Equity awards offer significant benefits to employees. However, there are inconsistent and counter-intuitive tax rules governing these awards. Ten of the most common misbeliefs about equity compensation taxation and the correct rules are outlined below:
- Myth 1: IRS Forms 3921 and 3922 are triggered by the same events. Both IRS forms are required under Section 6039 of the Internal Revenue Code. Form 3921 is prepared based on the calendar year in which an incentive stock option is exercised. The similar Form 3922 for employee stock purchase plans, however, is prepared based on the year when a "transfer of legal title" occurred. This date differs depending on the source of the shares, and whether they are deposited in a brokerage account after purchase or held in a registered share position at the transfer agent.
- Myth 2: A tax refund is available if stock under a Section 83(b) election never vests. Participants who make a Section 83(b) election within 30 days of a restricted stock grant pay withholding taxes based on the value of the stock at grant date. At vesting date, when the stock is at a higher value, no additional taxable income is recognized. However, if the participant never vests in the award, or the stock is worth less at vesting date than at grant, no refund is available for the excess taxes paid.
- Myth 3: Directors can elect payroll withholding for their equity awards. As nonemployees, directors receive a Form 1099-MISC reporting their income at the end of the year, not a Form W-2. The 1099-MISC has no box to report income tax withholding for payroll purposes. In addition, there is no mechanism by which taxes that have been withheld on nonemployee compensation can be paid over to the IRS. Instead, directors and other nonemployees should make estimated tax payments directly with the federal and state authorities.
- Myth 4: Dividends on unvested restricted stock, or dividend equivalents, are reported on Form 1099-DIV. Unvested restricted stock is not yet owned by the participants, so any dividends paid are considered regular compensatory income, subject to payroll withholding. The only exception is for participants who make a Section 83(b) election on their restricted stock—they will always receive a Form 1099-DIV on dividends paid on their awards.
- Myth 5: Form W-8BEN is completed by US employees who are working overseas. US taxpayers complete Form W-9 using their Social Security number or ITIN no matter where they live. The form never expires as long as the name and tax identification number remains the same. The form is not the same as a Form W-4, which is used for payroll withholding. Form W-9 is required by brokers to certify a participant's tax identification number and to prevent 28% backup withholding on proceeds or dividends.
- Myth 6: Options exercised by beneficiaries after the death of a participant are not subject to any tax withholding. It depends. In one of the few tax planning loopholes for equity awards, beneficiaries who exercise options or stock appreciation rights after the participant's calendar year of death avoid FICA (Social Security and Medicare) withholding, up to a 7.65% savings. Exercises that occur within the calendar year of death are subject to FICA withholding, which is withheld from the proceeds and reported on the decedent's final W-2. There is, however, no federal income tax withholding on options exercised after the death of a participant, regardless of when the exercise occurs.
- Myth 7: When federal tax withholding exceeds $100,000 for a restricted stock vesting event, the issuer can wait until settlement of the share sales to deposit. When the company's cumulative tax deposit liability exceeds $100,000, the deposit must be made by the next business day. The IRS did issue a field directive permitting companies to wait until the day after settlement date to deposit taxes. However, this only applies to broker-assisted cashless exercises of options. The field directive does not mention restricted stock awards (RSAs) or units (RSUs). Some issuers make anticipatory tax deposits in advance of a vesting event, to minimize any potential penalties.
- Myth 8: ESPP qualifying dispositions do not have to be reported by the issuer on Form W-2. When participants in an ESPP sell shares after holding them for the qualifying period, any compensation income should be reported on Form W-2. This applies even if the participants left the company years ago. Although it may require significant effort to add participants back to the payroll system, no corporate compensation deduction is available for this reportable income.
- Myth 9: When a stock split occurs, you only have to adjust the purchase price of ESPP shares. Stock splits affect not only the number of shares outstanding but also the cost basis of the shares. For a 2:1 stock split, the number of shares doubles and the cost basis per share is divided in half. For qualified ESPP shares, administrators should remember to adjust the FMVs at the beginning and end of each past purchase period, so that the calculations of qualifying or disqualifying income will remain correct.
- Myth 10: Cost basis reported on Form 1099-B for equity awards will always be accurate. When equity award shares are sold, the cost basis disclosed on Form 1099-B will very rarely be correct. Per IRS rules, the compensatory income generated by the award is not permitted to be included as cost basis on Form 1099-B—even though it is included in the participant's actual cost basis for Form 1040. Participants must make an adjustment for this amount on Form 8949—or risk overpaying taxes.
Always make sure to enroll the help of an expert on tax-related issues.
This article originally appeared in the January-February issue of The NASPP Advisor and is reprinted with their permission.