For many employees in corporate America, a portion of compensation comes from one or more forms of stock option plans.
Compensation income from stock incentives contributes to adjusted gross income, but not net investment income for purposes of calculating the new 3.8% tax on net investment income.
The Columbia Management Learning Center is dedicating a series of blog articles to this important and timely “Navigating the New Tax Regime” topic.
For many employees in corporate America, a portion of compensation comes from one or more forms of stock option plans. Depending on the type of plan, stock compensation becomes taxable wage income at either execution, vesting, or in limited circumstances, upon sale. As compensation, it’s reported on Form W-2 issued by the employer, and it is subject to ordinary income tax and generally payroll tax (including Social Security, Medicare and the Medicare surtax, if applicable). Employers are generally required to withhold for payroll and ordinary income taxes.
The most well-known stock compensation program involves grants of non-qualified stock options (NQSOs). The grants are issued with a specific exercise price. Most NQSOs do not become compensation until the employee has reached a vesting period and elects to execute all or a portion of a stock option grant. At execution, the spread between the stock option exercise price and the fair market value becomes compensation. Example: If the stock option exercise price is $10 and the fair market value is $15, then the spread is $5. If 100 shares are executed, the compensation amount is $500.
Grants of restricted stock have become increasingly common and differ from NQSOs in two ways:
- First, there is always a compensation value to the recipient. If a grant is accepted, there is no further action required to receive the stock, though vesting requirements still apply. Upon attainment of the vesting date, the recipient generally has compensation income for the vested stock at the fair market value as of the vesting date. Example: 100 shares of vested stock have a $12 fair market value upon the vesting date; $12 x 100 = $1,200 in compensation.
- Second, the recipient has ownership rights at the time of the grant, which includes receiving dividend payments even when those shares have not yet vested. Dividends received before vesting are treated as wage income and taxed as ordinary income. Note: The 60-day holding period required for qualified dividends does not begin until the vesting date unless the recipient made an 83(b) election to pay taxes at the grant date (only permitted for restricted stock, not for restricted stock units).
Restricted stock units (RSUs) are similar to restricted stock awards (RSA) except that the employee initially receives units that track stock performance rather than actual stock at the time of grant. This award represents an unfunded promise to pay cash or stock in the future. Payroll taxes are due at the time of vesting based on the value of the RSUs on the vesting date. However, compensation income is not recognized until the RSUs are paid out (in stock shares or cash) in accordance with the RSU payout schedule. In addition, while RSAs carry with them shareholder voting rights, RSUs do not.
Incentive stock options (ISOs) are similar to NQSOs in that recipients must exercise the options. However, ISOs have more rules than NQSOs when it comes to offering them, and there is no regular taxation at the time of exercise (though alternative minimum tax can still apply). Instead, ISOs are generally taxed at the time of sale.
Also, ISOs can qualify for special tax treatment. If, after exercising the options, the stock is held at least two years from the grant date and one year from the exercise date, all of the appreciation over the exercise price qualifies for general long-term capital gains treatment. Example: the exercise price is $10 and the option is exercised at $15. The stock is held over two years from the grant date and over one year from the exercise date before it is sold at a fair market value of $20. The entire $10 differential is treated as a long-term capital gain.
This is just a high-level overview of the various stock incentives. Investors and their financial advisors should incorporate stock compensation into their investment and tax planning. Some key considerations:
- Compensation income from stock incentives contributes to adjusted gross income, but not net investment income for purposes of calculating the new 3.8% tax on net investment income.
- Will exercising a stock option or selling stock push the investor over a tax threshold? Should perhaps a smaller exercise or sale amount be considered or is there a way to offset the additional income?
- If a restricted stock award or restricted stock unit grant vests or is paid out next year, can it be partially or fully offset by increasing pretax contributions to workplace retirement plans, including a non-qualified deferred compensation plan? Remember that non-qualified deferred compensation elections must be made in the prior year, so elections for 2014 must be made in 2013. For more detailed considerations around deferring compensation and increasing tax-deferred investments, see “Maximizing workplace retirement plans to reduce or eliminate the net investment income tax.”
- Finally, it’s important to recognize that once the stock is owned by the employee, it’s a taxable investment. Any short- or long-term capital gains, and any dividends from the stock, will count under both adjusted gross income and as net investment income.
What you may have missed:
- The role of asset location
- Trust accounts and the net investment income tax
- Strategies for business owners to reduce net investment income tax
- Retirement plan design for the new tax regime
- Maximizing workplace retirement plans to reduce or eliminate the net investment income tax, including our “Power of the workplace” podcast
- What is the net investment income tax?
- The three tax thresholds of the new tax regime, including our “Navigating the new tax regime” podcast