Heirs • The tax treatment for estates and heirs is the same as it is for an employee, with the income treated as income in respect of a decedent (IRD). Employer • When the employee exercises the option the employer can take a compensation deduction equal to the excess of the FMV at exercise over the exercise price. Transfer Taxation • The FMV of a gift is determined by formula. The recipient pays the exercise price, but the employee pays income tax on the spread at exercise. • Valuation for estate tax purposes is based on formula. Charitable Giving • For gifts during life, the employee will get an income tax deduction equal to the FMV of the NSO, based on a formula. • For gifts at death, the NSO is included in the employee’s estate. The estate receives an estate tax charitable deduction equal to the FMV, based on a formula. A charity will not pay income tax when it exercises the option because it is taxexempt. Tax Anatomy of Shares Purchased ISO Share Sale Price FMV at Exercise NQ Share $45 $45 $35 $35 AMT Adjustment Exercise Price $20 Tax Basis $20 Capital Gain Ordinary Income and Tax Basis Tax Basis Tax Basis Restricted Stock Income Taxation • At grant – NO. No tax if subject to a substantial risk of forfeiture (i.e., not vested) and is non-transferable. • At vesting – YES. The fair market value (FMV) of the stock is income to the employee. Dividends on restricted stock can be paid during the nonvested period and are subject to income tax. • Upon gift of stock – NO. No tax at the time of the gift, but the employee recognizes compensation income on the FMV when the restrictions lapse. • If the employee dies or becomes disabled owning restricted stock, unmet restrictions might mean stock must be returned to the employer, or plan may allow employee to keep it. • If death meets the requirements to lift the restrictions, the FMV is IRD and the heirs or estate will owe income taxes. • The employer gets a compensation deduction for the stock when, and in the same amount as, the income on the stock is reported. Transfer Taxation • During life the gift tax value is the FMV of the stock, although the restrictions may cause a discounted value or even incomplete gift. Gift tax treatment of restricted stock is unclear—gifts normally not permitted under the plan anyway. • At death the FMV of the stock is included in the employee’s estate. Charitable Giving • Gifts during life result in a discounted value for income tax deduction purposes and recognition of income upon vesting by the employee. This generally makes them a poor choice for charitable giving. • Bequests at death might make sense because a tax-exempt entity will not pay income tax on the IRD. The stock is included in employee’s estate, but will be offset by an estate tax charitable deduction. Net Unrealized Appreciation (NUA) Income Taxation • At grant – NO. The employer’s contribution of employer stock to the employee’s qualified plan is not taxable income. • At distribution from retirement plan – YES, partially. The basis in the employer stock is subject to ordinary income tax. The appreciated amount between fair market value (FMV) and tax basis is NUA, and is not subject to income tax at distribution. • Upon sale of stock – YES. The employee is taxed on the NUA at the long term capital gains rate. Gain in excess of the NUA is taxed at long or short capital gains rates, depending on how long the stock was held after distribution. • In order to receive favorable tax treatment of NUA, distributions must be a lump sum. • NUA is taxable to the estate and heirs as income in respect of a decedent (IRD). • Although the NUA is IRD and does not get a step-up in tax basis, any gain in excess of the NUA does get a step-up. Transfer Taxation • The gift is equal to FMV on the date of the gift. • The FMV of the stock is included in the employee’s estate at death. Charitable Giving • As with any stock, the income tax deduction for a lifetime gift is based on FMV. The charity doesn’t pay tax when it sells the stock, so the NUA is never taxed. • At death, an estate tax charitable deduction is available. The NUA is IRD, but charities do not pay tax on IRD. This document was prepared by the Advanced Planning Division of The Northwestern Mutual Life Insurance Company. Although the information contained in this document is believed to be accurate, this document is not intended as a primary or substitute resource for evaluating the relevant legal, tax or accounting principles related to the topic(s) addressed. Judicial and administrative interpretations of existing laws and regulations, and the actual tax and accounting laws, rules and regulations are subject to change, and Northwestern Mutual cannot predict whether, how and when such changes might occur. Northwestern Mutual’s publication of this document is not intended to provide legal, accounting or tax services or advice, and should not be relied on as such. Individuals must rely upon their own legal, accounting or tax advisors to consider and apply these principles to specific situations and transactions. – To comply with Circular 230 MDRT IR Index 4000.00 The Northwestern Mutual Life Insurance Company • Milwaukee, WI www.northwesternmutual.com 22-4374 (1006) (Rev. 0807)
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