Tax Law Allows Employees to Defer Income from Equity-Based Pay

Equity-based compensation can be a great way to reward and retain valued employees, especially for companies with limited cash on hand. And the Tax Cuts and Jobs Act (TCJA) makes it even more advantageous by offering a new tax-favored alternative to employees who receive these awards.

Under Internal Revenue Code Section 83(i), eligible employees can elect to defer for up to five years taxable income from exercising a stock option or receiving restricted stock. Here are the details.

Types of Equity-Based Compensation

There are various types of equity-based compensation awards. Popular examples include:

Restricted stock. The company grants  restricted stock units (RSUs) when it awards an employee restricted stock. Company stock is transferred to the RSU recipient when certain conditions (such as continued service to the company or predetermined performance goals) are met.

The fair market value of restricted stock is generally taxable to the recipient employee when there's no longer a substantial risk of forfeiture with respect to the shares. The most common risk of forfeiture is a requirement for continued employment through a specified date for the RSUs to become vested.

Incentive stock options (ISOs). Employees who receive  ISOs have the right (but not the obligation) to purchase shares at a predetermined (exercise) price by the exercise date. 

Gains from shares acquired by exercising ISOs are generally taxable when the shares are sold. However, if the employee is subject to the alternative minimum tax (AMT), the so-called "bargain element" (the difference on the exercise date between fair market value of the option shares and the exercise price) counts as AMT income.

Nonqualified stock options (NQSOs). These are stock options that don't qualify for the more-favorable tax treatment given to ISOs. With  NQSOs, the bargain element is taxable when the option is exercised. That amount is treated as additional salary income subject to both income taxes and federal employment taxes.

{Continue Reading}