The taxation of non-qualified stock options is subject to Section 83 of the Internal Revenue Code because stock options granted to employees are generally considered to be compensation for services. In addition, Section 409A of the Code may also apply to certain grants of non-qualified stock options.
How do you assess the tax consequences of receiving non-qualified stock options? The tax consequence to an employee who receives non-qualified stock options depends on whether or not, at the time of grant, the option has a readily ascertainable fair market value. Although non-qualified options have some value at the time of grant, ordinarily that value is not readily ascertainable unless the option is actively traded on an established market.
Do the non-qualified stock options have an ascertainable fair market value? If a non-qualified option is not traded on an established market, to have a readily ascertainable fair market value the options must be transferable and immediately exercisable in full. Additionally, the stock subject to the option must not be subject to any restriction or condition which has a significant effect upon the fair market value of the option. Furthermore, the fair market value of the option privilege—that is, the opportunity to benefit during a given period from increases in stock price without risking any money—must be readily ascertainable. These legal requirements generally highlight the reason why most non-qualified options that are not actively traded on an established market do not have readily ascertainable fair market values.
Assessing the receipt of non-qualified stock options that do not have an ascertainable fair market value. An employee has no includible income upon receiving a non-qualified option that has no readily ascertainable fair market value. Instead, Section 83 of the Code will apply in the year when the employee exercises the option. If the employee receives vested stock on exercise, then, in the year of exercise, the excess of the fair market value of the stock over the option price is includible in the employee’s income. If the employee receives nonvested stock on exercise, then in the year the stock vests the employee will have income unless the employee makes an affirmative election to include income in the year the option in exercised. If the 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 option price is includible in income.
What are the tax consequences of receiving non-qualified stock options with a readily ascertainable fair market value? Upon receipt of a non-qualified option with a readily ascertainable fair market value, the excess of the fair market value of the option over the amount, if any, that the employee paid is includible in income in the year the stock option vests. Thus, unless an employee affirmatively elects to include income in the year of receipt, such employee will not be subject to tax until the year when the employee has a vested right to the stock option. Because the employee will have income inclusion in the year of vesting, such employee will have no includible income upon exercising the option.
You still need to factor in Section 409A. In addition, Section 409A of the Code applies to non-qualified stock options that, for example, have an exercise price below fair market value of the stock, include a feature to defer income beyond vesting or where the underlying stock subject to the option is stock is other than common stock. While there are no prohibitions on granting stock options subject to I.R.C. § 409A, the options must be properly structured unless the employee will be subject to immediate income inclusion, a 20% penalty tax and interest.
Understand the bigger picture of receiving non-qualified stock options vs. statutory stock options. In the not so far distant past, stock options were referred to as “funny money” because, due to accounting standards, they enabled an employer to promise an executive a vast compensation without hurting the employer’s bottom line. However, the characteristics of the stock options received dictate serious tax consequences to an executive. For example, the amount includible in income with respect to non-qualified stock options includes income tax withholding, and social security tax and Medicare tax whereas the social security tax and Medicare tax, by specific exemption, do not apply to statutory stock options.
Blitman and King provides cutting edge, practical advice for clients in the Albany, Buffalo, Manhattan, Long Island, Rochester and Syracuse NY areas.