Stock in the employer is a commonly used form of compensation for employees and, in particular, executives. Stock based compensation includes stock, restricted stock, stock options, stock appreciation rights and phantom stock. Similar to nonqualified deferred compensation arrangements, stock may be granted to an employee pursuant to a formal plan or, alternatively, an individual’s employment agreement may provide for stock-based compensation.
What’s the income tax consequences associated with receiving stock compensation? Section 83 of the Internal Revenue Code applies to stock granted to an employee because the stock is property transferred in connection with the employee’s performance of services. In some cases, Section 409A of the Code may also apply to certain forms of stock-based compensation.
Whether an employee will be subject to immediate taxation at the time of receiving stock will depend on whether the employee’s right to the stock is subject to a substantial risk of forfeiture. Stock that is subject to a substantial risk of forfeiture has been coined nonvested stock, whereas, stock that is not (or is no longer) subject to a substantial risk of forfeiture is referred to as vested stock. Generally, an employee receives nonvested stock if the employee’s right to the stock is conditioned upon the future performance of substantial services or the occurrence of a performance- related condition. Additionally, the possibility that the employee might lose rights to the stock must be substantial.
What’s this vesting concept? Vesting may be thought of as having a secured right of present or future enjoyment where the employer may not take the stock back from the employee (well…at least not without paying fair market value for it). An employee may be vested and have a secured right to stock even though the employee does not have actual possession of the stock. On the other hand, stock that may be forfeited under certain conditions, such as termination of employment, will not be considered vested because there is a real possibility that the employee might lose any future right to the stock. Ultimately, the facts and circumstances surrounding the terms of the grant determine whether the employee is vested.
What tax consequences occur if you receive vested stock? If an employee receives vested stock, then the employee will have to include income, in the year of receipt, equal to the excess of the fair market value of the stock over the amount, if any, that the employee paid for the stock.
What happens if you receive nonvested stock? If an employee receives nonvested stock, then income inclusion is deferred until the year in which the stock vests unless the employee makes an affirmative election to include income in the year of receipt. If an employee does not elect otherwise, then, in the year the stock vests, the excess of the fair market value of the stock at the time of vesting, over the amount, if any, that the employee paid for the stock is includible in income.
An employee that receives nonvested stock may choose not to defer income inclusion and instead affirmatively elect to include, in the year of the receipt, the fair market value of the stock over the amount, if any, that the employee paid. An employee may make such an election no more than thirty (30) days after receiving stock. Although it seems counterintuitive to elect to be taxed now versus later, there may be limited circumstances under which an employee may benefit from being taxed in the year of receipt.
Are there any other tax consequences? Any amount includible in income as a result of receiving stock based compensation is also subject to income tax withholding and to social security tax as well as Medicare tax and must be reported on a Form W-2. Minor structural differences can dramatically change the tax consequences associated with the receipt of stock and stock options. In addition to losing the ability to control the timing of taxation, employees also run the risk of suffering severe penalties and having to pay interest on tax owed. In addition to tax considerations, there are also issues surrounding risk and reward, vesting and security and other contractual rights.
Blitman and King provides cutting edge, practical advice for stock compensation clients in the Albany, Buffalo, Manhattan, Long Island, Rochester and Syracuse NY areas.