3618 / What are NQSOs and how are they taxed?

Tax Implications for Employees

The tax implications of an NQSO are governed by IRC Section 83, and potentially by Section 409A, because they give a participant a legally binding right to compensation that will be realized in a later taxable year. Final regulations to Section 409A allow an NQSO to be structured to claim the equity plan exception and avoid Section 409A coverage. The requirements to claim the regulatory exception from Section 409A coverage are:

the option stock must be Section 409A “service recipient stock;”

the exercise price must be at fair market value on the option grant date;

the option share total must be fixed on the grant date;

the option stock must be subject to taxation under Section 83 and Treasury Regulation Section 1.83-7; and

the option cannot provide for any additional deferral of compensation features.

If an option does not meet these preconditions, and is issued below fair market value, it must comply with Section 409A, which usually destroys the intended objective and subjects the award to immediate 409A taxation with penalties. Fortunately, the IRS has provided for a correction method for such failures that allows the participants to avoid experiencing the 409A taxation scenario if the error is discovered early and corrected quickly ( Q 3541).

Under Section 83, an employee generally is not taxed on an NQSO at grant unless it has a readily ascertainable fair market value and is not subject to a substantial risk of forfeiture.¹ Options generally do not have a readily ascertainable fair market value unless they are publicly traded.² If an NQSO does not have a readily ascertainable fair market value at grant, it is taxed at the time of exercise.³ If an NQSO with a readily ascertainable fair market value is subject to a Section 83 substantial risk of forfeiture, it is taxed when the risk of forfeiture lapses. When taxed, the employee will recognize the excess of the market value of shares receivable over the grant price as ordinary income subject to FICA, FUTA, and federal income tax.⁴

On May 29, 2012, the IRS released proposed regulations clarifying the key definition of “substantial risk of forfeiture” for purposes of Section 83. On February 25, 2014, the IRS released final regulations that are substantially similar to the proposed regulations. (For details, see Q 3538.)⁵ These clarifications incorporate the IRS’ position in Revenue Ruling 2005-48, in which it rejected the extension of the court’s logic in the case of Robinson v. Comm. that implied that restrictions other than those related to the purpose of the transfer, such as lock-up agreement restrictions and Rule 10b-5 trading restrictions mandated by U.S. securities law, could result in the deferral of taxation. It also ruled that Section 16(b) of the Securities Exchange Act of 1934 is the ONLY securities law provision that will defer taxation under Section 83. The regulations apply to property transferred on or after January 1, 2013. The proposed regulations can be relied upon for transfers after May 30, 2012.

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Planning Point: These regulations would seem to clarify that federally mandated clawback requirements as in Dodd-Frank, TARP, and Sarbanes-Oxley will NOT defer taxation on stock options post exercise, or restricted stock awards post vesting, even if the stock is potentially subject to forfeiture or disgorgement upon triggering of such a clawback. They might even limit use of noncompete agreements and consulting agreements to defer taxation, given that the IRS has drawn language from Section 409A, and Section 409A specifically provides that noncompete and consulting agreements will not constitute a substantial risk of forfeiture, although this is less clear at the date of publication (note that the proposed Section 409A/457 integration regulations may change this result, as well). Time will tell if these regulations are only “clarifications” or substantive changes, so planners must follow the progress of the IRS’ administration of these regulations, now that they are finally effective.

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Within 30 days of the grant of an NQSO subject to a Section 83 substantial risk of forfeiture, an employee may elect under IRC Section 83(b) to be taxed currently on the fair market value of the option. Any appreciation after the election is taxable as a capital gain. If the NQSO is ultimately forfeited, no deduction is allowed for that forfeiture.⁶

Planning Point: The IRS has released a new form for making Section 83(b) elections.  A Section 83(b) election allows taxpayers who receive property that is subject to vesting (such as stock or equity compensation) to include that property in income when it is received, rather than when it vests.  First, note that the form is optional, and taxpayers can continue to use substitute forms as in the past.  The new Form 15620 aims to standardize the election to reduce the likelihood of errors.  The form does not change the 30-day deadline to make the election (which begins to run on the date the property is received).  Missing the deadline can lead to higher tax liability in the future, when the property eventually vests.  Because the Section 83(b) election form is often attached to an executive compensation equity award, many employers may wish to switch from their prior forms to the new, more streamlined form.

It is possible to escape state income taxation on certain nonqualified deferred compensation benefits by establishing new residence in a different state that does not impose income tax (e.g., Nevada) before distribution of the benefit begins However, the Supreme Court of Connecticut has held in a Connecticut case⁷ involving NQSOs that a former taxpayer cannot escape Connecticut state income taxation on options that are already issued only for services performed while in Connecticut. The Connecticut Supreme Court reached this conclusion even though the nonqualified options were exercised at the time. The taxpayer was a resident of another state. The SCOTUS denied review on appeal so the Connecticut holding imposing taxation on the vested NQSOs was allowed to stand despite the taxpayer’s argument that the Connecticut ruling was at variance with a number of the other federal appellate circuits.⁸

Tax Implications for Employers

An employer has a corresponding deduction (in the same amount and at the same time) as the ordinary income recognized by the employee.⁹ Compensation paid in the form of stock options normally triggers the receipt of wages for the purpose of employment tax and withholding provisions in the amount of the income generated under IRC Section 83(a).¹⁰