Marcum 2021 Year-End Tax Guide

Other Considerations The income tax treatment of NQSOs is governed by IRC Section 83 rules for property transferred in connection with the performance of services. If a NQSO has a readily ascertainable fair market value when it is granted, then that value (less any amount that must be paid for the option) is included by the service provider as compensation income at grant. In the more typical situation where an option does not have a readily ascertainable FMV, then its value, less any amount that must be paid for the option, is taxed to the service provider at the time it is exercised, or as soon after exercise as the option property is transferable or not subject to a substantial risk of forfeiture. The employer corporation has a corresponding compensation deduction for the amount included by the service provider, in the same year that the service provider includes it in income. IRC Section 83(b) and Treas. Reg. Section 1.83-2(a) permit a service provider to elect to include in gross income the excess (if any) of the fair market value of the property at the time of transfer, over the amount (if any) paid for the property, as compensation for services. IRC Section 83(b) election is allowed for NQSOs but not ISOs. With the enactment of the Tax Cuts and Jobs Act (“TCJA”), new Section 83(i) allows qualified employees of a privately held company to elect to defer the income from the exercise of an NQSO or vesting of an RSU received in connection with the performance of services for up to five years, if the corporation’s stock is an eligible corporation. An eligible corporation cannot have any stock readily tradable on an established securities market during any preceding calendar year. Reporting Requirements An employer must report to an employee the excess of the fair market value of stock received upon exercise of a NQSO, over the amount paid for the stock option, on Form W-2 in boxes 1, 3 (up to the social security wage base), and 5, and in Box 12 using the code “V.” For any non-employee service provider, the employer must report this income on Form 1099-NEC. A detailed discussion of IRC Section 83(b) and 83(i) is beyond the scope of this article.

There is a limit on the amount of ISO’s that can be exercised. An ISO will fail to be considered an ISO to the extent the aggregate fair market value of the stock with respect to an ISO exceeds $100,000. If the FMV (of the underlying stock) exceeds $100,000, the option is treated as a NQSO. This rule may also have an impact on the corporation’s deferred tax asset for stock-based compensation. Special rules additionally apply to a 10% shareholder. For options granted under an ESPP, there is a $25,000 yearly limitation on the amount that an employee can purchase. Reporting Requirements Compensation resulting from the exercise of an ISO or an ESPP, or from the disposition of stock acquired by exercising the option, is not considered compensation for social security, Medicare or FUTA tax purposes, and no federal income tax withholding is required. Form W-2 The employing corporation must report as income in Box 1 of Form W-2 (a) the discount portion of stock acquired by the exercise of an ESPP option upon a qualifying disposition of the stock, and (b) the spread (between the exercise price and the fair market value of the stock at the time of exercise) upon a disqualifying disposition of stock acquired by the exercise of an ISO or ESPP option. Box 14 of Form W-2 may also include the amount of compensation related to ISO disqualifying dispositions with a code similar to “ISODD,” or for the amount related to the ESPP, as “ESPP.” Form 3921 and 3922 In addition to issuing a Form W-2, an employer has an information reporting requirement following the exercise of either an ISO or ESPP. With respect to an ISO, IRC Section 6039 requires corporations to furnish Form 3921 to each employee on or before January 31 of the subsequent year. With respect to the exercise of an option under an ESPP, the transfer of stock to the employee is reported on Form 3922. TAX IMPLICATIONS FOR NQSOS NQSOs may be granted to employees, directors, and other service providers such as contractors and consultants. The employer corporation does not receive a tax deduction at grant, but is entitled to a tax deduction upon exercise, equal to the amount of ordinary income includible in the service provider’s income. The ordinary income to the service provider is the excess of fair market value of the option over the option price.

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