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Stock-based compensation brings elaborate rules

Jim HamillLarge employers, particularly those whose stock is publicly traded, often grant stock to their employees. Sometimes these stock awards are made broadly available, but they may be narrowly tailored to key employees.

The tax treatment of stock awards is generally fairly straightforward. Compensation received in property, such as stock, is income based on the fair market value of the property received.

If the employee has to pay something to receive the stock, the income amount is reduced by the payment.

The income is recognized upon receipt of the stock unless the right to the property has not vested. If the property is subject to a “substantial risk of forfeiture,” and cannot be transferred to another person without that forfeiture risk attaching to the transferee, there is no income until the restriction lapses.

The recipient of the non-vested stock may, within 30 days of receipt, make an election to ignore the restrictions. The taxable event then occurs upon receipt of the stock although it may later be forfeited.

This election allows the recipient to achieve two benefits. First, the tax effect of appreciation in the value of the stock from the date of receipt until the date it vests is deferred until the stock is sold. Second, the appreciation from date of grant to the date of vesting is converted from ordinary income to tax-favored capital gain. Notice both benefits depend on appreciation.

Employers may also grant options to acquire employer stock. Options are not taxed when granted. Instead, if the option is exercised the employee is taxed on receipt of the stock in the same manner discussed above.

“Incentive stock options,” or ISOs, are not taxed until the stock acquired upon exercise is sold. If the employee waits long enough for this sale, all income is capital gain.

New Mexico has many more private employers than publicly traded employers. Private companies often assume that stock-based compensation is not for them. They may not want more owners and they are not sure what the fair market value of the stock is.

The tax law permits an employer to use a formula price to set the value of the stock. This can be very important to a private employer not willing to pay for an appraisal of the stock.

ISOs cannot use a formula price for the stock subject to the option right. So an ISO is less useful when the stock is not publicly traded (and therefore easily valued).

A formula price could be based on accounting value of assets or some multiple of accounting earnings. To make the plan desirable to the employees, the company will probably need to be willing to be transparent about its earnings or assets.

Formula prices must be binding for all transfers to be allowed as the measure of FMV for tax purposes. This often means the company offers to buy the stock from the employee at the formula price.

Formula prices can also be tricky because the stock plan may be a deferred compensation arrangement subject to Section 409A of the tax code. If so, the valuation must comply with special rules.

Not all stock awards require a Section 409A valuation (ISOs do). The private employer’s plan choice may be affected by avoiding a costly valuation.

The 2017 tax act created a potential incentive to use stock compensation in private companies. The employee may elect to defer recognizing income for as long as five years after receipt of the stock.

This election can be helpful when the employee has no ready market to sell the shares. Without the election, receipt of vested stock could force the employee to recognize taxable income, and fund a payment to the IRS, with no available cash.

This special election comes with some strings attached. First, the private employer must make stock awards available to at least 80 percent of its employees. Second, no deferral of income is allowed if the employer will buy the stock back from the employee when it first becomes vested.

Public companies believe that stock-based compensation helps to align the incentives of the employer and the employee. Private companies face added challenges in using stock-based compensation but may still consider whether these challenges can be overcome.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at