Taxation of Stock Incentive Plans

Companies offer stock as an incentive for a variety of reasons. Some companies, such as start-ups, can't pay cash incentives. Other companies want to give employees the opportunity to become equity owners. Companies also use stock to retain key employees by granting awards that they'd forfeit if they left the company. The taxation of stock awards is complicated by the type of award, the risk of forfeiture, and how long employees hold the stock before they sell it.

A restricted stock award is a grant in which the employee's rights to the stock are restricted until the shares vest. The vesting schedule might be based on time, such as 25 percent per year over four years, or it might be based on attaining individual or company goals. If there's a substantial risk that the employee will forfeit the award -- for example, if the employee terminates employment before the end of the vesting period -- the award is taxable to the employee at the ordinary income tax rate when it vests, not when it is granted. When the employee sells the stock, she's responsible for capital gains tax on the stock's appreciation.

An employee who anticipates that a restricted stock grant will appreciate significantly during the restricted period can send a written statement to the IRS within 30 days of the grant to make a Section 83(b) election. This election taxes the employee immediately at the ordinary income tax rate for the full current market value of the grant, even though she could forfeit the award and pay tax on stock that's never received. When the grant vests, the employee is taxed at the capital gains rate on the appreciation between the grant date and the vesting date.

A company can normally take a tax deduction for taxable income it provides to an employee at the time the employee receives the income -- for example, when a restricted stock award vests. However, if an employee makes a Section 83(b) election, the company's tax deduction is limited to the amount on which she pays tax when the award is granted. If the shares appreciate significantly during the restricted period, the company gets no tax deduction for the stock's appreciation. For this reason, many companies award restricted stock units that automatically convert into restricted stock when the units vest. Restricted stock units aren't eligible for Section 83(b) election.

In granting an incentive stock option, a company grants the right to purchase a certain number of shares of stock at a fixed price. For example, this might be 500 shares of stock at $10 per share. Three "events" occur with an incentive stock option -- the company grants the option, the employee exercises the option, and the employee sells that stock. There are no tax implications for an employee when an option is granted. When an employee exercises the option, the difference between the grant price and the purchase price must be included when the employee calculates alternative minimum tax. There's an exception if the employee exercises and sells the stock in the same year.

If an employee exercises stock options and holds the stock for at least two years after the grant date and for at least one year after the exercise date, and if she remains employed by the company that granted the option until at least three months before the exercise date, there is no taxable income to the employee when she exercises the option, except for calculating alternative minimum tax. When she sells the stock, she's taxed at the long-term capital gains rate on the difference in the purchase and sales prices.

If an employee doesn't meet the holding or employment requirements, the sale of the stock becomes a nonqualifying disposition. She pays tax on the difference between the grant price and the purchase price of the stock at the ordinary income tax rate, and she pays capital gains tax on the stock's appreciation between the exercise and sales dates.