Property for Services Series: Part 5 of 5
As we have discussed previously in our Property for Services Series, when the property is received in exchange for services, it is taxable as compensation to the service provider. One of the most common situations we encounter is when our clients hold options to purchase the stock of their employer. It is important for stock options holders to plan and to understand their options’ tax consequences and timing.
Options are not considered property for Section 83 purposes as long as they do not have a “readily ascertainable fair market value.” As a general statement, most employers will issue options that do not have a readily ascertainable value, but it is essential to understand a company risks an 83 issue if the options are issued with a strike price lower than the fair market value of the stock at the date of grant. Most companies use options to incentives an employee to contribute to increasing the value of the employer. For employees, this provides some significant advantages:
- A risk-free investment in the employer while the options remain unexercised; and
- Delayed taxation until the options are exercised.
The positives are often forgotten when it comes time to exercise the options and recognize the tax consequences of the options.
The following equation measures compensation at exercise:
Number of Options Exercised x (FMV – Strike Price)
There are two types of compensatory options, with very different tax treatments.
1. Incentive Stock Options (ISOs)
Incentive Stock Options (“ISOs”) have favorable but confusing tax treatment. For our RIA clients, the essential points to understand are:
- There is no REGULAR tax income when exercised.
- Alternative Minimum Tax (“AMT”) may be due and depends heavily on the employee’s tax
situation and AMT income based on the above equation. - The employee can ultimately receive long term capital gain on the difference between the
ultimate sale price of the stock and the strike price if the stock is held- One year and one day from date of exercise; and
- Two years and one day from the date of the option grant.
- If not held for this period, the income is ordinary income.
The significant consideration with ISOs is when the employee exercises the stock option, owes the strike price, AMT tax, and wants to hold the stock long enough to get long-term capital gains. Consideration needs to be given to the risks associated with a decline in stock value post-exercise. The gamble is converting a risk-free investment to putting funds at risk to gain a tax advantage. You and the client’s tax advisor should work closely to analyze and understand the risks of the exercise and hold strategy, including the applicability of Section 83(i) is beyond this blog’s scope.
2. Non-Qualified Stock Options (NSOs or NQSOs)
Non-Qualified Stock Options (NSOs or NQSOs) are not as tax-favored as or complicated as ISOs. Very simply, at the date of exercise, there is compensation income based on the equation above. From a planning perspective, NSOs should always be exercised and sold on the same day. There is no reason to hold the stock as that converts a risk-free investment to an at-risk investment.
Not all clients have a tax advisor that can help analyze the tax consequences of holding and exercising options. Elevate CPA Group provides our RIA clients with a fractional tax department providing a competitive advantage over competitors. If you have questions about property for services taxation, give us a call.