As the year-end approaches, startups need to focus on the filing requirements associated with stock options, a key part of employee compensation and retention strategies. Missteps in reporting or filing can lead to unexpected burdens for employers and employees. This article provides a comprehensive guide on how various types of equity compensation—such as Restricted Stock Awards (RSAs), Restricted Stock Units (RSUs), Incentive Stock Options (ISOs), and Non-Qualified Stock Options (NSOs) are treated for tax purposes, the impact of an 83(b) election, and the necessary year-end reporting requirements.
Before diving into the details of this article, a reminder that RSAs and RSUs are forms of equity compensation that companies grant to employees and service providers, typically subject to vesting or other restrictions. On the other hand, stock options, whether incentive (ISOs) or non-qualified (NSOs), allow employees to purchase company shares at a fixed price in the future. However, you don’t own the shares until you choose to exercise the option.
Restricted Stock Awards (RSAs):
- Tax Treatment: The difference between the purchase price (often zero) and the fair market value (FMV) of the stock at the time of vesting is reported as ordinary income to the employee if an 83(b) election is not made.
- 83(b) Election: If the employee makes an 83(b) election, the FMV of the stock at the time of grant is reported as ordinary income rather than at the time of vesting.
What is an 83(b) election? It is a provision under the Internal Revenue Code that allows individuals who receive restricted property (often stock as part of compensation) to elect to be taxed on the total fair market value of the property at the time it is granted, rather than when it vests. This election can significantly reduce the recipient’s tax liability if the property is expected to increase in value over time.
- Form Reporting Requirement: The ordinary income is reported on the employee’s W-2 form.
Restricted Stock Units (RSUs):
- Tax Treatment: The difference between the purchase price (often zero) and the FMV of the stock at the time of settlement (usually when the stock vests) is reported as ordinary income to the employee.
- 83(b) Election: Not applicable.
- Form Reporting Requirement: The ordinary income is reported on the employee’s W-2 form.
Incentive Stock Options (ISOs):
- Tax Treatment: ISOs are not taxed at grant or exercise for regular income tax purposes, but may trigger Alternative Minimum Tax (AMT) for employees. Tax liability arises when stock is sold.
- 83(b) Election: If permitted under the ISO grant agreement (if early exercise is allowed) and an 83(b) election is made, the spread (FMV–exercise price) for AMT purposes is calculated at grant rather than at the time of exercise.
- Reporting Requirement: Employers are required to file Form 3921 when ISOs are exercised. This form is not a tax return but provides information needed for AMT calculations, if applicable. ISO exercises are not reported as income on the W-2 for regular income tax purposes.
Non-Qualified Stock Options (NSOs):
- Tax Treatment: The difference between the strike price and the FMV of the stock at the time of exercise is reported as ordinary income to the employee.
- 83(b) Election: If allowed under the NSO grant agreement (when early exercise is permitted) and the employee makes an 83(b) election, the spread is reported as ordinary income at the time of early exercise rather than at the time of vesting and exercise.
- Reporting Requirement: The ordinary income and applicable taxes withheld are reported on the employee’s W-2 form.
Additional Points to Note:
- Determining FMV: The most recent 409A valuation report, conducted by an independent appraisal firm, is used to determine the FMV of the stock. This valuation is typically valid for up to 12 months unless significant changes in the company’s circumstances affect its valuation.
- Form 3921 Details: Used for ISOs, Form 3921 records the exercise date, number of shares, and exercise price. Many cap table management platforms (e.g., Carta) can generate these forms.
- Record Keeping: Both employers and employees should maintain accurate records of stock grants, exercises, and 83(b) elections to ensure proper reporting and compliance.
- 83(b) Election Overview: The 83(b) election, a provision under U.S. tax law, allows employees who receive restricted stock or stock options as part of their compensation to pay taxes on the FMV of the stock at grant or early exercise, rather than at vesting or exercise. This election must be made within 30 days of receiving the stock.
- 83(b) Election for RSAs vs. RSUs: With RSAs, employees own the stock upon grant (subject to vesting), allowing for the 83(b) election, which can reduce tax liability when the FMV is low. RSUs represent a promise to receive shares in the future, so the 83(b) election is not applicable.
- 83(b) Election for ISOs and NSOs: The 83(b) election generally applies when options are exercised early, especially for NSOs. Making the election allows income to be recognized at early exercise rather than at vesting, which is advantageous when the early exercise price equals the FMV.
- Ordinary Income Calculation: Ordinary income is based on the spread (FMV minus purchase price). If the spread is zero (e.g., purchase price equals FMV), W-2 reporting is not required.
Equity compensation offers significant incentives and rewards for startup employees, but also requires careful year-end planning and reporting. If you need support with these year-end reporting requirements or have questions about the best approach for your company’s specific situation, our firm is here to help.
