Stock Options And Tax Returns: Nine Big Mistakes To Avoid

With stock options, tax-return reporting is not optional. Whether you exercised stock options and held the shares during 2015 or sold shares acquired from stock options, the resulting income or gain must be included in the tax return that you file in 2016. As with much of equity compensation, tax issues with stock options can be tricky.

Alert: If you sold stock during 2015, you must file with your tax return IRS Form 8949 along with Schedule D, using what your brokerage firm reports to you on IRS Form 1099-B. In most situations, the cost-basis information on Form 1099-B for stock sales from equity compensation cannot be used "as is" for accurate tax-return reporting. If you do not understand the rules, you will overpay taxes (see a related FAQ at myStockOptions.com).

Below are several mistakes to be aware of and avoid when completing your return.

1. With a cashless exercise/same-day sale, the spread is reported on your W-2 and on your tax return as ordinary income. Even though you never owned the stock after exercise, you still need to report this transaction on Form 8949 and Schedule D, which are used to report capital gains and losses on all stock sales. You may even have some small gains or losses, depending on how your company calculates the spread at exercise and on any commissions and fees for the stock sale. For an annotated example of how to report the cashless exercise on these forms, see the FAQ on this topic at myStockOptions.com.

Alert: If the IRS were to receive a report of your gross sale proceeds from your broker (on Form 1099-B) but without a corresponding report of the sale on your Form 8949 and Schedule D, it would think you had failed to report the gain on the sale. Assuming a tax basis of $0, the IRS computers would then automatically send you a notice for the taxes due.

2. With nonqualified stock options (NQSOs), for employees the spread at exercise is reported to the IRS on Form W-2 (for nonemployees, it is reported on Form 1099-MISC). It is included in your income for the year of exercise. (Income from an ISO disqualifying disposition, such as an early sale, will also appear.) Thus, when you report the sale on Form 8949, if Box 1e on your 1099-B reports the exercise price as the cost basis, do not list the exercise price as your cost basis without also making an adjustment in column (g). Only for ISO stock sold in a qualifying disposition will the tax basis equal the exercise price.

Alert: If the cost basis is not reported on Form 1099-B, avoid double taxation by listing the market price on the date of exercise as your cost basis in the stock. The basis should be the exercise price plus the amount of ordinary income you already paid taxes on. For an annotated diagram showing how to report the company stock sale on Form 8949 and Schedule D, see the related FAQ.

3. You will also mistakenly double-report income if you do not realize that your W-2 income in Box 1 already includes stock compensation income. Wrongly thinking it was left out may prompt you to erroneously report the income on your Form 1040 in the line for "Other income" (Line 21 on the 2015 form). Doing this will cause the income to be taxed twice as ordinary income. You use Line 21 only when your company mistakenly omits the exercise income from your W-2 or 1099-MISC.

Each type of exercise method can create its own confusion with the reporting of shares sold either at exercise or later. For example, if you sold only some of the shares in a sell-to-cover exercise, you don't want to report on your Form 8949 the cost basis for all the shares exercised. This would result in a much larger tax basis and a capital loss for these shares sold.

4. With incentive stock options (ISOs), when you exercise and hold through the calendar year of exercise, remember that you need to complete an AMT return (Form 6251) to see whether you owe AMT. If the tax amount is higher than the ordinary income tax, you need to pay AMT. Your company does not send you a W-2 for this spread amount when you hold the ISO stock, so remember to do this. For more details on the AMT, see the content sections AMT and AMT Advanced.

Alert: ISO exercises in a given tax year are reported on IRS Form 3921 early in the following year. The form helps you collect information for reporting sales of ISO shares on your tax return. It also helps in the AMT calculation at exercise. The IRS receives a copy of the form, ensuring that it knows about your ISO exercise and therefore any AMT triggered by the exercise income.

5. When you have paid AMT because of your ISO exercise and hold, you get a tax credit. The rules now get even more complex. You do not need to sell the stock to start using this credit. In addition, every year until the credit is used up, you do need to complete IRS Form 8801 to calculate it, as explained in a related FAQ. Once you have sold the stock, avoid paying or calculating more AMT than is required for your ISO stock sale by reporting (as a negative amount) your "adjusted gain or loss" on Part I of IRS Form 6251. For more details, see the relevant FAQ. See also a general FAQ on mistakes to avoid on your tax return after you have paid AMT stemming from ISOs.

To read four other crucial tips on tax-return reporting involving stock options, see the full FAQ about this topic on myStockOptions.com. You may also want to read our in-depth article on tax returns involving stock options. Additionally, we have FAQs detailing the biggest tax-return blunders to avoid with restricted stock and RSUs, employee stock purchase plans, or stock appreciation rights.

If you are reporting stock sales acquired from any type of stock compensation, our FAQs with annotated diagrams of Form 8949 and Schedule D are a valuable resource to help you avoid expensive errors.

Tax Reporting For Stock Compensation: Understanding Form W-2, Form 3922, And Form 3921

The end of January is in sight. Along with snowflakes, personal tax-return documents are in the air—or rather, hopefully either in your safe possession or on their way to you. When you have stock compensation, tax-return documents and the information they contain can be confusing and hard to decipher.

Making Sense Of Form W-2 When Stock Compensation Is Reported

Employees who had income from stock compensation or an employee stock purchase plan in 2015 must understand where that income is reported on Form W-2 so that they can complete their tax returns properly. In the Tax Center at myStockOptions.com, we have a section of FAQs about Form W-2 reporting for stock compensation. Each one includes an annotated diagram of Form W-2 that clearly interprets this sometimes cryptic document.

Restricted Stock, RSUs, Performance Shares

The vesting of restricted stock, the share delivery from restricted stock units (RSUs), and the vesting of performance shares all prompt W-2 reporting of the income received. The treatment on the W-2 is essentially the same for all three grant types. Income is included in the following places:

• Box 1: Wages, tips, and other compensation
• Box 3: Social Security wages (to income ceiling)
• Box 5: Medicare wages and tips
• Box 16: State wages, tips, etc. (if applicable)
• Box 18: Local wages, tips, etc. (if applicable)

To learn which boxes show the taxes withheld, and other reporting details for all three grant types, see the related FAQs, including annotated diagrams, in the Tax Center.

Alert: If you made a Section 83(b) election to be taxed on the value of restricted stock at grant, your W-2 for the year of grant, not vesting, will show the income and withholding.

Stock Options

If you exercised nonqualified stock options last year, the income you recognized at exercise will be reported on your W-2. The income from a nonqualified stock option (NQSO) exercise appears on the W-2 with other income in:

• Box 1: Wages, tips, and other compensation
• Box 3: Social Security wages (up to the income ceiling)
• Box 5: Medicare wages and tips
• Box 16: State wages, tips, etc. (if applicable)
• Box 18: Local wages, tips, etc. (if applicable)
• Box 12 (Code V)

That last item, Code V in Box 12, identifies the NQSO income included in Boxes 1, 3, and 5. For the places where the tax-withholding amount appears, see our FAQ on W-2 reporting for NQSOs. (The W-2 reporting is, by the way, identical for stock appreciation rights, with the exception that Code V is not used.)

With incentive stock options, the spread value appears on the W-2 only when you make what is technically called a disqualifying disposition, i.e. when you sell or gift the stock before you have met the required holding periods of one year from exercise and two years from grant. In that case, the income appears on the W-2 as compensation income. Unlike with NQSOs, your company does not withhold federal taxes on ISO exercises and no money is owed for Social Security and Medicare, even with a same-day sale or any later disqualifying dispositions. For the details of W-2 reporting for ISOs in this situation, see our FAQ on this topic in the Tax Center.

Employee Stock Purchase Plans (ESPPs)

The W-2 reporting for ESPP income depends on whether your company's ESPP is tax-qualified or not and, if it is tax-qualified, how long you hold the shares. For a nonqualified ESPP, there is withholding on the income you recognize at purchase, and the income and withholding are reported on your W-2 in a way resembling that for nonqualified stock options. With a tax-qualified ESPP, nothing appears on your W-2 until you sell the shares. The details of all three situations are clearly presented, with annotated diagrams, in the section on ESPP W-2s in the Tax Center at myStockOptions.com.

Form 3922 For ESPPs And Form 3921 For ISOs

Form W-2 is not the only important piece of tax paperwork that companies are sending these days. In 2015, did you buy shares in your company's employee stock purchase plan (ESPP)? Did you exercise incentive stock options (ISOs)? If so, you should have by now received from your company either IRS Form 3922 (for ESPPs) or IRS Form 3921 (for ISOs). Companies must issue these forms to employees by the end of January, and they must also file them with the IRS (though the IRS filing need not occur until the end of March if it is electronic).

Alert: In 2016, the amount of the IRS penalty doubled for companies that file information returns late or fail to distribute the employee statements.

For employees, many companies issue the information on their own substitute statements instead of using the actual IRS forms. A substitute statement allows a company to aggregate all purchases or exercises in one form rather than issuing a separate IRS form for each transaction.

While Forms 3922 and 3921 may seem confusing at first glance, they are useful because they can help you gather information you will need to prepare your tax return. As the forms also ensure that the IRS has ample information about your ESPP purchases and ISO exercises, they mean that accurate and timely tax-return reporting is more important than ever.

Annotated Diagrams Of Forms 3922 And 3921

To help companies and participants understand these forms and the related tax rules, myStockOptions.com has an article and FAQ on Form 3922 for ESPPs and an article and FAQ on Form 3921 for ISOs. These include annotated examples of the forms that translate IRS jargon into understandable language. You will find this content in the ESPP and ISO tax sections of both myStockOptions.com and the Knowledge Centers that we license to companies and stock plan service providers.

Each ESPP purchase is reported on a separate Form 3922, which presents the following information:

• date of grant (usually the beginning of the offering period)
• stock FMV on the date of grant
• purchase price per share
• price per share had the grant date been the purchase date (for purchases where the purchase price was not fixed or determinable on the grant date)
• purchase date
• stock FMV on the purchase date
• date of transfer of legal title
• number of shares for which legal title is transferred

Each ISO exercise is reported on a separate Form 3921, which shows the following details:

• grant date
• exercise price per share
• exercise date
• the stock FMV on the exercise date
• number of shares exercised

Sell Shares In 2015? The Fun Is Just Beginning

If you sold shares from stock compensation or an ESPP last year, you will need guidance to report the sale proceeds on your tax return. Fortunately, the Tax Center at myStockOptions.com features the section Reporting Company Stock Sales. Each FAQ in the section includes annotated diagrams of Form 8949 and Schedule D, the two crucial forms for stock-sale reporting. These FAQs clearly explain how the information on Forms W-2, 3922, and 3921 can help you accurately complete IRS Form 8949 when you prepare your tax return.

Resources For Stock Plan Participants And Companies

All of our tax-season content, including our popular annotated tax forms, is available for corporate licensing. Help your participants make the most of their stock compensation by giving them resources for avoiding expensive mistakes on tax returns.

The excellence of our resources is attested by the many testimonials we have received, so don't just take our word for it. As one of our licensees puts it, employees "find the tax information and annotated tax forms extremely helpful." In the words of another client, "employees understand concepts much better with the straightforward illustrations." Please contact us for licensing details (617-734-1979 or [email protected]).

The Taxation Of Stock Options In Canada Is Likely To Change

In Canada, employees who exercise stock options receive enviable tax treatment. As in most countries, the spread between the exercise price and the market value of the shares on the exercise date is subject to tax at ordinary income rates. However, in a significant difference from the usual tax treatment, when the exercise price equals the fair market value of the stock at grant, employees are allowed to deduct 50% of the "option benefit" (i.e. the spread) when computing taxable income (Quebec residents can deduct only 25%).

The favorable tax treatment of stock options in Canada has kept them popular there, in contrast to the decreasing use of options in the United States, but it has attracted political opposition. For example, the New Democratic Party (NDP), a leader among Canada's minority parties, opposes the 50% deduction and would like it to end (see an article in Toronto's newspaper The Globe and Mail).

The Liberal Party, which won Canada's recent national election and forms the new government, does not go that far. Nevertheless, the Liberals have indicated that they do want to change the treatment of tax-preferred stock options. In statements made during the election campaign, the Liberal Party indicated that while it respects the useful role of stock options, it wants to place a limit on the amount of income from an option exercise that can be subject to the standard tax deduction. Amounts above the income threshold will not be eligible for the deduction, though the deduction will remain for lower amounts. While the income limit has not yet been finalized, the Liberals have stated that it will be at least C$100,000. (For some background and commentary on the government's proposed changes, see a memo from the Canadian law firm Torys.)

It remains unclear whether the Liberals' proposed limitation of the option tax deduction would truly raise additional revenue in the long term or merely serve to discourage the use of options. In general, the Liberal Party has made it clear that its top fiscal priority is lowering taxes on the middle class and raising tax rates for those with higher incomes, and that it wants new tax laws in place by the start of 2016. Other potential tax changes being eyed by the Liberal Party include higher rates on income above C$200,000 (from 29% to 33%), as discussed in a commentary from the website Advisor.ca.

What does the Liberal government's stance on option taxation mean for optionholders in Canada? An article in the Financial Post points out that employees with vested options may want to take quick action: it is possible that the change in tax law may be immediately effective (without any grandfathering) from the announcement date, which could occur as early as December 3, when parliament is recalled. The article's author says that exercising options before that date would "pretty much guarantee" the 50% tax deduction, assuming the tax changes will not be applied retroactively. (Of course, optionholders should also consider whether exercising options now makes good financial sense for them.)

For the tax treatment of equity compensation in Canada and related insights, see the Canada section of the Global Tax Guide at myStockOptions.com.

In The News: RSUs And Stock Options At Major Companies

At myStockOptions.com, we see and hear a lot of media coverage and commentaries involving equity compensation. Indeed, part of our daily routine here is staying plugged into news and trends in stock compensation that may affect our content. In this blog piece, we present some of the interesting stories and snippets that have come our way over the past few months.

Apple

In the shareholder-dominated world of publicly traded companies, "pay for performance" continues to be the rallying cry for equity compensation. Apple Insider details a recent payout of shares to Apple's CEO, Tim Cook, after the company met the performance goals attached to his restricted stock units (RSUs). For this slice of Mr. Cook's RSU grant to fully vest, Apple's total shareholder return (TSR) had to rank in the top third of the S&P 500 between 25 Aug. 2013 and 24 Aug. 2015. Apple's TSR performance of 76.76% during that period placed 46th out of 458 companies, putting it in the 90th percentile. If Apple's TSR had been in the middle third, the award would have been reduced to 50%, and the award would have been zero if TSR had ended up in the bottom third. Details of the grant terms occur in Mr. Cook's Form 4 filing.

General Motors

As reported by The Detroit News, General Motors has made its first option grants since the company emerged from bankruptcy in 2009. At least for senior executives, the GM grants have some interesting performance-based quirks not often found in option grants (see the related 8-K filing and grant agreement form). Time-based vesting applies to 40% of each grant, with a vesting date of February 15, 2017. The remaining 60% of each grant vests over the following three years in 20% annual installments, provided the company's TSR meets or exceeds the median of a peer group of automotive companies during the period from the grant date through December 31 of the year preceding each vesting date. The awards also include explicit noncompete and nonsolicitation restrictions: for one year after they leave the company, the executives are not allowed to join a competitor or recruit employees away from GM.

Why are performance-based stock options somewhat rare? Our FAQ on them explains.

Google

Google's move to split into an array of businesses (e.g. Nest, Calico, Google X) under a parent company called Alphabet has spawned much media attention. The coverage includes a commentary in Wired that ponders the shift's impact on Google's stock compensation. Although these companies currently trade under the Google stock symbol, the Wired writer believes that each will eventually be able to grant its own subsidiary-specific stock options. The writer predicts that these separate businesses will be spun off into their own publicly traded companies, potentially boosting the upside of the grants.

Whole Foods

In a feature on John Mackey, the CEO of Whole Foods, Fortune has drawn attention to an unusual practice involving stock options at the company. Famously, Mr. Mackey leads the company on a salary of just $1 per year, and he forgoes stock options. Whole Foods donates to one of its foundations the options that it otherwise would have granted to him. (myStockOptions.com has in-depth content on donating stock options and company stock to charitable foundations.) 

Pre-IPO Companies: Uber, Airbnb, And Twitter

An article in The New York Times notes that the so-called unicorns of the pre-IPO world, i.e. fast-growing startups with valuations of at least $1 billion (such as Uber and Airbnb), are using RSUs to recruit talent from established public companies such as Google. The NYT writer explains the approach:

"To snag employees from large rivals, unicorns have a simple recruiting pitch: They are on a path to success, as illustrated by their rising valuations. Many offer generous equity packages of restricted stock units that can later translate to big paydays for employees if the unicorn goes public or is sold—a lure that neither Google nor any other public tech company can dangle."

Journalists continue to watch the transition from options to RSUs at young technology companies. In a blog commentary, The Wall Street Journal observes that while Twitter employees have felt the decline of the company's stock price, having RSUs instead of options has spared them from worse agony.

Our section Pre-IPO has articles and FAQs on equity compensation at privately held companies.

Keep Up With Equity Comp News

Like keeping an eye on equity comp trends? Follow our cool and fun Twitter page for frequent updates about stock compensation in the news.

New Videos And Articles On Stock Options Diversify Our Educational Offerings For Plan Participants

Although restricted stock and RSUs have become the most commonly used types of equity award, stock options continue to be a prominent form of compensation, as they have been since the first dotcom boom made stock options a household term. The enduring legacy of stock options is even preserved in our website's name (although, of course, we cover all types of equity compensation).

New videos and articles at myStockOptions.com have enhanced and diversified our array of educational content on stock options. As with all of our offerings, this content can be licensed and customized by your company for its stock plan participants.

New Video Series On Stock Options

In alignment with our video series on restricted stock/RSUs and ESPPs, the first two videos in a new series on stock options offer a lively introduction to the basics of option grants.

Employee Stock Options: Core Aspects To Know (4:12). With expert insights from Bruce Brumberg, the editor-in-chief of myStockOptions.com, this video covers the essential aspects of employee stock options that employees must know to make the most of them, including the key concepts of vesting, exercise, the option term, the impact of job termination and other life events, and the wealth-building potential of employee stock options.

Employee Stock Options: NQSO Taxation (2:58). In this video, Bruce covers the tax basics of nonqualified stock options (NQSOs). With animated examples, the video presents how taxes are calculated for NQSOs, what types of taxes apply to NQSOs, how withholding works, and how capital gains taxes apply when employees sell the shares.

On myStockOptions.com, these videos appear in our section on NQSOs. By enticing viewers into the subject of their equity comp, the videos provide a helpful gateway to our more detailed content on the related topics. The video on core concepts also occurs in the section on incentive stock options (ISOs), where a new video on ISO taxation is in the works.

Other New Stock Option Content: Articles, A Podcast, And A Quiz

At myStockOptions.com, we have comprehensive resources on equity compensation for all levels of experience. Among our popular content on fundamental topics are articles on the basics of restricted stock and RSUs (Restricted Stock 101) and employee stock purchase plans (ESPPs 101). To these, we have added a new article on the basics of stock options, Stock Options 101: The Essentials. In clear, non-technical language, it presents the core concepts, facts, and terms that employees must know to make the most of stock options.

Stock options can be very lucrative if handled properly, but there are situations in which people can easily make mistakes with them. In a new exclusive article, CFP Paul Palazzo discusses the most common financial-planning errors that he sees involving stock options—and how to avoid those pitfalls. Common mistakes include exercising early without a good reason, allowing tax treatment to drive decisions, and ignoring the very real risks of having too much wealth concentrated in just one company's stock. This article includes a special podcast interview of the author.

After reading our articles and FAQs on stock options, you will want to test your knowledge. Fortunately, you can do this immediately with the interactive quizzes at myStockOptions.com. We have a new quiz about nonqualified stock options (NQSOs) alongside a general quiz on stock options. In addition, 12 other quizzes cover many other topics in equity compensation. For those pesky questions you get wrong, the answer keys in all of our quizzes provide links to related content for further learning.

License Our Expertise For Your Employees

For companies, education is vital for ensuring that stock compensation motivates and retains highly valued employees and executives. All of our expert yet reader-friendly articles, FAQs, and other content are available for licensing by companies that want to improve their stock plan education and communications for participants. Content licensing is just part of the suite of corporate services that we offer.

Potential Tax Changes For Equity Comp And Nonqualified Deferred Comp In Senate Finance Committee's Report

Although it's been a busy summer, we have tried to catch up on some of our reading, including (yes, really) reports from Congressional committees. In May, the staff of the Senate Finance Committee (SFC) released the seventh in its series of reports for committee members on alternatives to consider when they start writing tax-reform legislation. Just as we are getting used to the tax changes that started in 2013 for stock comp and nonqualified deferred comp, it now seems that additional tax law changes, including possibly major reforms, may be on the way. Of course, it is impossible to predict what new legislation Congress may seriously consider or the likelihood and timing of its eventual passage.

The SFC staff's report, Economic Security, looks at tax-code modifications related to retirement plans, health-care benefits, executive compensation, life insurance and annuities, and employee fringe benefits. Without putting forward a particular proposal, the report summarizes legislative ideas that have been introduced in Congress, presented during committee hearings, or suggested by independent tax experts and bipartisan commissions. Listed in Section V (Executive Compensation), some of the possibilities that apply to stock compensation include:

• Eliminating Section 162(m) or the exception for stock options, or linking the deduction limit to a multiple of employee salary.
• Eliminating incentive stock options.
• Limiting the corporate tax deduction for options to the earnings charge and making companies take it in the year when the options are expensed.

As for nonqualified deferred compensation, the listed potential reforms include:

• A repeal of IRC Section 409A, either for all companies or just for privately held ones, or at least a repeal of the 20% penalty and interest currently imposed on distributions to NQDC plan participants when they or their companies do not comply with 409A.
• A major change in the timing of NQDC taxation to the moment when the compensation is earned or vested. Currently, only Medicare and Social Security taxes apply at that point, and ordinary income tax applies upon distribution.
• Considering tax earnings in NQDC accounts on a current basis instead of at distribution, and/or limiting yearly deferrals to $1 million.

Writing in a client alert, attorneys at the law firm McGuire Woods find the report significant for numerous reasons. First, they note, these areas will receive "close scrutiny" during the debate on tax reform. Second, the report presents a thorough outline of suggested tax-reform proposals that may make their way into any legislative compromise. Third, the report shows the complexity of the current tax system and the competing goals of various tax provisions. The author of a memo from the accounting firm Schneider Downs also sees the report as a viable framework for Congress to use, as provisions relating to employee benefits are "tax expenditures and an easy target for tax reform."

Stock Comp And Nonqualified Deferred Comp Impacted By Supreme Court's DOMA Decision

As widely reported, the Supreme Court ruled last month in US v. Windsor that Section 3 of the Defense of Marriage Act (DOMA) is unconstitutional. Section 3 provided that only opposite-sex marriages would be recognized as valid for the purposes of federal law. As a result of the decision, people in same-sex marriages recognized under the laws of the states where they live are considered married for the purposes of federal statutes and regulations that mention or involve marital status.

We did not see how the ruling could affect stock plans until we began receiving a slew of memos and alerts on the subject from law firms, such as Goodwin Procter, Paul Hastings, and Wagner Law Group. Among more than 1,000 federal laws and regulations impacted by the Windsor ruling are those which affect the design and administration of employee benefit plans. In short, spousal provisions in employee benefit plans should treat same-sex spouses and opposite-sex spouses in the same way, at least if they live in a state that recognizes same-sex marriages. While stock plans and nonqualified benefit plans are not affected by federal laws in the same way as qualified retirement plans (e.g. a 401(k) plan) or health and welfare plans, the changes that will be required in these other benefit plans will probably lead to similar modifications in stock plan documents.

The updates from law firms mentioned above, such as Goodwin Proctor's memo, suggest that companies should look through benefit plans and policies, as well administrative procedures, for situations where marital status matters. Companies will want definitions of spouse and married to be consistent across benefit and compensation plans. In any place where your stock plan documents, forms, and procedures refer to a spouse, this reference can now be defined to include same-sex spouses. This type of wording may appear in spousal consents, beneficiary designations (and default beneficiary rules), limits on transferable options, surviving-spouse rights to stock grants upon death, and procedures to be followed for dividing grants in divorce.

As for nonqualified deferred compensation plans, a connection with the underlying qualified plan terms usually occurs in supplemental or excess 401(k) plans (i.e. deferrals for amounts over 401(k) maximums). Thus the new rules imposed by the DOMA decision will flow from the qualified plan, as explained in part of an update from Kilpatrick Townsend & Stockton. In addition, the allowable hardship withdrawals for an "unforeseeable emergency" under the 409A rules may now consider certain expenses (such as medical, tuition, and funeral costs) of same-sex spouses.

For details on the related tax impacts of the DOMA decision, see a helpful guide from CCH.

Strategies For Increased Tax Rates: Ideas For Stock Compensation And Nonqualified Deferred Comp

Well into July, there has been no summer slowdown in the worlds of equity compensation and nonqualified deferred comp. The tax-rate increases that took effect at the start of 2013 have kept us busy with adding and updating content on financial and tax planning at myStockOptions.com. In-depth analyses of the new tax landscape occur in two articles by experts:

• New Tax Act And Medicare Surtax: Impact On Stock Option And Restricted Stock Strategies, by Alan B. Ungar. The American Taxpayer Relief Act and the Affordable Care Act introduced tax-rate increases you need to consider in deciding when to exercise stock options, when to sell company stock, and how to plan around income from restricted stock vesting. This article explains the changes in tax law and suggests strategies for minimizing the new taxes.
• Tax Planning For Options, Restricted Stock, And ESPPs After 2013 Tax Law Changes: High-Income Taxpayers Impacted Most (Parts 1 and 2), by Tom Davison and William Whitaker. The beginning of 2013 brought notable shifts in tax rates for people at higher income levels. Part 1 surveys the important tax changes and considers their impact on planning. Part 2 looks at planning strategies involving capital gains rates, the AMT, and ISOs, and considers general ideas related to income-shifting.

For a quicker read with highlights of the new tax provisions and the related planning ideas, see our series of FAQs on the tax-rate increases:

• What tax changes under the American Taxpayer Relief Act affect stock compensation?
• How does the health-care reform law affect my Medicare tax and stock compensation planning?
• What's the impact of the 2013 tax increases on my restricted stock grants?
• How have the withholding taxes on my equity compensation changed in 2013?
• What are the federal tax-withholding rates on stock compensation? Is the rate different for amounts above $1 million?
• What are capital gains and capital losses? What are the capital gains tax rates?
• I am thinking about selling some company stock this year, as next year my income will trigger the 3.8% Medicare surtax on investment income, along with higher tax rates on capital gains and dividends. After selling the stock this year, I would then repurchase it to reset the basis. What are the issues I need to consider?

More insights and analysis on the new tax landscape will appear as 2013 progresses.

Articles Dissect The Impact Of 2013 Tax Changes On NQDC

Over at our sister website myNQDC.com, our comprehensive resource about nonqualified deferred compensation (NQDC), four articles examine the impact of the recent tax changes on planning for NQDC:

• When Higher Tax Rates Make Nonqualified Plans More Attractive, by William L. MacDonald. This article considers whether the 2013 tax changes have increased the appeal of NQDC plans, looks in number-crunching detail at the pros and cons of a lump-sum payout versus installment distributions, and warns about tax problems that can arise from certain features of NQDC plan design.
• Four Nonqualified Plan Trends To Watch With Tax Rate Increases, by Michael Nolan. After explaining why the timing for NQDC plans could not be better, the author pinpoints trends involving income deferral that are likely to gather pace in the new tax and financial-planning environment.
• NEW! Tax Increases That Affect Your Planning For Nonqualified Deferred Compensation, by Bruce Brumberg. The capacity for tax-planning and income-shifting is one of the main benefits that make nonqualified plans appealing. When tax rates increase, the advantages of NQDC plans also grow. In this article, the author explains the various tax changes that affect NQDC planning.
• UPDATED! Advantages To Pre-Tax Deferral Of Income In An Uncertain Tax Environment, by Steve Broadbent and Chris Nyland. Learn how to consider recent and future tax-rate changes and investment returns when analyzing whether to participate in your company's NQDC plan. The authors' analysis compares deferred compensation to the after-tax investment of the same money. When tax rates rise, NQDC can perform better over the long term than a comparable personal investment account.

See also the full range of content on tax topics at myNQDC.com.

Discounted Stock Options Hit With Section 409A Surtaxes

A recent summary judgment decision, in Sutardja v. United States (Federal Claims No. 11-724T 227-13), makes it clear that discounted stock options face the draconian penalties of IRC Section 409A. The ruling upheld the IRS assessment of a 20% surtax plus interest on income the plaintiff received at option exercise under deferred compensation arrangements found to be noncompliant with 409A. The amounts in dispute total $3,172,832, plus another $304,456 in interest. While in this challenge to the IRS assessment the court still must decide whether discounted stock options were actually granted, it brushed off all the plaintiff's legal arguments claiming that Section 409A does not apply to discounted options.

This case drew attention in a few different law firm blogs. These included Benefits Notes by Leonard Street & Deinard, where attorney bloggers discussed the case on March 7 and again on March 12. As the attorneys warn, the IRS is strictly enforcing the Section 409A rules in examinations of employers. Unless discounted options are structured to be exercised only on a fixed date or upon an allowable 409A event, the law firm urges companies to use one of the safe harbors in the regulations on setting exercise prices. It also warns executives that "they can be the ones who suffer even if they are not the ones who set the discounted price for the options."

In an alert on March 21, the law firm Morgan Lewis examines some implications of the decision. In their view, the case symbolizes the need for careful attention in determining and documenting how the fair market values of options are determined—at the risk of dire tax consequences. The firm also notes that the plaintiff, a co-founder of a now public and successful semiconductor company, "may still prevail" in the trial to determine whether the options were discounted when the company was private, so additional developments in this case "merit watching."

In his Executive Compensation Blog (Mar. 26), comp and benefits attorney Michael Melbinger of Winston & Strawn criticizes the IRS decision to bring the case, given the common stock option grant practices at the time of the disputed activities. He feels "it is extremely disappointing that the IRS would demand penalties under the facts and timeline in this case."

For additional information on discounted stock options, see the related FAQ on myStockOptions.com. See also myNQDC.com, our sister website on nonqualified deferred compensation, for details on IRC Section 409A.

Tax-Rate Uncertainty Complicates Year-End Planning For Option Exercises & Company Stock Sales

Future tax rates on your mind? You're not the only one. Although less than three weeks remain before the current tax law ends at the close of 2012, the tax landscape beyond is still unclear. Unless a compromise is reached in Washington, tax rates will rise, though so far only the 0.9% Medicare tax increase and new 3.8% Medicare surtax seem to be beyond any possibility of modification.

In our most recent quarterly newsletter, we introduced two new FAQs discussing strategies with stock options and company stock holdings in light of potential tax increases after 2012. Both FAQs, also available in our section Year-End Planning, are reproduced in full below.

With the potential for tax-rate increases in 2013, I am thinking about exercising my nonqualified stock options to accelerate income into 2012. What issues do I need to think about?

Before you rush into exercising, you may want to do some calculations with potential future stock prices and tax rates. When you exercise earlier than necessary and pay taxes on your option spread, you lose some of the leverage that stock options offer. Experts feel the likelihood of higher tax rates ahead should not be the only reason for exercising at the end of 2012. The tools on myStockOptions.com, including the Quick-Take Option calculator, can help you consider various "what if" scenarios.

Here are some general situations where it makes sense to evaluate whether you should exercise options in 2012 rather than later:

• You were already planning to exercise options in next few years.
• The options are close to expiration.
• The options are deep in the money (i.e. there is a big spread between the market price and the exercise price).
• You need to diversify because your holdings are overly concentrated in company stock.
• You plan to change jobs soon. (Vested options almost always expire if they are not exercised soon after leaving the company.)

I am thinking about selling some company stock this year, before the new 3.8% Medicare surtax and the potential rise in capital gains tax rates, and then repurchasing it. This would reset the basis. What are the issues I need to consider?

By selling stock at a gain and then buying it back at the current price, you create a new basis in the stock. Because the shares are sold for a gain, there is no wash sale to worry about. The main reason for selling would be to avoid higher capital gains tax rates in a future year and the new Medicare surtax on net investment income. Compare this technique to tax-loss harvesting, in which stock is sold at a loss (without repurchase) to have future losses that can be netted against gains (another year-end planning strategy).

Example: You own company stock worth $100,000. The tax basis is $60,000. If you sell it now, you have $6,000 taxes on a $40,000 gain (at the current 15% capital gains rate). If you buy the stock back at same time, you obtain a $100,000 basis for a future sale.

Before you decide to do the same type of transaction, consider these issues in the situation presented by the example above:

• Check the size of capital-loss carry-forwards or losses from this year. Depending on your prior tax-loss harvesting, you may have $40,000 in losses to net against gains. If so, you can wait on a sale until the future, as you would not be paying any tax on gains up to that amount.
• Decide how you will pay the taxes and think about alternative uses of that money.
• Individuals who may be close to death should consider that the step-up in basis which occurs at death eliminates entirely the tax on the gain (i.e. you would want to wait on the sale).
• Think about whether a sale would trigger an unwanted disqualifying disposition for shares acquired through an employee stock purchase plan or incentive stock options.
• Remember that insider-trading rules and company blackouts may prevent sales and purchases. Unless you already have a Rule 10b5-1 plan in place, best practices for these plans usually require more than a few weeks to elapse between the time of plan setup and the first sale under the plan.

Director Stock Compensation: Three New Studies Reveal Trends In Stock Options, Restricted Stock, And RSUs For Directors On Company Boards

Trends in the use of stock options and restricted stock/RSUs for directors on corporate boards is a topic on which equity compensation surveys are often silent. This is why we were pleasantly surprised to find no fewer than three recent surveys that include details on stock comp for directors. The trends they reveal will undoubtedly be of interest to many compensation and stock plan professionals.

Towers Watson, a compensation consulting firm, published data on equity awards to directors in its newsletter Executive Compensation Bulletin. The firm reports that while most Fortune 500 companies tend to pay an equal mix of cash and equity to directors, recent increases in pay have come from the stock side. The firm views this as a way to further strengthen the alignment of interests between shareholders and directors.

At the median, the mix of pay for directors was 45% cash and 55% equity in 2011. These figures were 48% cash and 52% equity back in 2009, and Towers Watson attributes the shift to some companies that have increased grant values. The firm states that equity awards to directors are now almost entirely restricted stock grants, and the number of Fortune 500 companies using stock options has dwindled to a "select group." The value of equity awards to directors has not been affected by volatility in stock prices because most companies base grant guidelines for directors on a fixed value rather than on a fixed number of shares. The median value of annual equity awards for directors rose 9% between 2010 and 2011, to about $125,000.

The most common type of grant made to directors is restricted stock or deferred shares (79%), followed distantly by a combination of stock options/restricted stock (11%) and by grants of just stock options (3%). Stock ownership guidelines and share retention policies appear at 87% of the companies (up from 83% in 2010). The median value of the stock ownership required is $300,000.

In an analysis of director compensation in 2011 at S&P 500 companies, the HR consulting firm Mercer found the following:

• Most of the companies (77%) grant only restricted stock to directors.
• The percentage of companies granting options or SARs to directors fell from 26% in 2010 to 22% in 2011.
• Stock options are awarded alongside restricted stock at 18% of the companies, where typically each grant type makes up about half the total value of a director's equity compensation.
• The majority (62%) of the companies award at least one grant type on a fixed-value basis, meaning the dollar value of grants remains the same each year, with a variable number of shares or options accordingly.
• At 23% of the companies, new board members get both a yearly grant plus a separate initial equity award upon the election to the board of directors.
• Annual cash retainers for directors increased in 2011, to a median value of $75,000, while stock compensation rose 10%, to a median value of $131,900.

In its 2012 Director Compensation Report, the consulting firm Frederic W. Cook & Co. found some similar trends in its research, which covered 240 public companies in the financial services, industrial, retail, and technology sectors, divided into three size categories based on market capitalization. Among the firm's key findings:

• Full-value stock awards (restricted stock and RSUs) are the "most prevalent" form of stock grant, using a fixed-dollar value for the grant size. This is a continued shift away from options and fixed-share grant sizes.
• The number of companies using stock options has declined about 25% since the prior study. Stock options are used by less than 15% of the financial services, industrial, and retail companies, by contrast with 34% of the tech companies.
• The average pay mix varies among sectors and company sizes. For example, stock awards make up 49% and stock options 17% of the total compensation at tech companies (the remaining percentage is cash), while at financial service firms the corresponding percentages are 41% and 3%.
• Large-cap companies grant more equity compensation (56% stock and 8% options) than small-cap companies (38% and 7%). The firm explains that large companies are under more pressure to align pay with shareholder interests.
• In the industrial and retail sectors, 85% of the companies use stock grants only, while 17% of the tech companies and 5% of the retail companies provide only stock options. At tech companies, 17% use a combination of stock grants and options, while only 7%–12% of the companies in the other sectors use this approach.

At myStockOptions.com, we continually watch for new surveys on equity compensation, as we know how valuable these are to the stock plan professionals who routinely use our website. More recent survey data on stock comp is available in one of our most popular FAQs.

Facebook Stock Comp: A Status Update

Earlier this year, we blogged about the potential stock comp wealth (and related tax issues) that seemed certain to blossom for Facebook employees amid the company's much-hyped initial public offering in May. Time and the market have popped these balloons of expectation. Although investors were predicted to "like" Facebook stock in huge numbers, skepticism about the company's valuation and prospects has prompted significant investor flight over the past few weeks. The surprising plunge in the stock price has created unexpected difficulties for the company's equity compensation.

Angst among Facebook employees about their equity awards has been widely reported (e.g. by Reuters and Business Insider). While the expiration date of the lockup on most employee shares (almost 50% of total shares outstanding) is still fairly far off (Nov. 14), Reuters notes that some employees are already adjusting their expectations because of the poor post-IPO performance. Many now plan to sell a smaller portion of their stake in the company than they otherwise would have if the stock price had risen or even just stayed flat. "I will definitely take some," said an employee anonymously quoted in the news report. "But my debate is how much." The article in Business Insider wonders whether Facebook may develop problems with employee retention, at least in the short term.

Additionally, Facebook needs to raise cash for the taxes ($2.5–4 billion) incurred by its share withholding at RSU vesting, and it has been planning to sell shares to cover this. Because of the fallen stock price, financing that tax bill will now be more difficult than expected.

Facebook employees who joined the company during the past 18 months (perhaps half its workforce) were granted restricted stock units (RSUs). This is fortunate for them. Unless the underlying stock price drops to zero, RSUs always have some value. Stock options, by contrast, would be well underwater, as the exercise price would reflect the pre-IPO stock valuation—much higher than the current depressed price. Before the IPO, various option-valuation models gave Facebook stock a worth of $24.10 during the first quarter of 2011 and around $31 in the first quarter of 2012. Now that the stock price is below these thresholds, the golden handcuff would have lost its lure for restless employees.

In this blog we have also discussed Zynga's pre-IPO demand for nonproductive employees to give back large unvested stock grants. Bloomberg has revealed that Zynga is now broadly granting stock options to retain staff after a fall in the company's stock price. Like Facebook, Zynga had previously granted mostly RSUs. The reasoning behind the switch seems clear. Stock options have much more upside than restricted stock. In short, you get more options per grant, and the fixed purchase (exercise) price provides investment leverage. As a result, options have the power to generate much greater wealth from stock-price appreciation than restricted stock/RSUs do. This, in turn, may help to keep employees at the company.

If Facebook believes its stock is unreasonably depressed, we wonder whether it too will start proffering the golden carrot of stock options to motivate and retain employees. This move could also signal some much-needed optimism about Facebook stock. If or when the stock price does rise, these options would be much more valuable and attractive than RSU grants.

Got Eight Minutes? Get The Facts On The New IRS Forms & Reporting For Stock Sales

If there's a way to make learning about tax forms fun, we'll try it. In the Tax Center at myStockOptions.com, we just published an animated presentation on the expanded IRS Form 1099-B, the new IRS Form 8949, and the revised Schedule D. It's a painless way to learn these important developments and prevent expensive mistakes on tax returns during the imminent tax season.

In a concise, engaging overview, our editor-in-chief Bruce Brumberg will inform you about:

• the expanded reporting on Form 1099-B, and why the reported cost basis may be wrong or omitted
• how to figure out the right cost basis for your stock sales
• the new Form 8949 and how to report stock sales on it
• how to interpret Form 1099-B when completing Form 8949
• what to do when the cost basis in Box 3 of Form 1099-B is too low or not given
• totaling the reported stock sales on the revised Schedule D

Need further information? There's plenty more where that came from. A new article and FAQ at myStockOptions.com give full coverage of these tax-return topics. Additionally, our special section Reporting Company Stock Sales presents FAQs with annotated diagrams of Form 8949 and Schedule D. Each FAQ explains and illustrates a different reporting situation involving stock options, restricted stock, restricted stock units, performance shares, employee stock purchase plans, or stock appreciation rights. Clear instructions and diagrams show how to complete the forms, whether the cost-basis information on Form 1099-B is accurate, too low, or omitted.

Stock Comp Income & Withholding On Your Form W-2? Time For Our FAQs & Diagrams

Form W-2 is in the air—or, hopefully, safely in your mailbox or desk by now. If you had income from stock compensation or an employee stock purchase plan in 2011, you need to understand where that income is reported on the W-2 so that you can complete your tax return properly. In the award-winning Tax Center at myStockOptions.com, we have a series of FAQs dedicated to interpreting this sometimes cryptic document. These FAQs include annotated diagrams of Form W-2 that clearly show you around the form.

Stock Options

If you exercised nonqualified stock options last year, the income you recognized at exercise will be reported on your W-2. The income from a nonqualified stock option (NQSO) exercise appears on the W-2 with other income in:

• Box 1: Wages, tips, and other compensation
• Box 3: Social Security wages (up to the income ceiling)
• Box 5: Medicare wages and tips
• Box 16: State wages, tips, etc. (if applicable)
• Box 18: Local wages, tips, etc. (if applicable)
• Box 12 (Code V)

That last item, Code V in Box 12, identifies the NQSO income included in Boxes 1, 3, and 5. For the places where the tax-withholding amount appears, see our FAQ on W-2 reporting for NQSOs. (The W-2 reporting is, by the way, identical for stock appreciation rights, with the exception that Code V is not used.)

With incentive stock options, the spread value appears on the W-2 only when you make what is technically called a disqualifying disposition, i.e. when you sell or gift the stock before you have met the required holding periods of one year from exercise and two years from grant. In that case the income appears on the W-2 as compensation income. Unlike with NQSOs, your company does not withhold federal taxes on ISO exercises and no money is owed for Social Security and Medicare, even with a same-day sale or any later disqualifying dispositions. For the details of W-2 reporting for ISOs in this situation, see our FAQ on this topic in the Tax Center.

Restricted Stock, RSUs, Performance Shares

The vesting of restricted stock, the share delivery from restricted stock units (RSUs), and the vesting of performance shares all prompt W-2 reporting of the income received. The treatment on the W-2 is essentially the same for all three grant types. Income appear in the following places:

• Box 1: Wages, tips, and other compensation
• Box 3: Social Security wages (to income ceiling)
• Box 5: Medicare wages and tips
• Box 16: State wages, tips, etc. (if applicable)
• Box 18: Local wages, tips, etc. (if applicable)

To learn which boxes show the taxes withheld, and other reporting details for all three grant types, see the related FAQs, including annotated diagrams, in the Tax Center.

Alert: If you made a Section 83(b) election to be taxed on the value of restricted stock at grant, your W-2 for the year of grant, not vesting, will show the income and withholding.

Employee Stock Purchase Plans (ESPPs)

The W-2 reporting for ESPP income depends on whether your company's ESPP is tax-qualified or not and, if it is tax-qualified, how long you hold the shares. For a nonqualified ESPP, there is withholding on the income you recognize at purchase, and the income and withholding are reported on your W-2 in a way resembling that for nonqualified stock options. With a tax-qualified ESPP, nothing appears on your W-2 until you sell the shares. The details of all three situations are clearly presented, with annotated diagrams, in the section on ESPP W-2s in the Tax Center at myStockOptions.com.

Sell Shares In 2011? The Fun Ain't Over Yet

If you sold shares from stock compensation or an ESPP last year, you'll need more guidance to report the sale proceeds on your tax return. Fortunately, the Tax Center at myStockOptions.com features the section Reporting Company Stock Sales. Each FAQ in the section includes annotated diagrams of Form 8949 and Schedule D, the two crucial forms for stock-sale reporting.

Resources For Stock Plan Professionals

All of our tax-season content, including our popular annotated tax forms, is available for corporate licensing. Help your participants make the most of their stock compensation by giving them resources for avoiding expensive mistakes on tax returns. The excellence of our resources is attested by the many testimonials we have received, so don't just take our word for it. As one of our licensees puts it, employees "find the tax information and annotated tax forms extremely helpful." In the words of another client, "employees understand concepts much better with the straightforward illustrations." Please contact us for licensing details (617-734-1979 or [email protected]).

Media Spotlight On The Corporate Tax Deduction For Stock Compensation

Many executives are now sitting on big gains in stock options that were granted when stock prices sank to extreme lows during the financial crisis of 2008 and early 2009. Not surprisingly, this has attracted attention from the news media. Skeptical business commentators wonder whether these executives are benefiting more from the overall rising tide of the stock market than from corporate achievements. In addition, the media spotlight has also singled out the corporate tax deduction. The common media view of it is exemplified by a plaintive article in The New York Times (30 Dec. 2012):

"Thanks to a quirk in tax law, companies can claim a tax deduction in future years that is much bigger than the value of the stock options when they were granted to executives. This tax break will deprive the federal government of tens of billions of dollars in revenue over the next decade."

This notion that companies are exploiting a tax loophole does not necessarily take into account the symmetry that exists in the tax code's treatment of compensation. When an employee recognizes income from any type of compensation, the company gets a tax deduction for that same amount. In some situations with stock compensation, the government gets taxes twice. First, at option exercise (or restricted stock/RSU vesting) the employee pays taxes on the grant at ordinary income rates; later, after shares have been held, capital gains rates apply at sale. This can generate tax revenue at least equal to the tax revenue that is not received when companies deduct the value of the grant from their taxable income.

Dean Baker, the co-director of the Center for Economic and Policy Research, writes in his blog that "it is not clear that this treatment is improper." While he acknowledges that companies which granted options at market lows in 2008–2009 will benefit from the current "bounceback" of stock prices, he also points out that the reverse occurred with "options issued in the years 2005–2007 that ended up being worthless" during the downturn. To him, the real issue is that "many executives were rewarded for a run-up in strike prices that had nothing to do with their performance, [but] this is a problem of corrupt corporate governance, not the tax code."

In Congress, Senator Carl Levin has regularly proposed to limit the corporate tax deduction to the amount of the earnings charge. However, this would raise other issues in linking the tax deduction to the accounting treatment of stock options. (For example, companies would deduct the accounting value of option grants that, after vesting, are never exercised because they are underwater.) Nevertheless, companies should prepare for a potential fight over the tax deduction if Congress gets serious about tax reform.