Stock Options: Statutory Stock Options - ISOs & ESPPs (Part I)

📈 Stock Option: What Is It?

The right of an employee, but not an obligation, to buy shares of their employing company stock at a predetermined price.

📈 Statutory vs. Nonstatutory: What Is The Difference?

Statutory Stock Options receive more favorable treatment thru special statutes in the tax code.

✅ Income reported when stock is sold

✅ No FICA

✅ No federal income tax W/H

✅ Capital gains treatment on all income if the holding period is met

🔁Conclusion:

Statutory Stock Options > Nonstatutory Stock Options

What types are there?

1️⃣Incentive stock options (ISOs)

🟠Disqualifying DIsposition ISO

🟠Qualifying Disposition ISO

2️⃣Employee Stock Purchase Plan (ESPPs)

🟠Disqualifying disposition of qualified ESPP

🟠Qualifying disposition of qualified ESPP

🟠Nonqualified ESPP

3️⃣Nonqualified Stock Options (NQSOs) - Part II

4️⃣Restricted Stock Units (RSUs) - Part II

1️⃣ Incentive Stock Options (ISOs)

Basics

• Only employees are eligible

• Vesting usually 2-5 years

• Options expire at the end of 10 years

• Max $100K of value exercisable in one year (determined on the grant date)

• Only type with an AMT disconnect

🤔 Did you know that the value of ISOs is not deductible by the issuing company if sold on qualifying disposition.

ISOs Example #1

• Tim C works at Apple.

• Tim C receives the option to buy 1,000 shares of Apple at $50 per share on March 1, 2020.

• Apple stock is worth $40/share on March 1, 2020

• After his 3-year vesting schedule, Apple stock is worth $150.

• Tim decides to exercise his option to purchase 1,000 shares.

🧮 Cost basis

• Qualified disposition✅: exercise price

• Disqualified disposition ❌(gain): exercise price plus ordinary income included in W2

• Disqualified disposition ❌ (loss): exercise price

🧩Documents to request (i.e. the puzzle pieces🧩 )

• Option agreement

• Confirmation of Exercise

• Form 3921 (2010+)

• Form W2

• Form 1099-B (maybe)*

ISO Tax Treatment - Disqualifying Disposition ❌

• Holding period not met

• Immediate taxation of bargain element (ordinary)

• Income reportable in Box 1 of W2

• Not subject to FICA or FITW

• Not required to notate on Box 14 of W2

• No AMT adjustment

📃 ISO Sample Forms 📃

Form 3921

W2 (Disqualifying❌)

Option Confirmation (Disqualifying ❌)

*Quirky 1099-B Rule

🚨There might not be a 1099-B (employers can elect out of issuing under Rev Proc 2002-50) In this case, all the income is reported on Form W2.

1099B (Disqualifying❌)

🚨🚨🚨

Starting in 2014, brokers are prohibited from adding the compensation component to the cost basis, thereby understating the total cost and overstating the gain on the sale of the stock on Form 1099-B (Treasury Decision 9616)

This makes the likelihood of novice tax preparers/self-preparers overstating the gain very, very high. 😱

🚨🚨🚨

ISO Tax Treatment - Qualifying Disposition ✅

🌸Regular Tax

No tax reporting for regular tax purposes when ISO is exercised.

Income is reported when stock is sold.

😵Alternative Minimum Tax

The bargain element is a positive AMT adjustment when exercised

The bargain element is a negative AMT adjustment when sold

W2 (Qualifying ✅)

Option Confirmation (Qualifying ✅)

Form 3921 (Qualifying ✅)

😵Alternative Minimum Tax (Qualifying ✅)

📅 Is there an optimal time to exercise an option?

🅰️Yes! January, February or March. This will allow the taxpayer to hold the shares 1 year before having to pay any 😵Alternative Minimum Tax liability on their tax return.

Holding the shares for one year will not trigger ordinary income compensation.

2️⃣ Employee Stock Purchase Plan (ESPPs)

How they work

• The employer withholds funds from employees (Offering period)

• At the end of the offering period, the employee chooses:

• purchase stock or receive funds back

• It may not be discriminatory

• May allow employees to purchase stock at a 15% discount

• Maximum of $25,000 per year

🧮 Cost basis

• Qualified disposition: purchase price plus ordinary income included in W-2

• Disqualified disposition: market price at purchase

🧩ESPP Documents to request (i.e. the puzzle pieces🧩 )

• Confirmation of Exercise

• Form 3922

• Form W2

• Form 1099-B

• Stock Plan Transaction Supplemental Information

ESPP Tax Treatment - Disqualifying Disposition ❌ of Qualified ESPP

• No income is reported when stock is purchased even if discounted.

• Income reported when stock is sold

• Holding period not met

• Bargain element reportable in Box 1 of W2

• Not subject to FICA or FITW

• No AMT adjustment

ESPPs Example #1 (Disqualifying Disposition❌)

• Frankie works at FaceBook.

• Frankie has $100/pay x 13 weeks

• Offering period Jan 1, 2020 - June 30, 2020.

• FMV Jan 1 = $20 ($20 x 85% = $17)

• FMV June 30 = $25 ($25 x 85% = $21.25)

• 15% discount

• Lookback provision available

• Same day sale (this makes it disqualifying)

Purchase price?

$17/share

Shares purchased?

$1,300/$17 = 76 shares

Bargain element?

($25 - $17) x 76 shares = $608

Discount?

($20 - $17) x 76 shares = $228

Form 3922

Stock Plan Transaction Supplemental Information

Result of ESPP Example #1 Disqualifying Disposition ❌

🚨The "adjusted amount" is included in W2 box if a disqualifying disposition❌ :

Box 1 = Wages + $608

Box 3 = Wages

Box 5 = Wages

Box 14 = Might notate bargain amount, but not required.

ESPP Tax Treatment - Qualifying Disposition✅ of Qualified ESPP

• Discount income reported when stock is sold

• Holding period met

• Discount reportable in Box 1 of W2 (not to be confused with bargain element)

• Not subject to FICA or FITW

• No AMT adjustment

ESPPs Example #2 (Qualifying Disposition✅)

• Frankie works at FaceBook.

• Frankie has $100/pay x 13 weeks

• Offering period Jan 1, 2020 - June 30, 2020.

• FMV Jan 1 = $20 ($20 x 85% = $17)

• FMV June 30 = $25 ($25 x 85% = $21.25)

• 15% discount

• Lookback provision available

• Sells stock in 2023(this makes it qualifying)

• Stock is sold for $27/share

ESPP Result - Qualifying Disposition✅

Income reported when stock is sold:

-($20-$17) x 76 shares = $228 ordinary income (the discount)

-($27-$20) x 76 shares= $532 LT capitan gain

🚨🚨Be sure not to confuse the bargain element and discount

In conclusion

Income from Statutory or Qualified Options reported when sold.

Income not subject to FICA

ISOs less common than NQSOs

Qualified ESPP more common than Nonqualified ESPP