Employee stock options tax treatment and tax issues


If you receive an option to buy stock as payment for your services, you may have income when you receive the option, when you exercise the option, or when you dispose of the option or stock received when you exercise the option. There are two types of stock options:. Refer to PublicationTaxable and Nontaxable Incomefor assistance in determining whether you've been granted a statutory or a nonstatutory stock option. If your employer grants you a statutory stock option, you generally don't include any amount in your gross income when you receive or exercise the option.

However, you may be subject to alternative minimum tax in the year you exercise an ISO. For more information, refer to the Form Instructions.

You have taxable income or deductible loss when you sell the stock you bought by exercising the option. You generally treat this amount as a capital gain or loss. However, if you don't meet special holding period requirements, you'll have to treat income from the sale as ordinary income. Add these amounts, which are treated as wages, to the basis of the stock in determining the gain employee stock options tax treatment and tax issues loss on the stock's disposition. Refer to Publication for specific details on the type of stock option, as well as rules for when income is reported and how income is reported for income tax purposes.

This form will report important dates and values needed to determine the correct amount of employee stock options tax treatment and tax issues and ordinary income if applicable to be reported on your return. Employee Stock Purchase Plan - After your first transfer or sale of stock acquired by exercising an option granted under an employee stock purchase plan, you should receive from your employer a Form This form will report important dates and values needed to determine the correct amount of capital and ordinary income to be reported on your return.

If your employer grants you a nonstatutory stock option, the amount of income to include and the time to include it depends on whether the fair market value of the option can be readily determined. Readily Determined Fair Market Employee stock options tax treatment and tax issues - If an option is actively traded on an established market, you can readily determine the employee stock options tax treatment and tax issues market value of the option.

Refer to Publication for other circumstances under which you can readily determine the fair market value of an option and the rules to determine when you should employee stock options tax treatment and tax issues income for an option with a employee stock options tax treatment and tax issues determinable fair market value.

Not Readily Determined Fair Market Value - Most nonstatutory options don't have a readily determinable fair market value. For nonstatutory options without a readily determinable fair market value, there's no taxable event when the option is granted but you must include in income the fair market value of the stock received on exercise, less the amount paid, when you exercise the option. You have taxable income or deductible loss when you sell the stock you received by exercising the option.

For specific information and reporting requirements, refer to Publication For you and your family. Individuals abroad and more. EINs and other information. Get Your Tax Record. Bank Account Direct Pay. Debit or Credit Card. Payment Plan Installment Agreement. Standard mileage and other information. Schedule A Form Application for Automatic Extension of Time.

Employer's Quarterly Federal Tax Return. Employee's Withholding Allowance Certificate. Request for Transcript of Tax Return. Popular For Tax Pros. Apply for Power of Attorney. Apply for an ITIN. Home Tax Topics Topic No. Topic Number - Stock Options If you receive an option to buy stock as payment for your services, you may have income when you receive the option, when you exercise the option, or when you dispose of the option or stock received when you exercise the option. There are two types of stock options: Options granted under an employee stock purchase plan or an incentive stock option ISO plan are statutory stock options.

Stock options that are granted neither under an employee stock purchase plan nor an ISO plan are nonstatutory stock options. Statutory Stock Options If your employer grants you a statutory stock option, you generally don't include any amount in your gross income when you receive or exercise the option.

Nonstatutory Stock Options If your employer grants you a nonstatutory stock option, the amount of income to include and the time to include it depends on whether the fair market value of the option can be readily determined.

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Employers offer a variety of different forms of stock incentive employee stock options tax treatment and tax issues. An understanding of the relevant tax rules is essential in designing incentive plans that meet the needs of both employer and employee. This article will consider the most common type of incentive plan — employee stock options.

Employee stock options are popular because they meet a number of business objectives. In particular, they help employers to recruit, retain and motivate employee stock options tax treatment and tax issues, without impacting cash flow.

Most of the tax rules governing employee stock options are found in section 7 of the Income Tax Act. A stock option is defined as an agreement to sell or issue shares. It is important to note that section 7 only applies to stock options issued to employees. Therefore, these rules do not apply to option issued to contractors or other non-employees. Corporate directors and officers are considered to be employees for the purposes of these rules. There are two important exceptions to the above rules.

The capital gain would be unchanged. However, there are several others. In future articles, we will consider other stock incentive plans that may be of interest.

It is worthwhile to have a discussion with a tax lawyer on any transaction or life event that may involve a significant amount of tax. By being proactive, you can enjoy the tax savings that you are entitled to.

Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice. By Matthew Clark September 17 The following is a summary of the basic tax rules regarding employee stock employee stock options tax treatment and tax issues Option issued to employee on Jan. Value of Employerco shares at Jan.

Employee is not taxed on grant of option, despite option being in the money. Employee exercises option on Jan 1, Employee stock options are the most popular form of employee stock incentive.

Invitation for Discussion It is worthwhile to have a discussion with a tax lawyer on any transaction or life event that may involve a significant amount of tax.

Employee stock options tax treatment and tax issues paper by Partner Sarah Bernhardt discusses a number of current and emerging issues in relation to employee option plans. We all know that 'remuneration' income is taxed at marginal rates of tax, whereas only 50 percent of 'capital gains' made by individuals are taxed at marginal rates of tax, provided the 12 month holding period rule is satisfied. The question then is, are gains on employee options characterised as remuneration income or capital gains?

Division 13A of the Income Tax Assessment Act all future statutory references will be to this Division, unless otherwise stated has the effect of treating any 'discount' on the grant of employee options as remuneration income which is taxed at marginal rates of tax. However, Division 13A generally provides an employee with a choice of whether to pay tax on this 'discount' in employee stock options tax treatment and tax issues year that the options are granted up-front tax method or to defer the taxing time, generally until the year the options are exercised deferred tax method.

Importantly, the calculation, timing and characterisation of an employee's tax liability can differ depending on which of these methods is used. Under the up-front tax method an employee pays the tax liability on the 'discount' on the grant of options in the year the options are granted. The 'discount' on the grant of options is generally calculated pursuant to tables contained in the Tax Act which have regard to the deemed market value of the shares at the time employee stock options tax treatment and tax issues options are granted, the exercise price of the options, the maximum life of the options and any consideration paid for the grant of the options.

I will talk some more about how options are valued for tax purposes later in this paper. Employee stock options tax treatment and tax issues present purposes, all I need you to note is that options are likely to have a deemed taxable value even if the exercise price of the options is equal to the market value of the shares at the time the options are granted. If the up-front tax method is used, no further tax employee stock options tax treatment and tax issues generally be payable on the options until the sale employee stock options tax treatment and tax issues shares acquired on exercise of the options, at which time capital gains tax would apply.

Only 50 percent of the gain would be required to be included in income provided the employee had held the shares for at least 12 months. The deferred tax method generally allows an employee to postpone any tax liability on the options until the earlier of the time when:. The amount that is subject to tax when the deferral ceases is calculated by reference to the market value of the shares at that time, rather than by reference to the market value of the shares at the time the options were granted.

This amount is taxed as remuneration income, not a capital gain, and therefore the 50 percent CGT discount does employee stock options tax treatment and tax issues apply. Thus, a consequence of claiming the deferral concession on options is that any increase in the value of the options until the deferral ceases is fully taxed without the 50 percent CGT discount applying.

If the employee then chooses to continue to hold the shares after the options are exercised, capital gains tax will also apply to the later disposal of those shares. However, in order to avoid double taxation, the employee is deemed to have an up-lift in their cost base of the shares to take into account that tax employee stock options tax treatment and tax issues have already been paid on some of the gain made on the options.

The possible differences between the up-front and deferred tax methods are best shown by way of an example calculation. It is important to note that this benefit only arises if the shares acquired on exercise of the options are held for at least 12 months after exercise.

Further, as this benefit only arises if the up-front tax method is used, the benefit needs to be weighed against the cash flow costs of paying tax on the options in the year of grant. As the shares acquired on exercise of the options are not held for at least 12 months after the options are exercised, the same net gain is made regardless employee stock options tax treatment and tax issues which tax method is used.

This would generally mean that it would be more advantageous to use the deferred tax method as there would then not be the cash flow costs of paying tax in the year the options are granted. As indicated in the above example, the main differences between the two tax methods are the year in which tax is payable and the characterisation of the gain as ordinary income or a capital gain.

Employee stock options tax treatment and tax issues an employee will be better off using the up-front tax method or the deferred tax method will depend on many factors, employee stock options tax treatment and tax issues. Unfortunately an employee is generally required to make a choice between the tax methods by the time they lodge their tax return for the year in which the options are granted, notwithstanding the fact that the majority of the above factors will not be known to an employee for some significant time after that.

Generally, the only things about the choice of tax method that can be said to an employee with any certainty are as follows. My experience to date has indicated that, despite the recent introduction of the 50 employee stock options tax treatment and tax issues CGT discount, most option recipients still tend to use the deferred tax method, with the possible exception of options where the taxable value is relatively low generally as a result of the exercise price being at a premium to the market value of the shares at the time of grantor where there is a possibility of 'blue sky' in the share price eg, start ups.

This is particularly so where employee stock options tax treatment and tax issues exercise of the employee stock options tax treatment and tax issues is subject to the satisfaction of performance conditions.

No doubt this is due to the fact that most Australian employees tend to take the view that they would prefer a definite tax deferral rather than a cash flow cost of paying some tax now that may or may not result in a tax advantage to them in the future. In this paper to date I have been assuming that an option recipient will generally have a choice between the two tax methods.

However, if the employee stock options tax treatment and tax issues are not in fact 'qualifying rights' under Division 13A, then the taxpayer will be required to use the up-front tax method. So lets now look at the pre-requisites for options to be 'qualifying rights'. First, the option must be acquired under an employee share scheme section CD 2. The satisfaction of this condition is often a 'no brainer' as all it generally requires is that the option be acquired in respect of employment or services provided by the taxpayer or an associate of the taxpayer section C.

The main circumstances where I have seen this definition being an issue in practice are where the employee has paid market value consideration for the shares or options refer section C 3or where there is some question as to why an employee may have received options.

I will consider this issue in more detail when I look at the possible tax implications of replacing out of the money options. The second condition is that the company in which the taxpayer has an option to acquire a share must employee stock options tax treatment and tax issues the employer of the taxpayer or the holding company of the employer section CD 3. This means that up-front tax will automatically apply if, for example:.

The third condition is that the options must be options to acquire ordinary shares section CD 4but there is no definition of what is meant by 'ordinary'. This is rarely an issue in an Australian public company context, but can sometimes be problematic where you are dealing with options in an overseas company that does not have a similar concept to 'ordinary shares'.

The last two conditions are that the employee must not hold a legal or beneficial interest in more than 5 percent of the shares in the company 5 percent holding test nor must they be in the position to cast or control the casting of more than 5 percent of the maximum number of votes that may be cast at a general meeting 5 percent voting test section CD 6 and 7.

These tests are done at the time the options or shares are acquired. In the case of shares, it is clear whether the tests employee stock options tax treatment and tax issues be breached. For example, if an employee already has 3 percent of the shares in the employer and acquires a further 3 percent shares, the tests will be breached. However what about the situation where an employee already has 3 percent of the shares in the employer and is offered options to acquire a further 3 percent of the shares?

It is clear that the 5 percent holding test will not be breached in this case. However, it is not as clear whether the 5 percent voting test will be breached. If there are no pre-conditions to be satisfied to exercise the rights ie the rights are 'vested' from the outsetthe employee may be considered to be in a position immediately after acquiring the options to cast more than 5 percent of the votes by exercising the options, and therefore be in breach of the 5 percent voting test.

If, on the other hand, there are vesting conditions to be satisfied before the options can be exercised it seems likely that the 5 percent voting test would not be breached. The last thing to note about the qualifying conditions is that, unlike shares, 'qualifying rights' do not have to satisfy the 75 percent offer test which requires that at least 75 percent of the permanent employees must be, or have been, entitled to acquire shares or rights in the employer at a discount.

This can lead to some interesting opportunities to design plans which allow a select group of employees to acquire interests in an employer company without the need for the company to have offered its shares at a discount to its general employees. Interestingly, Division 13A allows a continued tax deferral on such shares post vesting, provided the shares are subject to certain restrictions, notwithstanding the fact that such a deferral would not have been available if the shares were originally acquired without first acquiring a right to acquire such shares.

I mentioned earlier that the 'discount' on the grant of options is generally calculated pursuant to tables contained in the Tax Act which have regard to the deemed market value of the shares at the time the options are granted, the exercise price of the options, the maximum life of the options and any consideration paid for the grant of the options. It is these tables that tell us, for example, that an option with an exercise price equal to the market value of the share at the time the option is acquired, and a maximum 5 year life, has a deemed taxable value of I understand that these tables are based on an economic model for valuing options which attempts to value the 'inherent' benefit in options being effectively like a limited recourse interest free loan.

Some of the practical issues I have encountered with these valuation rules include the following. An employee will acquire a 'right to acquire shares' under Division 13A when another person creates that right in them section G.

Generally, an offer of options would only create a right to accept an offer of a right to acquire shares, rather than creating a right to acquire shares Fraunschiel v FCT 89 ATC Thus, where you are dealing with a more traditional Australian option plan that envisages the employer making an offer of options to the employees, the employees accepting that offer, being followed by the actual grant of the options by the company, there can be an issue as to whether an employee may in fact acquire a 'right to acquire shares' at the time they accept the offer, rather than the later date that the options are actually granted.

If this was correct, and employees accepted the offer on different days, they could potentially have different taxable values of their options depending on the share price movements around the acceptance time. In practice, one possible way around this issue would be for the option plan documentation to make it clear that, notwithstanding an acceptance of an offer, an employee would have no right to acquire shares until such time as the options are actually granted.

If, instead of the more normal offer and acceptance process, employees are just told that they have been granted options which can occur with certain US based employee option plansthen this could be seen as analogous to a gift. The likely implication of this is that the employee could dissent to the gift but, if they choose not to dissent, they are arguable treated as having acquired the options at the earlier date the options were granted, notwithstanding the fact that they may not have known they have been granted the options until a later time FCT v Cornell 73 CLR at An employee may pay tax on their options without their options ever having been transferred or exercised.

This could occur, for example, where the employee has used the up-front tax method, or they have used the deferred tax method but have had a 'cessation event' under that method other than a transfer or exercise of the options eg termination of employment, where the options don't lapse on termination.

In these circumstances, if the options later lapse, section DD provides for an ability to claim a refund of tax paid on the options regardless of the statutory time limits that normally govern amendments if the following conditions are satisfied. This could occur, for example, if the options lapse as a result of non-satisfaction of performance conditions, or if the employee allows the options to lapse at the end of their term because, for example, the exercise price is greater than the market price of the shares at that time.

However, it would be unlikely to occur where, for example, the options were cancelled for consideration. The time at which this second requirement must be satisfied is unclear.

There are at least 2 possibilities:. In my view, the first possibility is the better view. Otherwise, an employee who leaves their employment and loses their options later would be unable to amend their return because at the time that they 'lose' the option, the company is no longer their employer. It is important to note that this second requirement means that the refund rules are not available to an employee whose options are granted to an associate, or to an employee who has transferred their options after grant.

This is notwithstanding the fact that the employee will have been taxed on those options under Division 13A, in the first case — in the year the options were granted and, in the second case — in the year the options were transferred. This means that, if there is a risk that the options may not be exercised, it would generally be preferable for the options to stay in the name of the employee, rather than being granted or transferred to an associate.

As I outlined at the beginning of this paper, any 'discount' on the acquisition of employee options is going to be taxed to the employee as remuneration income, without the 50 percent CGT discount applying. However, if an employee were to accept up-front tax on their options for example, because they expected that the future increase in the value of the underlying shares would be significantly greater than the deemed taxable value of the optionshow could the employee ensure that they are entitled to claim employee stock options tax treatment and tax issues 50 percent CGT discount on the increase in the value of the shares over the deemed taxable value of the options?

I mentioned earlier that, if it is unlikely that an employee will be able to access the 50 percent CGT discount in the future, then the deferred tax method is most likely to be the employee stock options tax treatment and tax issues route. I also mentioned that, if the options employee stock options tax treatment and tax issues non-transferable, then the employee is only likely to be able to access the 50 percent CGT concession in the future if they are prepared to hold the shares for at least 12 months after the options are exercised.

This is because the relevant asset that is being disposed of would be the shares, not the options, and the likely acquisition date of those shares for CGT purposes would be when the options are exercised and the shares issued see Item 2 of employee stock options tax treatment and tax issues of the ITAA and TD16 and I understand that there may be some advisers who take the view that the shares are possibly acquired for CGT purposes at some time prior to the time when the options are exercised, but I am not sure of the technical basis for such an argument.

Maybe it has something to do with the fact that section arguably only applies where an asset is acquired other than as a result of a CGT Event, whereas shares acquired on exercise of options could be seen as being acquired a result of CGT Event C2 happening to the options.

Of course, holding the shares for at least 12 months after exercise of the options would generally involve an employee being required to fund the exercise price of the shares for that 12 month period.

A possible way around this practical problem would be if the options were transferable. This is because the 50 percent CGT discount should then be able to be accessed by disposing of the options, provided the options have been held for at least 12 months. The issue then becomes whether employee option plan rules should be allowing for options to be transferred? If you were drafting new employee option plan rules then, in my view, it would be prudent to at least allow the flexibility for the options to be transferred, even if only in limited circumstances.

Apart from the possibility that this may then enable an employee who has elected for up-front tax on their options to access the 50 percent CGT discount in the future without having to hold the shares for 12 months after the exercise of the options, such a clause could also have the commercial advantages of allowing an employee to cash in on the increase in the value of their options without having to fund the exercise price, and also employee stock options tax treatment and tax issues employees who want to hold the underlying shares in an associated entity's name eg, for asset protection reasons to have the shares actually issued directly to the associated entity without the need for possible brokerage costs in transferring the shares from the employee to the entity, following exercise of the options.

The following issues should be considered in the context of drafting option plan rules to provide the flexibility for the transferability of options. Generally, the deferred tax method automatically applies unless the employee elects to use the up-front tax method Tax Election. It is important to remember however that a Tax Election would apply to both employee shares and options from any employer acquired in the same employee stock options tax treatment and tax issues year — ie it is not possible to make a Tax Election that will only apply to the acquisition of one or the other.

As no doubt you know, exempt share plans are often designed to take advantage of a limited tax exemption on the acquisition of shares which is only available to employees who elect for up-front tax to apply. In my experience, it is not uncommon to see the application form for participation in such a plan to include an automatic election for up-front tax. This is presumably done on the grounds that the majority of participants in such plans are often 'blue collar' workers who may forget to make the requisite tax election unless it is included as part of the application form.

However, if the company allows all employees to participate in such a plan, notwithstanding that some of those employees may have received employee options or deferred employee shares in the same tax year as they have participated in the exempt share plan, then it will be critical for the company to adequately communicate to such employees, before they lodge their tax return for the year the shares and options are acquired, that they may want to revoke the tax election that was included in the application form for participation in the exempt share plan.

Of course this often has the follow on administrative complications of ensuring that such employees remember that they will be required to pay tax on their exempt plan shares in the year that the restrictions on disposal of those shares cease to apply generally 3 years from acquisition. It is for these reasons that employers should seriously consider whether it might be advisable to exclude option or deferred share plan participants from participating in an exempt share plan in the same tax year in which they have received options or deferred shares, especially if the exempt share plan is operated on a salary sacrifice basis, rather than just a freebie.

However, if this were to be done, care would need to be taken to ensure that the company still satisfied the 75 percent offer test that is a pre-requisite for the tax exemption being available to other recipients in the exempt share plan.