Taxation of Stock Options and Restricted Stock Units Taxation of Stock Options and Restricted Stock Units

Taxes

Taxation of Stock Options


This article is another in City National’s ongoing summaries of the Tax Cuts and Jobs Act of 2017 (the “New Act”). The New Act significantly modifies the rules established under the Tax Reform Act of 1986 as amended (the “Old Code”).

In this article, we explain how the changes that are introduced under the New Act affect the Taxation of Stock Options and Restricted Stock Units.

Under the Old Code

  • Non-qualified stock options (NQSOs) were taxed as ordinary income when the options were exercised.
  • Incentive stock options (ISOs) were (generally) not taxed when they were exercised, but any gain realized on the exercise of the ISOs was included when calculating a taxpayer’s alternative minimum tax (AMT).
  • Stock options issued and exercised under an Employee Stock Purchase Plan (ESPP) were taxed when the shares were sold (the tax due depended on (1) whether the shares were offered at a discount and (2) how long the shares were held before the shares were sold).
  • Restricted Stock Units (“RSUs”) were taxed when the shares that made up the RSUs were settled, which was almost always at vesting.

Under the New Act

  • New Section 83(i) allows non-executive employees of privately held (non-public) companies to defer income tax (not Social Security, Medicare or unemployment tax) when exercising stock options or when settling RSUs for (generally) up to five years from when the rights in the stock vest or are otherwise not subject to a substantial risk of forfeiture; if
  • The company has a written plan; but
  • The plan must state that 80 percent of the employees participate in the stock grants or RSU awards; and
  • Those employees must have the same rights and privileges to receive qualified stock.

Conclusion

The New Act appears to encourage the growth of small (closely held) businesses and startups by promoting the granting of options and RSUs without causing income tax burdens on the employees when those awards vest. Companies may wish to consider consulting with their attorneys and tax advisors to explore whether this change will be beneficial in recruiting or retaining key talent.

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