U.S. Taxation of Stock Options – Part 1

by margento | December 15, 2020

Introduction

Stock option plans are a popular method to attract, motivate, and create loyalty among employees in both Canada and the US. The tax treatment of stock options is complex, and rules vary between different countries.

This article is part-one of a three-part series.  First, we will discuss US tax implications of stock options.  Part-two will explain Canadian stock options and lastly, part-three explores tax treatment of cross border stock options when a resident of Canada is granted stock options from a US company.

US Taxation of Stock Options – Part 1

The US has two types of stock option plans, qualified stock options, also called Incentive Stock options (ISO’s) and non-qualified stock options (NSO’s). Alternatively, US companies can also issue Restricted Stock Units (RSO’s). All three stock incentives will be discussed below.

Incentive Stock Options (ISO)

There are several conditions that need to be met for a stock option plan to be qualified.  If any of the following conditions are not met the options become NSOs:

  1. This type of option can only be granted to an employee
  2. The employee must be granted the option at fair market value (FMV) as of the date of the grant
  3. If the employee is a greater than 10% shareholder of the company, the following additional conditions must be met:
    • The grant date must be 110% of FMV as of the grant date
    • The option term cannot exceed 5 years from the grant date
    • The exercise price cannot be less than the FMV of the stock at the grant date
    • The total value of the stock options cannot exceed $100,000 to each employee as of the grant date and the option must be exercised within 10 years of the grant
  4. The holding period between being granted the options and being allowed to exercise must be at least one year
  5. Once exercised, the stock cannot be sold for at least a year
  6. The options must not be transferable to any other party, and must be granted to, exercised by, and sold by the employee
  7. The stock option plan must be approved by the employer’s shareholder within 12 months before or after the date the plan is adopted

The granting of an ISO and the subsequent exercising of the option after one year does not result in tax consequences to the employee. When the options are sold, they receive long term capital gains treatment, resulting in nil tax for the lower tax brackets, 15% for income up to $450,000 (married filing jointly) or $400,000 (single) and 20% for income in the highest tax bracket. The capital gain is calculated as the difference between the proceeds on the sale and the grant price.

Because ISOs have a preferential tax treatment, Alternative Minimum Tax (AMT) might arise as a result of ISO stock options being exercised. AMT is a parallel tax system separate from regular tax law that can be complex and is out of the scope of this article.

There is no income tax deduction for the employer when ISO’s are issued.

Example: Cindy is US citizen who signed an employment contract on Nov 1, 2018 with Dot.com (an American start up company that offered her stock options as part of her employment contract). The contract granted her 1,000 options for $1 each, which was the estimated fair market value of the company’s shares on the grant date. The company had $1 million outstanding shares at that time, and she did not own any shares of the company at the time of the grant. The contract stipulated that she was required to hold the options for one year before she could exercise them and once exercised, she was unable to sell the share for one year. The contract also stipulated that the options were non-transferable, and the option plan was approved by all shareholder on Nov 30, 2018.

On Nov 2, 2019 Cindy exercises all 1,000 options when the fair market value of Dot.com’s shares were $3 per share. On Nov 2, 2020 Cindy sold all 1,000 shares when the stock was worth $10 per share.

Cindy’s stock options are considered ISO because they met all the conditions listed above. Cindy has no tax consequences on the grant date Nov 1, 2018 or one year later, Nov 2, 2019, when she exercised the options. Her only tax consequences are on Nov 2, 2020 when she sold all 1,000 shares. When she files her 2020 US personal tax return, she will report a long-term capital gain of $9,000 (10,000-1,000).

Non-Qualified stock options (NSO)

A stock option that does not meet all the ISO conditions or is issued to a contractor, supplier or director is a non-qualified stock option (NSO). An NSO can be issued at any price and there is no waiting period between grant and exercise.

There are no tax consequences when a NSO is granted. However, ordinary income is triggered at the time of exercise, which is calculated as the difference between the fair market value at exercise date and the grant price. When the shares are eventually sold, a capital gain will be incurred.   The capital gain is calculated as the difference between the proceeds on sale and the exercise price.

The advantage to the employer for issuing NSO’s is they are permitted a tax deduction equal to the ordinary income earned by the recipient when the options are exercised.

Example: Cindy is a contractor for Dot.com that is issued 1,000 stock options at a price of $2 per share on Nov 1, 2018. The company’s stocks are worth $1 per share on the grant date. On Nov 2, 2019 she exercised the options and sells the shares when the share value is $10 per share.

Cindy’s stock options are considered NSO because the options did not meet a number of the conditions for it to be an ISO, including the fact that she is a contractor and ISO’s can only be issued to employees.

There are no tax consequences when the options are granted on Nov 1, 2018. On Nov 2, 2019 she will incur ordinary income of $8,000 ($10,000 – $2,000) that will be reported on her 2019 US personal tax return. Since the options were exercised and subsequently sold at the same price, she will not incur a capital gain on the sale.

Restricted Stock or Restricted Stock Units (RSUs)

When shares are issued to an employee which include a stipulation that a future event occurs, this type of share is called an RSU. These shares are issued to the employee; however, they must be returned if the stipulated future event does not occur. Because there is substantial risk of forfeiture there is no tax effect when the employee is issued the shares. Once the future event occurs and the substantial risk of forfeiture is eliminated the tax consequences are triggered.

At the time that the substantial risk of forfeiture has been eliminated the employee will be considered to have earned ordinary income calculated as the difference between the fair market value of the shares at that time and the amount they were required to pay for them, which is generally nil.

When the shares are eventually sold, they will incur a capital gain, which is the difference between the proceeds on the sale and the fair market value at the time the substantial risk of forfeiture was eliminated. This gain will be subject to long term capital gains treatment if the holding period is longer than one year.

Similar to NSO’s the employer is allowed a tax deduction equal to the ordinary income earned by the recipient when the recipient incurs ordinary income at the time the substantial risk of forfeiture occurs.

Example: Cindy is an employee of Dot.com that was issued 1,000 shares of the company on Nov 1, 2018. At the time of issuance, the stock price was $1 per share. The shares had a stipulation that they must be returned if the stock price was not worth $5 per share in two years. On Nov 2, 2020, the stock price was $6 per share, therefore the substantial risk of forfeiture had been eliminated. On Nov 3, 2021 Cindy sells all 1,000 shares when the stock price is $10 per share.

Cindy will have to report ordinary income of $6,000 on her 2020 US personal tax return, this is because the substantial risk of forfeiture was eliminated when her 1,000 shares were worth $6,000 and she did not pay anything out of pocket for these shares. She will also incur a $4,000 ($10,000-$6,000) long term capital gain that will be reported on her 2021 US personal tax return.

Stay tuned for part-two where we will discuss Canadian stock options!

Contact Argento CPA today if you have any questions or looking for expert advice.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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