Level 1 Taxation Flashcards
Ordinary Income
Income generated by the work you do.
Income, such as compensation income, taxed at ordinary rather than capital gains rates under the Code.
Ex. When a Restricted Stock Grant Vests because when the vest happens, the value of that grant is considered “Income”.
Capital Gains
Income generated by the assets you hold.
The increase in value, or profit, realized from the sale or exchange of a capital asset; that is, the excess of the proceeds received from the transaction over the basis of the asset.
Capital Loss
loss generated by the assets you hold is known as capital loss.
The decrease in value realized from the sale or exchange of a capital asset; that is, the excess of the basis of the asset over the proceeds received from the transaction
IRC Section 422 Incentive Stock Options Tax Status
Statutorily Tax Qualified
Statutory Requirements: • Plan-level terms and conditions • Recipient eligibility conditions • Individual grant terms and conditions • Allowable Discretionary Conditions • Tax Treatment
Statutory Plan Requirements
- Must be written
- Must be adopted by the Board of Directors
- Must be approved by the shareholders within 12 months before or after board approval
- Must state the number of shares available to be granted as ISOs
- Identifies eligible award recipients, i.e., specific employees or class of employees because ISOs are only issuable to employees.
Common Discretionary Conditions acceptable under Section 422
- Right of repurchase
- Right of first refusal
- Right to pay for exercise with company stock (e.g., stock swap or net exercise)
Statutory Recipient Requirements:
Options may be granted only to….
A person who is an employee of the company (or its parent or subsidiary) on the date of grant.
“employee” defined by IRC Section 422 for ISOs
- Control of hours, working conditions, work product, power to terminate and W-2 issuance are the most significant factors
- A “20 Factor Test” has been assembled based on court cases and IRS rulings to determine whether an employer/employee relationship exists
Defined with reference to the common-law definition of employee as used for purposes of wage withholding under Section 3402 of the Internal Revenue Code.
Boils down to whether the employee is a 1099 or W2.
ISO Transferability
May not be transferable during the employee’s lifetime.
may only be exercised by the employee.
ISO post-termination exercise periods are maximum
- 3 months after termination of employment, except
- 12 months after disability, or
- Until original expiration date by the employee’s estate if the employee dies
- None of these periods can exceed the original expiration date
ISO Statutory Grant Requirements
Exercise price
Must be at least 100% of grant date fair market value.
10% owners must have an exercise price of at least 110% of the grant date fair market value and the maximum term of the grant is 5 years from the date of grant.
ISO Statutory Grant Requirements
Grant term
- Must be granted within 10 years of the earlier of board or shareholder approval
- Cannot be exercisable more than 10 years after grant date
- 10% owners have maximum grant term of 5 years
ISO Statutory Grant Requirements
Grant limit/ $100k Rule
No limit to aggregate number or value of individual grant, HOWEVER, only an aggregate of ISO options first exercisable as to $100,000 worth of stock in any calendar year based on the grant date fair market value of each award
- Early exercise options are counted toward the limit in the year of grant
- Accelerated options are counted toward the limit in the year of acceleration
- Excess converts to non-qualified stock options and are taxed as NSOs upon exercise
Fair Market Value
the value of a share of stock on any given date
Gain
Difference between exercise date fair market value and exercise price paid (also called “spread”).
Profit
What does “Tax Rates” refer to?
Published tax rates under the Internal Revenue Code
Disposition
the sale, gift, or other transfer of stock purchased pursuant to an option
Tax Benefit of ISOs over NSOs
The gain at the date of exercise is exempt from taxation as ordinary income at the time of exercise, unlike NSOs
Holding period to maximize taxation benefits on an ISO
2 years after GRANT and 1 year after EXERCISE
Alternative Minimum Tax (AMT)
Places a floor on the percentage of taxes that a filer must pay to the government, no matter how many deductions or credits the filer may claim.
Meant to prevent the rich from sheltering their income from taxes.
Qualifying Disposition
Qualifying disposition refers to a sale, transfer, or exchange of stock that qualifies for favorable tax treatment. Individuals typically acquire this type of stock through an incentive stock option (ISO), or through a qualified employee stock purchase plan (ESPP).
How is taxation treated for a Qualifying Disposition
Treated as Capital Gain at subsequent sale if holding periods are met
How are Disqualifying Dispositions treated during Taxation event.
Treated as Ordinary Income if holding periods not met
ISO transactions that don’t count as dispositions
- Transfer of ISOs, or shares acquired upon the exercise of an ISO, to an estate after the optionee’s death.
- Transfer of the option shares acquired upon the exercise of an ISO into “street name.”
- Transfer of the option shares acquired upon the exercise of an ISO to the nonemployee spouse incident to a dissolution of marriage.
IRC 422 ISO – IRC Section 6039 Reporting
Employer Tax Treatment On Exercise Date for IRC 422 ISOs
No income reported, must provide Form 3921 to both employee and IRS to report the terms of the exercise
Employer Tax Treatment
Qualified Dispositions
- Nothing for the company to report
- No tax deduction for the company
Employer Tax Treatment on Disqualifying Disposition
- Company reports income on W-2, no withholding required, and
- Takes a tax deduction based on income reported
Treatment and calculation of Employee taxation on a qualifying disposition for an 422 ISO
No ordinary income tax if the holding periods are satisfied (2 years from date of grant and 1 year from date of purchase).
Capital Gains taxes on spread between exercise price and sale price.
= Exercise Price - Sale Price
No AMT trigger
Subject to alternative minimum tax (AMT) in year of exercise
When and what is AMT tax calculated from
On spread at time of exercise
Tax Preference Item
type of income, normally received tax-free, that may trigger the alternative minimum tax (AMT) for taxpayers.
How can taxpayer avoid AMT application
AMT avoided if stock is sold in same year as exercise in disqualifying disposition.
Tax is calculated on gain or loss at time of sale.
Tax Cuts and jobs Act of 2017
Amended the Internal Revenue Code of 1986.
Major elements of the changes include:
- reducing tax rates for businesses and individuals
- increasing the standard deduction and family tax credits
- eliminating personal exemptions and making it less beneficial to itemize deductions
- reducing the alternative minimum tax for individuals and eliminating it for corporations
A disqualified disposition occurs when
an employee loses the legal power to control or further dispose of the option shares.
How to calculate 422 ISO taxation on a disqualifying disposition for a Employee during Income Tax
Tax on the lesser of :
-spread between exercise price and stock’s fair market value on exercise date
= Exercise Date FMV - Exercise Price
OR
-spread between exercise price and stock’s sale price.
= Sale Price - Exercise Price
These are due in year of stock sale.
How to calculate ISO taxation on a disqualifying disposition for a Employee during Capital Gain
Treated as NSOs! Difference between fair market value on exercise date and sale price of stock.
= Exercise Date FMV - Sale Price
ISO taxation on a disqualifying disposition for a Employer: Tax deduction
The company is allowed to take a tax deduction for the amount of ordinary income
reported on the employee’s W-2.
Must report that amount on the employee’s W-2 in the year of the disqualifying disposition in order to claim the deduction.
How to calculate NSO taxation for an optionee’s Ordinary Income
Difference between the exercise price and the fair market value on the exercise date
“Spread” = Exercise Price - Exercise Date FMV
How to calculate NSO taxation for an optionee’s Capital Gain or Loss
Difference between fair market value on exercise date and price for which shares are sold
= Exercise Date FMV - Sale Price
Internal Revenue Code 162(m)
precludes publicly held corporations from deducting more than $1 million per year in compensation paid to certain covered employees.
NSO taxation for an employer
- Can take tax deduction for amount optionee must include in income upon exercise as reported on W-2 or 1099-MISC
- If optionee is an employee, company required to withhold income taxes on spread
How to calculate NSO Taxation at Exercise for Employees
Spread between fair market value on exercise date and exercise price.
= Exercise Date FMV - Exercise Price
This income is recognizable in the year of exercise.
• Not subject to alternative minimum tax (AMT)
NSO – Taxation at Exercise for Employer
- Deduction on amount reportable as ordinary income.
- Must withhold income and social taxes
How to calculate NSO Taxation at Sale for Employees
Capital gains taxed on difference between fair market value on exercise date and sale price
= Exercise Date FMV - Sale Price
NSO – Taxation at Sale for Employer
- No tax deduction beyond that on exercise date
- No reporting requirements
- No withholding for taxes
IRC Section 422 Covers
Governs the Incentive Stock Options
IRC Section 423 Covers
Options issued under an employee stock purchase plan.
“423” rhymes with “ESPP”
3 Components of IRC Section 423 Statutory Requirements
- Plan-level terms and conditions
- Recipient eligibility conditions
- Purchase Limit
IRC 423 ESPP - Statutory Plan Requirements:
Written plan
- Shareholder approval within 12 months before or after board approval
- Equal rights and privileges for all participants of the plan
IRC 423 ESPP - Statutory Plan Requirements: Who can participant
Employees only WITH limited exclusions permitted:
• No 5% or greater shareholders
• Right to purchase not transferable
IRC 423 ESPP - Statutory Plan Requirements: Purchase Limit
$25,000 purchase limit per person, per calendar year
- Measured on the FMV on the offering date
- Aggregate across all related ESPPs (issuer, parent, subsidiary)
- Can be up to $50k if Offering Period overlaps calendar year
$25,000/Offering Date FMV = Number of Shares that may be purchased under Section 423 in any given calendar year
IRC 423 ESPP - Statutory Plan Requirements: Purchase price
Maximum 15% discount on lesser of:
• Grant date (offering date) FMV
• Purchase date FMV
• If the Plan specifically states the lesser of term it’s called a “lookback” feature
IRC 423 ESPP - Statutory Plan Requirements: Maximum term (offering period)
- 5 years if the option price is based on the FMV of the stock on the date of exercise
- 27 months if the option price is set using a lookback feature
IRC 423 ESPP Excess payroll contribution carryover rules:
- Carry over from one purchase period to another, within the same offering period, is okay (and customary)
- Carry over from one offering period into a new offering period can trigger “equal rights and privileges” direct payment by all participants up to the largest carryover amount allowed in that period.
IRC 423 ESPP – Withdrawal rules
Plan withdrawal must be available or tax laws deem an exercise takes place every time money is withheld from the participant’s paycheck, instead of only at the end of the purchase period.
IRC 423 ESPP post-termination exercise periods
3 months after termination of employment, except:
- After death, exercisable until original expiration date by the employee’s estate
- Automatic withdrawal - in practice most plans refund the participant’s contributions if termination or death occurs before the next scheduled purchase date
IRC 423 ESPP- Options Transferability
- The option are never transferable during the employee’s lifetime and may only be exercised by the employee.
- The stock acquired by the option may be transferred after exercise without triggering a disqualifying disposition under certain special circumstances.
IRC 423 ESPP Option Holding Period for optimal Taxation at Disposition
- 2 years from first day of offering period AND 1 year after purchase date
- Qualified disposition can occur only after completion of BOTH holding periods
When does a Disqualified Disposition occurs through an option granted through a IRC 423 ESPP
Occurs when ONE of the holding periods is not met.
It triggers recognition of:
• ordinary income on the difference between FMV on purchase date and the purchase price, and
• capital gain on difference between the sales price and the purchase date FMV (or the FMV on the date of transfer if the stock is transferred instead of sold)
IRS Form 3922
Transfer of Stock Acquired Through an Employee Stock Purchase Plan (ESPP) Under Section 423(c) is for informational purposes only and isn’t entered into your return.
IRC 423 ESPP - Employer Deduction & Reporting if employee sells stock in a Qualified Dispositions
- No corporate tax deduction available
- Company reports income on W-2 for grant date discount
- No withholding required
IRC 423 ESPP - Employer Deduction & Reporting if Disqualified Dispositions take place
Corporate tax deduction based on ordinary income reported
Ordinary Income = Exercise Price - Exercise Date FMV
- Company reports income on W-2 for actual discount element
- No withholding required
IRC 422 ISO – IRC Section 6039 Reporting
IRC Section 6039 Tax Reporting Deadline for ISOs
- Company is required to furnish information to the IRS and employee upon exercise of an ISO
- Form 3921 is to be used for ISO filings.
- Deadline for the employee reporting is January 31 of the year following the ISO exercise for the employee
reporting - Deadline for IRS reporting is February 28 if via paper forms or March 31 if electronically (required if 250 or more forms)
Tax Reporting for ISOs - Form 3921
Reports on participants who’ve exercised ISOs must include:
- Employer’s name, address, and tax ID number (also of company whose stock is being transferred if it’s a different entity)
- Name, address, and identifying number of transferor
- Date of option grant
- Exercise price per share
- Exercise date
- FMV on exercise date
- Number of shares to which title transferred pursuant to exercise
Tax Reporting for ESPPs - Form 3922. Reports on “first transfer” of ESPP shares must include:
- Name, address, and identifying number of transferor
- Company’s name, address, and tax ID number
- Date of option grant
- Stock’s FMV on grant date
- “Exercise” price per share (purchase price)
- “Exercise” (purchase) price per share determined as if the option (ESPP share) was exercised (purchased) on the grant date (beginning of offering period)
- “Exercise” (purchase) date
- FMV on “exercise” (purchase) date
- Date legal title of shares transferred by transferor
- Number of shares to which legal title was transferred
Form 3921 & Form 3922 Difference
On the Form 3922 the “Exercise” (purchase) price per share determined as if the option (ESPP share) was exercised (purchased) on the grant date (beginning of offering period).
You can have an ESPP where the discount is based upon the purchase date FMV, but the Form 3922 still has to report the discount based on the grant date, which is the first date of the offering period.
IRC 423 ESPP – IRC Section 6039 Report Triggering
Company is required to furnish information to the IRS and employee upon FIRST TRANSFER of legal title of shares purchased under a 423 Plan.
If shares are immediately deposited into a brokerage account, the deposit is considered “first transfer.”
Internal Revenue Code IRC Section 6039
Requires the company to furnish information to the IRS and to the employee related to the exercise of ISOs and the first transfer of ESPP stock. Must report to the IRS when transferring stock acquired through an Employee Stock Purchasing Plan (ESPP) or when employees exercise Incentive Stock Options (ISO). Since companies must report every transaction by every employee
IRC 422 ISO – IRC Section 6039 Reporting
Tax Reporting for ISOs - Form 3921:
When are reporting for ISO exercised shares are NOT nessecary
When the ISOs turn into NSOs. If the grant itself loses preferential tax treatment for any reason then those ISO exercises are not required as part of that reporting.
So remembering that ISOs cannot be transferred other than by situations of death to the estate, any other transfer will be considered disqualifying and any subsequent exercise will be treated as an NSO and not reported on Form 3921.
Non-423 ESPP – Tax Treatment and calculation for Employees
- ESPP options not granted under a Section 423 plan are, basically, NSOs for tax purposes
- Difference between the fair market value of the stock and the exercise price on the exercise date are included as ordinary income in the year of exercise
= Exercise Date FMV - Exercise Price
How do ESPPs get classified as a Non-423 Plan
a) it does not meet the requirements of Section 423
b) the company decides to treat it as such, typically to avoid the challenges of staying compliant or simply because they want to provide even better benefits.
Non-423 ESPP – Tax Treatment for Employers
Generally, employer takes a tax deduction equal to the amount of ordinary income declared by the employee.
IRC 83(b) Election
Acceleration of a tax event
gives an employee, or startup founder, the option to pay taxes on the total fair market value of restricted stock at the time of granting.
Acceleration of tax event
A taxpayer can elect to accelerate the recognition of the income and pay taxes while there is still a substantial risk of forfeiture by filing an 83(b) Election
IRC 83 – Recognition of Income: Timing of Taxation on Restricted Stock
upon vesting (or on date after which vesting is guaranteed by retirement eligibility)
IRC 83 – Recognition of Income: Timing of Taxation on Stock Options
after exercise AND vesting (or on date after which vesting is guaranteed by retirement eligibility)
IRC 83 – Recognition of Income: How to calculate the amount taxed
The taxable income is the difference between the FMV of the stock on vest date and the amount paid
= Vest Date FMV - Amount Paid
Benefit of filing 83(b) Election
Most beneficial to accelerate the recognition of income in this way when the exercise or purchase price is very low, and the underlying stock is expected to appreciate significantly before the award vests.
Freezes ordinary income component of the award for taxation purposes – meaning that taxable income will be measured as the difference the FMV on the date of award and the payment price, instead of between FMV on the date the risk of forfeiture lapses (usually vest date) and the payment price
Risk of filing 83(b) Election
No revocation or refunds if award is later forfeited before vesting
Most important 83(b) Election filing requirement for Stakeholder
Election must be made within 30 days of grant (RSA) or within 30 days of the early exercise.
Most important 83(b) Election filing requirement for company
Include income in w-2 and take a tax deduction.
Restricted Stock Award Employee Tax Treatment without 83(b) Election is filed
- Restricted Stock is taxed at vesting
- The spread between the vest date FMV and the purchase price is taxed as ordinary income.
= Vest Date FMV - purchase price
An 83(b) Election includes:
- Your name, address, and taxpayer identification number
- A description of each property for which you are making the choice
- The date or dates on which the property was transferred and the tax year for which you are making the choice
- The nature of any restrictions on the property
- The fair market value at the time of transfer (ignoring restrictions except those that will never lapse) of each property for which you are making the choice
- Any amount that you paid for the property
- A statement that you have provided copies to the appropriate persons
Restricted Stock Award Employee Tax Treatment if an 83(b) Election is filed
spread at time of grant (if any) is taxed as ordinary income in the year of grant.
Subsequent gain on sale is taxed as capital gain
= sales proceeds – FMV grant date
(i.e. income recognized)
When is Restricted Stock Taxed?
Restricted Stock is taxed at vesting, unless an 83(b) Election is filed.
When is Restricted Stock Taxed?
Restricted Stock is taxed at vesting, unless an 83(b) Election is filed.
Restricted Stock Award Employer Tax Treatment
The employer can take a tax deduction for compensation reported to the awardee.
Special Circumstances for Death & ISOs
- Transfer to estate without restrictions
- Taxes due by estate
- Estate calculates AMT liability in year of exercise (if shares held through calendar Y/E)
- ISO holding periods and employment requirements are waived
Special Circumstances for Leave of Absence with IRC 422 ISOs Awards
No guaranteed right to return to work:
- On the day after three months of LOA, participant is considered terminated for ISO purposes.
- Unvested ISOs become NSOs and vested ISOs have three more months in which to be exercised as ISOs.
- After that six month period, all ISOs become NSOs and are taxed as NSOs when exercised.
Special Circumstances for Leave of Absence with IRC 423 ESPPs
- If leave lasts longer than three months and no guaranteed right of reemployment, the right to participate in a 423 Plan could be forfeited.
- Leaves of less than three months do not disqualify participant.
Maintaining ISO Status Through Change in employment status:
Employee to Consultant
unvested awards become NSOs immediately, vested awards have three months to be exercised as ISOs
Maintaining ISO Status Through Change in employment status: Termination
three months post-termination, then convert to NSOs
Maintaining ISO Status Through Change in employment status: Disability
12 months from date of disability
Maintaining ISO Status Through Change in employment status: Death
Until award expiration, must be exercised by estate of the deceased optionholder up until the award’s original expiration date.
Maintaining ISO Status Through Change in employment status:
Pre-exercise transfer
disqualifies award
IRC 422
Effect on ISOs of a divorsed option holder BEFORE option is exercised
Automatically disqualifies the award from ISO status
Maintaining ISO Status Through Change in employment status:
Post-exercise transfer
permissible to ex-spouse per divorce decree
Treatment of NSO deductions through Mergers and Acquisitions
If Company A merges with Company B, or Company B is acquired by Company A during an option’s life, the allocation of the deduction for an NSO exercise depends upon the form of the acquisition:
- If Company B (the target) survives the acquisition, possibly as a subsidiary, then Company B can take the deduction.
- If Company B (the target) is liquidated in the acquisition and only Company A (the acquirer) survives, then Company A can take the deduction.
How to calculate taxation on 423 ESPP during a qualified disposition
Both Ordinary Income and Capital Gains are recognized.
Ordinary income From Exercise is lesser of:
= Grant Date FMV - Price of Shares at Grant (with discount if applied)
= Sale Date FMV - Actual Purchase Price
THEN
Capital Gains = (Actual Exercise Price (with discount) - Ordinary Income from Sale) - Ordinary Income From Exercise
Wash Sale Rule
A wash sale occurs when an investor sells or trades a security at a loss, and within 30 days before or after, buys another one that is substantially similar.
The wash-sale rule prevents taxpayers from deducting a capital loss on the sale against the capital gain.
If the holder of an ISO believes it will appreciate substantially before vesting and intends to hold it for the statutory holding period, how do you minimize the potential AMT burden
Filing an 83(b) election when shares are unvested and the employee intends to sell in a qualifying disposition.
What is the primary difference between tax-qualified and non-qualified stock options?
To be tax-qualified the option and the plan under which it is issued must comply with certain statutory requirements.
Section 6039 Reporting
Requires a company to file an IRS on Form 3921 information return with the IRS and provide a written information statement to an employee whenever the company has transferred shares of stock to the employee in connection with the employee’s exercise of an ISO.
Each option exercise or stock transfer is a separate transaction, and therefore multiple transactions by a single optionee will trigger multiple filings
Tax Treatment on Restricted Stock Awards (RSAs)
Underlying shares are issued at time of grant, so they are actual shares held in escrow until vesting.
Taxed Against IRS Code 83
-Section 83(b) election allowed
Tax Treatment on Restricted Stock Units (RSUs)
Shares are issued directly to the stakeholder at the time of a tranche
- Fixed payout date or valid deferral election
- For restricted stock units, plan may permit employees to elect to defer payout of shares beyond vesting
Employee recognized compensation income upon vesting = (FMV-amount paid for stock)
Employee recognizes capital gain or loss upon sale of the shares = (Grant Date FMV - amount paid for stock)
Company’s Responsibility to withhold taxes and how its reported…
-Company must withhold taxation on all current and former employees
- Reported on Form W-2 for employees
…… Form 1099 MISC for non-employees
Ordinary Income paid to non-employees, such as outside directors, will still qualify for what for the Corporation?
Corporation receives a corporate tax deduction
Procedures when filing an 83(b) Election for an RSA
- Copy filed with the IRS
- Copy furnished to company
- Filed within 30 days of purchase or award dates
- Mailing date is the filling date
- Will receive evidence of filing
What is included when filing an 83(b) Election for an RSA?
- Names, address, tax ID and taxable year
- Description of property and restrictions
- Date received, FMV, and amount paid
- Statement that copies have been provided as required
Holding Period for ISOs to qualify for tax-preferred treatment
2 Years from grant date + 1 year from exercise
$100,000 Rule
No more than $100,000 worth of ISOs can become exercisable per year.
$100,000/FMV on Grant Date = # of shares that may be granted and become exercisable as ISOs in any given calendar year.
Exceeding the limit does not disqualify the whole grant as an ISO, but any shares granted in excess of the $100k limit will be treated as NSO, including the option that puts the grant over the limit.
Non-qualified ESPPs Participant Tax Treatment
- Ordinary income at time of purchase = difference between purchase price and share price on purchase date
- Capital gain or loss at time of sale
Non-qualified ESPPs Company Tax Treatment
- Tax deduction equal to employee’s ordinary income
- Income tax withholding required
IRS Form 3921
Company is required to furnish information to the IRS and employee upon exercise of an ISO
Internal Revenue Code 162(m)
precludes publicly held corporations from deducting more than $1 million per year in compensation paid to certain covered employees.
IRC 422 ISO – IRC Section 6039 Reporting
IRS 3922 Required Sections
- Name, address, and identifying number of transferor
- Company’s name, address, and tax ID number
- Date of option grant * Stock’s FMV on grant date
- “Exercise” price per share (purchase price)
** “Exercise” (purchase) price per share determined as if the option (ESPP share) was exercised (purchased) on the grant date (beginning of offering period) ** - “Exercise” (purchase) date
- FMV on “exercise” (purchase) date
- Date legal title of shares transferred by transferor
- Number of shares to which legal title was transferred
IRC 422 ISO – IRC Section 6039 Reporting
IRS 3922 FMV Tracking
you can have an ESPP where the discount is based upon the purchase date FMV, but the Form 3922 still has to report the discount based on the grant date, which is the first date of the offering period – as if there were no lookback.
When is Restricted Stock Taxed?
Restricted Stock is taxed at vesting, unless an 83(b) Election is filed.
When is Restricted Stock Taxed?
Restricted Stock is taxed at vesting, unless an 83(b) Election is filed.
When is Restricted Stock Taxed?
Restricted Stock is taxed at vesting, unless an 83(b) Election is filed.
When is Restricted Stock Taxed?
Restricted Stock is taxed at vesting, unless an 83(b) Election is filed.
