Non-Qualified Stock Options-Private Companies
General Tax Rules for Non-Qualified Stock Options
If the stock option has a readily ascertainable market value when granted, then it is taxable to employees as ordinary income equal to the difference between the option’s fair market value and any consideration paid for the option. Employees pay ordinary (compensation) income tax when they exercise options (taxable gain/income = Fair Market Value of stock at exercise less price at which they can buy stock). This difference is taxed as ordinary income upon exercise. When the employee sells those shares there is capital gain on the difference between the adjusted basis and sale price. The adjusted basis is generally the Fair Market Value of the stock at exercise.
If stock is held for more than one year from exercise, it is taxed as long-term capital gain. If upon sale of stock it is a short-term capital gain, then ordinary income tax rates apply. If long-term capital rates apply then the gain is taxed at either 0%, 15% or 20% depending on taxable income. Capital gain tax rates in 2020 are as follows: a) 20% if taxable income is $488,851 and married jointly; and b) 15% if taxable income is between $78,751 and 488,850.
There are tax issues (potential treatment of all gain as compensation) related to secondary sales of private company shares acquired by options. Furthermore, there is the question of valuation. Internal Revenue Code Section 409A provides that stock options are compensation if they have an exercise price that is less than the stock’s fair market value on the exercise date. In order to not be treated as compensation, stock options must comply with rules, including but not limited to, the following:
On the grant date, the exercise price must be equal to or greater than the fair market value of the option;
On the grant date, the shares subject to the option must be fixed in number;
The option must not include any additional features allowing for deferral of compensation or other modifications.
A private company will have to set the fair market value of the shares in order to set a price for exercise. Without a traded market in the shares, it can be difficult to determine fair market value. The Section 409A provides detailed guidelines to determine fair market value. Some of the valuation methods serve as “safe harbors.” The risk to private companies and their employees is that the amounts deferred under a stock option plan (sales price less 409A valuation) could be treated as compensation income (as opposed to capital gain). In addition, the compensation could be subject to an additional 20% federal income tax, plus interest and penalties. This directly impacts the employees and the employers who could be liable for failing to withhold proper taxes When a company repurchases stock shares from employees at a premium (employer pays more than the fair market value of the shares), the gain is generally taxed as compensation income and not as capital gain.
Further, the use of cashless exercise increases the risk that all the gain could be treated as compensation. There is also the risk that a repurchase may be treated as a dividend. A repurchase of stock from an employee will generally be treated as a sale of stock and qualify for capital gain treatment if the sale is a substantially disproportionate redemption of stock, meaning that both:
a) The employee owns immediately after the redemption less than 50% of the total combined voting power of all classes of stock entitled to vote; and
b) The employee’s share of the company’s voting stock immediately after the redemption is less than 80% of the employee’s share of the voting stock before the redemption.
A liquidation of an employee’s entire ownership interest, for example, generally would qualify for exchange treatment, resulting in capital gain or loss. Even if the repurchase is essentially equivalent to a dividend, the payment received for shares may be a “qualifying dividend” eligible for long-term capital gain treatment if it meets certain requirements. However, while long-term capital gain rates might apply to dividends that are “qualifying dividends”, an employee cannot use any of its tax basis in the company stock to reduce the amount of dividend income.
For more information on the taxation of stock options, please contact our office.
Bowman Law Firm, Gene M. Bowman, Attorney, CPA
