You have worked hard in contributing to the success of your company, and in return your company may reward you beyond your basic annual salary. Below are some of the more common forms of supplemental and incentive compensation, and how they will affect your tax liability and reporting obligations.
Bonuses and commissions. Bonuses and commissions are generally tied to some type of metric, and so may vary from year to year, and they are awarded much less frequently than regular salary perhaps only annually. In addition, because these are considered supplemental wages, they are generally withheld at a statutory 22% and 10.23% for Federal and California, respectively. For many executives, they will be in a higher tax bracket than 22%, thus, this withholding will not be sufficient, and they may have a large tax bill at yearend. For these reasons, tax planning is very important in order to estimate what your annual income and tax liability will be, as well as ensure that your withholding is sufficient to cover such liability.
Stock options. There are two types of stock options: Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs). The tax treatment of these two are different:
Event | Incentive Stock Option (ISO) | Nonqualified Stock Option (NQSO) |
---|---|---|
Grant of option | Not taxable | Taxable as ordinary income to the extent that the fair market value at grant exceeds the exercise price |
Exercise of option | Not taxable for regular tax; however, difference between the fair market value at exercise and exercise price is subject to alternative minimum tax (AMT), reported on Form 3921, Exercise of an Incentive Stock Option Under Section 422(b). | Taxable as ordinary income to the extent that the fair market value at exercise exceeds the exercise price. Included in Box 1 of W-2, as well as reported in Box 12, Code V. FICA and Federal income tax withholding is required. For independent contractors, reported on Form 1099-MISC if $600 or more. |
Sale of stock | Difference between sale price and basis (exercise price) is long-term capital gain if sold one year or more from exercise; ordinary income reported on W-2 if sold less than one year from exercise. FICA and Federal income tax withholding is not required. | Difference between sale price and basis (exercise price + any income recognized upon grant /exercise) is long-term capital gain if sold one year or more from exercise; short-term capital gain if sold less than one year. |
Upon sale of the stock the financial institution will issue a Form 1099-B reporting the proceeds. They may or may not include cost basis. Often the cost basis reported only represents the exercise price; it usually does not represent what was already included in the employee’s W-2. As such, you will most likely need to add the W-2 portion to your cost basis, so as not to double count the gain. Because often a cashless exercise and sale generally occur concurrently (a disqualifying disposition), the proceeds and cost basis should be similar, and there would only be a slight loss representing the commissions on the transactions. You may need to get additional statements or reports from your payroll department and/or your financial institution to determine the cost that went through your W-2 if it is not specifically delineated. Because the concurrent sale is reported on the W-2, it is treated as ordinary income. Another strategy is to exercise the stock option and hold it for at least a year before selling, in order to get long-term capital gain treatment, albeit, this may be cash-flow prohibitive.
Employee Stock Purchase Plan (ESPP). In an ESPP, the employee may purchase company stock at a discounted price of generally 85% of the fair market value. The discount is considered additional income and is included on the W-2 in box 1, and may be detailed further in either Box 12 or on the final paystub. In addition, you will receive a Form 3922, Transfer of Stock Acquired Through an Employee Purchase Plan Under Section 423© in January following the year of purchase. This is an informational return, which doesn’t need to be reported on your tax return per se, but you should keep track of the details, so that you will have correct cost basis when you subsequently sell the stock. Your financial institution may track this for you, so that you can obtain the correct cost basis on sales of this stock.
Restricted Stock Unit (RSU). An RSU is a grant valued in terms of company stock, but company stock is not issued at the time of the grant. Generally, the vesting period is over 3-4 years, with a pro rate shares vesting on the anniversary of the grant date, at which time stock is actually issued. The corresponding fair market value of this stock is included in W-2 income. Often a portion of the stock is concurrently sold in order to cover the mandatory taxes on this income. What is important to remember here is that the employee must keep track of
- the vesting schedules of his/her various grants, and plan on this additional income;
- the cost basis of shares that were concurrently sold for tax purposes in order to calculate gain or loss; and
- the cost basis of RSU shares sold at a later date, which will result in a gain or loss.
Again, most financial institutions will track this for you, so you can obtain the correct cost basis on sales.
Although stock compensation can be a very lucrative form of compensation, the tax reporting of the different types, as well as the timing of taxable events can be confusing and create a puzzle of documents from your payroll department and financial institution, as well as tax forms. However, to the extent that you are in control of some elements of the timing of these events, you can plan accordingly.
Please contact us to determine how the timing, tax and cash-flow effects of these various forms of stock compensation may affect you in the current and future tax years.
Photo by Markus Spiske on Unsplash