So you want to attract the best talent to your business and have them stick around for a while? Well potential employees are seeing past some of the sillier tactics some employers have used over the past decade. Gone are the days of enticing strong candidates with bean bag chairs and ping pong tables. With the globalization of the workforce and the ability of employees to reach beyond their geographical limitations, people are focusing more on company culture and finding places where they can grow with a company and be valued. Offering stock options to your employees are a great way to incentivize them to stick around for longer, while also benefitting more from their labor as the organization grows and becomes more valuable.
That being said, issuing stock options comes with complex tax implications that employers and employees must carefully navigate. Below, we break down the different types of stock options and highlight key considerations, including the significance of the 83(b) election.
Types of Stock Options
- Incentive Stock Options (ISOs)
- Description: ISOs are typically reserved for key employees and provide favorable tax treatment if specific conditions are met.
- Tax Implications: Employees do not recognize income upon grant or exercise. However, the difference between the exercise price and the fair market value (FMV) at exercise may be subject to the Alternative Minimum Tax (AMT). Gains are taxed at long-term capital gains rates if the shares are held for at least two years from the grant date and one year from the exercise date.
- Types of ISOs:
- Time-Based ISOs: These options vest based on the length of time the employee remains with the company. For example, an employee may receive 25% of the total options granted after each year of service over four years.
- Performance-Based ISOs: These options vest upon achieving specific performance targets, such as meeting revenue goals or project milestones.
- Cliff-Vesting ISOs: These options vest fully after a predetermined period, such as one year, rather than incrementally over time.
- Non-Qualified Stock Options (NSOs)
- Description: NSOs can be granted to employees, contractors, and consultants and do not have the same restrictions as ISOs.
- Tax Implications: Employees recognize ordinary income upon exercise, calculated as the difference between the exercise price and the FMV of the stock. Employers can deduct this amount as a compensation expense. Any subsequent appreciation is taxed as capital gains when the stock is sold.
- Types of NSOs:
- Restricted NSOs: These options may have limitations on when they can be exercised or sold, often tied to vesting schedules or company performance.
- Unrestricted NSOs: These options can be exercised immediately upon grant, providing employees with greater flexibility but also immediate tax consequences.
- Reload NSOs: These options grant employees new stock options to replace those exercised, incentivizing them to hold on to company shares while benefiting from ongoing participation in the stock option plan.
Tax Reporting Requirements
For both ISOs and NSOs, accurate tax reporting is crucial. Employers must report taxable income related to NSOs on employees’ W-2 forms and may need to provide additional disclosures for ISOs on Form 3921.
The 83(b) Election
The 83(b) election is a critical consideration when issuing stock options, particularly for early-stage startups or companies with rapidly appreciating stock. This election allows employees to pay taxes on the FMV of the stock at the time of grant, rather than at vesting. If you so choose you can read the actual tax code here.
Key Points:
- The election must be filed with the IRS within 30 days of the stock grant.
- If the FMV of the stock is low at the time of grant, the tax liability can be minimal.
- Any subsequent appreciation is taxed at capital gains rates upon sale.
Example Scenario: An employee receives 10,000 shares of stock at $1 per share, and the FMV is $1 per share at grant. By filing an 83(b) election, they pay taxes on $10,000 of income upfront. If the stock appreciates to $10 per share over time, the employee only pays capital gains taxes on the $90,000 gain upon sale.
Planning Tips for Employers
- Understand Valuation: Regularly assess the FMV of company stock to ensure accurate tax reporting and compliance.
- Educate Employees: Provide resources or consultations to help employees understand their tax obligations and opportunities like the 83(b) election.
- Consult Professionals: Work with tax advisors to structure stock option plans that align with business goals and minimize tax liabilities.
Conclusion Stock options can be a powerful tool to motivate employees and drive business growth, but they come with significant tax implications. Both employers and employees need to understand the differences between ISOs and NSOs, the tax reporting requirements, and the strategic use of the 83(b) election. By planning ahead and seeking professional advice, companies can maximize the benefits of stock options while mitigating potential tax risks.
If you are thinking of offering stock options to your employees, or already do and need help with the accounting and tax implications, reach out to High Impact CPA and our professionals can make sure your are doing it right!
