Exam Overview Webinars Certified Equity Professional Institute L1 Exam Overview Webinar Taxation Certified Equity Professional Institute 2011 http://cepi.scu.edu The information presented herein is of a general nature and has been simplified for presentation to a large audience. It is not a complete discussion of all aspects the laws, rules, regulations, standards, and principles that govern equity compensation plans. The contents are neither designed nor intended to be relied upon, and should not be considered, as legal, tax or accounting advice. Your specific situation may involve circumstances that cause the laws, rules, regulations, standards and principles described herein to apply differently. You should consult your own advisors before deciding what, if any, course of action to take in your own particular situation.
Taxation = 33% of test = Syllabus General terminology Section 83: governs taxation of NSOs and restricted stock Section 422: governs taxation of ISOs = With sections 421 and 424 Section 423: governs taxation of ESPPs = With sections 421 and 424 NSOs Special circumstances Restricted stock/restricted stock units -2-
Tax Basics = Compensation income Same as salary or wages Company has a reporting obligation Tax withholding may also be required Company is usually entitled to a tax deduction = Capital gain (or loss) Short-term or long-term Short-term rates are equal to ordinary income tax rates Long-term capital gains are subject to lower tax rates (typically 15%) Company has no reporting or withholding obligation Company does not get a tax deduction -3-
Tax Basics = U.S. taxes paid as income earned Pay taxes as earned or receive income throughout the year, generally through payroll withholding for income from your employer. Earned income that is not subject to withholding, will likely lead to estimated tax payments each quarter of the tax year. -4-
Tax Withholding = Income taxes Federal income tax = Eligible for flat rate withholding of 25% on supplemental income = Rate increases to 39.6% for supplemental income over $1 million per year State income tax = Varies by state = FICA/FUTA Employment or payroll taxes Social Security (subject to annual maximum) Medicare SDI or SUI = Varies by state (typically subject to annual maximum) Company must pay matching amounts -5-
ISO Basics = Incentive stock options (ISOs) = Know Internal Revenue Code (IRC) Section 422 inside and out Section 422 governs ISO plans = Some basic ISO characteristics: Option must meet all requirements of Section 422 at time of grant in order to benefit from tax rules = ISOs must be granted under a qualified Section 422 ISO plan Vesting can be based on hire date, review date, or other Company eligible for tax deduction for disqualifying ISO No withholding obligation upon exercise -6-
ISO Requirements = Holding period Must hold two years from grant and one year after exercise to retain taxpreferred status = Plan Must state eligibility and maximum number of shares that can be granted as ISOs Maximum term of 10 years Approved by shareholders ISO grants only to employees -7-
ISO Requirements = ISOs granted under a plan Minimum option price equal to FMV (110% of FMV for 10% owners) Term no longer than ten years (five years for 10% owners) Non-transferable except to estate after death No more that $100,000 worth of stock can become exercisable per year Conditional on employment status = 3-month grace period for voluntary/involuntary termination Includes change to non-employee (consultant) = 12 months for termination due to disability = Does not apply for death = Leaves of absence -8-
ISO Tax Considerations = Employee tax consequences No tax to employee upon grant No tax to employee upon exercise of shares = AMT (item of adjustment) Dispositions = Qualifying = Disqualifying = Company tax consequences No withholding at time of exercise = Informational reporting on form 3921 At sale = If DD, company required to report ordinary income on Form W-2, no withholding = If QD, company is not required to report on Form W-2, no withholding = Company can take a tax deduction for ONLY DD ordinary income amounts reported on Forms W-2-9-
ISO $100,000 Limit Example $100,000 (minus aggregate value* of previously granted ISOs first becoming exercisable in year) FMV on grant date Number of shares that may be granted and become exercisable as ISOs in any given calendar year *Based on FMV on original grant date (shares first becoming exercisable x FMV on grant date) -10-
ISO $100,000 Limit Example = An employee is granted an ISO for 10,000 shares on June 15, 2015. The option price is $15 per share (equal to the FMV on grant date) and the shares vest and become exercisable in four equal, annual installments on the anniversary of the grant date. This is the first ISO grant the employee has received. Year 2016 2017 2018 2019 Shares vesting this grant Value of shares vesting this grant (# of shares x $15) Remaining value under Limit 2,500 2,500 2,500 2,500 $37,500 $37,500 $37,500 $37,500 $62,500 $62,500 $62,500 $62,500 ($100,000 value) -11-
ISO $100,000 Limit Example = On May 15, 2016, that same employee receives a second ISO for 1,000 shares. The option price is $25 per share (equal to the FMV on grant date) and the shares vest and become exercisable in four equal, annual installments on the anniversary of the grant date. These are the only two grants the employee has received. Year 2016 2017 2018 2019 2020 Value of shares vesting in original grant Shares vesting this grant Value of shares vesting this grant (# of shares x $25) Remaining value under limit ($100,000 value of grant 1 value of grant 2) $37,500 $37,500 $37,500 $37,500 $0 0 250 250 250 250 $0 $6,250 $6,250 $6,250 $6,250 $62,500 $56,250 $56,250 $56,250 $93,750-12-
ISO $100,000 Limit Example = Now that same employee receives a new fully vested grant in 2020 for 5,000 shares when the FMV is $30. = We exceed the $100,000 limit in 2020. Can only have $93,750 for ISO. = Only 3,125 of the 5,000 shares are ISO ($93750/$30) the remaining 1,875 are disqualified and treated as NSO Year 2016 2017 2018 2019 2020 Value of shares vesting in original grant Value of shares vesting 2016 grant (# of shares x $25) Value of shares vesting in new 2020 grant Remaining value under limit ($100,000 value of grant 1 value of grant 2- grant 3) $37,500 $37,500 $37,500 $37,500 $0 $0 $6,250 $6,250 $6,250 $6,250 $150,000 $62,500 $56,250 $56,250 $56,250 <$56,250> -13-
Qualified / Statutory Stock Plans = Preferential tax treatment - Sections 421 + 422 No ordinary income at the time of the exercise = AMT consequences All long-term capital gain/loss at the time of disposition if shares are held more than 2 years from the grant date and more than 1 year from exercise/ transfer date (qualifying disposition) = Disqualifying disposition: dispositions that occur before the end of both holding periods = Disqualifying disposition ordinary income = (lesser of FMV at exercise or actual sale price grant price) x disposed shares Income is included in year of disposition Not FICA/FUTA taxable Cannot deduct sale commissions/fees when calculating ordinary income = No AMT if there is a disqualifying disposition in same calendar year as the exercise -14-
Qualifying Dispositions Grant Date 4/16/2015 A 4/16/2017 Exercise Date 5/12/2016 B 5/12/2017 C 5/12/2017 First date to sell ISO shares in a qualifying disposition is 5/13/2017. Any sale earlier would be a disqualifying disposition -15-
Taxation Example = ISO qualifying disposition $50 Entire gain (profit) is Capital Gain - $40 per share $10 $15 FMV $30 Gain (Spread) at exercise ($20 per share) = Tax Preference item for AMT Calculation Grant Vest Exercise (AMT consequences) Sale (Capital gain or loss long term since shares held over 1 year after exercise date) -16-
Taxation Example = ISO disqualifying disposition $30 $50 Any additional gain (profit) is capital gain - $20 per share $10 $15 FMV Gain (Spread) at exercise ($20 per share) = Tax Preference item for AMT Calculation Spread at exercise is compensation income ($20 per share) Grant Vest Exercise (AMT consequences) Sale Compensation income and capital gain or loss -17-
Taxation Example = ISO disqualifying disposition $30 $25 $10 $15 FMV Compensation Income is $15 per share Grant Vest Exercise (AMT Consequences*) Sale Compensation Income -18-
Non-Qualified Stock Options = Do not comply with US IRC 422 regulatory requirements = No limitations on: Plan Optionee Term Transferability Shares -19-
NSO Taxation = Tax treatment (assuming no early exercise and no discount) No income realized upon grant No income realized upon vest Compensation income at exercise equal to spread (regardless of exercise type) = Capital gain at sale equal to sale price less FMV at exercise = Company responsibilities Withholding (employees only) Reporting (Form W-2 for employees, Form 1099-MISC for non-employees) = Tax deduction for company equal to employee income, dependent on proper reporting -20-
NSO Taxation = Calculations for taxes Taxes due = Ordinary income x applicable tax rate Withholding required: = Federal income tax / Supplemental wage rate = FICA-Social Security and Medicare = State income tax (sometimes disability/unemployment tax) = Local income tax Reporting required = Form W-2 for employee/former employee = Form 1099-MISC for non-employee = Company sends to participants Later sale of shares subject to capital gain/loss rules -21-
NSO Example = NSO exercise and sale $50 Additional profit after exercise optionee recognizes $20 per share capital gain $10 $15 Tax Basis FMV $30 Gain (Spread) at exercise: optionee recognizes $20 per share compensation income Grant Vest Exercise (compensation income) Sale (capital gain or loss) -22-
Taxation Basics = IRC Section 83 Income recognition when property is transferred unless subject to substantial risk of forfeiture or is non-transferable 83(b) accelerates tax liability, if elected = Early exercise NSOs exercised prior to vesting = Compensation income realized when shares vest instead of at exercise = Section 83(b) election can be filed to recognize compensation income at exercise ISOs exercised prior to vesting = Income for AMT purposes is realized when shares vest instead of at exercise = Section 83(b) election can be filed to recognize income for AMT purposes at exercise -23-
Section 83(b) Elections = Procedures: Copy filed with the IRS Must be filed within 30 day of exercise date Mailing date is filing date Should be sent certified or registered, mail receipt is evidence of filing (you may want to request acknowledgment of receipt) = Must include: Name, address, tax ID number, and taxable year Description of property and restrictions Date received, FMV, and amount paid Statement that copies have been provided as required Employee provides copy to company -24-
Section 423 ESPP = Requirements Plan must state eligible participants and total number of shares to be issued Must be approved by shareholders Participation = Substantially all employees must be allowed to participate, except: Part-time employees Employees with less than 2 years of service Highly compensated employees 5% shareholders are prohibited from participating = Non-employees are prohibited from participating -25-
Section 423 ESPP Price can be a minimum of 85% of the lower of the: = FMV at enrollment = FMV at purchase Offering period can t exceed 27 months = Offering period can be 5 years if purchase price is based on ending FMV only Non-transferable Participants cannot purchase more than $25,000 worth of stock per year -26-
ESPP $25,000 Limit Example $25,000 (minus aggregate value* of previously purchased ESPP shares in same calendar year) FMV on enrollment date* Number of shares that may be purchased under Section 423 plan in any given calendar year *Limit is calculated based on FMV on enrollment/grant date, regardless of discount amount or actual purchase price. (Shares purchased x FMV at enrollment) -27-
Section 423 ESPP = Tax Treatment No income realized at enrollment No income realized at purchase Compensation income realized at sale = Disqualifying disposition: Compensation income is equal to spread at purchase. Difference between FMV at purchase and sale price is capital gain or loss. = Qualifying disposition: Compensation income is enrollment discount or actual gain, whichever is lower. Any additional profit is a capital gain. Shares held for 2 years from start of offering period AND 1 year from purchase = qualifying disposition -28-
Section 423 ESPP = Company Responsibilities Purchase = Informational reporting on Form 3922 Disqualifying disposition = Reporting (Form W-2) = Tax deduction Qualifying disposition = Reporting (Form W-2) = No tax deduction even on amounts included as income -29-
Special Circumstances =Divorce NSO = Transfer of option pursuant to divorce is not a taxable event = Ex-spouse recognizes ordinary income upon exercise Income taxes and FICA/FUTA must be withheld Income taxes (and income) are reported on Form 1099 issued to the spouse FICA/FUTA taxes are based on employee s income, attributed to employee, and reported on employee s Form W-2 (but are paid by the ex-spouse) ISO = Transfer of ISO shares acquired prior to divorce is not a disposition and ex-spouse is eligible for preferential treatment if holding periods are met Transfer must be incident to divorce (i.e., be within 1 year of divorce) = Transfer of option disqualifies it from ISO treatment -30-
Restricted Stock = Tax treatment Restricted stock awards = Exempt from Section 409A = Subject to Section 83 Restricted stock units = Subject to Section 409A. Doesn t apply if fixed payout date or valid deferral election Company responsibilities = Withholding (employees only) = Reporting (Form W-2 for employees, Form 1099-MISC for non-employees) = Tax deduction -31-
Restricted Stock/Restricted Stock Units = Tax Treatment Employee recognizes compensation income upon vest = Equal to FMV (less any amount paid for the stock) For restricted stock awards, employee can file a Section 83(b) election to accelerate recognition of compensation income to grant date For restricted stock units, plan may permit employees to elect to defer payout of shares beyond vesting = Election must comply with 409A = Defers recognition of income for FIT purposes FIT income is FMV when shares are ultimately paid out FICA still due at vest -32-
Reporting = Section 6039 required information statements Statements to participants = Upon first transfer ISO upon exercise, if shares issued in street name (to broker) ESPP upon purchase, if shares issued in street name (to broker) IRS return requirements = Form 3921 for ISOs = Form 3922 for ESPPs = Mailed to employees AND filed with the IRS If 250 or more of either form, must be filed electronically -33-
Special Circumstances = Death NSO = Estate recognizes ordinary income equal to spread at exercise Reported on a Form 1099 Withholding is not required unless exercise occurs in calendar year of employee s death, in which case only FICA/FUTA taxes are withheld FICA/FUTA taxes are reported on employee s final Form W-2-34-
Special Circumstances = ISO and leaves of absence No impact on ISO if employee has guaranteed right to return to work = Maternity leave = Disability or sick leave = Family Leave Act = Military leave = Company policy No impact on ISO if leave is not longer than 3 months Where both of the above do not apply: Leave Begins 3 months 3 months Employee considered terminated ISO status is no longer available -35-
Special Circumstances =Divorce NSO = Transfer of option pursuant to divorce is not a taxable event = Ex-spouse recognizes ordinary income upon exercise Income taxes and FICA/FUTA must be withheld Income taxes (and income) are reported on Form 1099 issued to the spouse FICA/FUTA taxes are based on employee s income, attributed to employee, and reported on employee s Form W-2 (but are paid by the ex-spouse) ISO = Transfer of ISO shares acquired prior to divorce is not a disposition and ex-spouse is eligible for preferential treatment if holding periods are met Transfer must be incident to divorce (i.e., be within 1 year of divorce) = Transfer of option disqualifies it from ISO treatment -36-
Educational Courses to Assist In Exam Preparation NASPP = https://www.nasppuniversity.com NCEO = http://www.nceo.org/training/cepstudy.html Although the CEP Institute makes this information available to candidates, we do not endorse educational programs. The candidate must determine whether the program is suitable for his/her needs. -37-