NCEO’s CEP Exam Preparation Course –Spring 2018 Level 1 ... · Level 1 Core Topic: Taxation Presented by Sarah ... •Must state the number of shares available to ... power to

NCEO’s CEP Exam Preparation Course – Spring 2018Level 1 Core Topic: Taxation

Presented bySarah Roberts, CEP

Stock & Option SolutionsModerated by

Achaessa James, CEP, NCEO

Sarah Roberts, CEP

Sarah Roberts is a Senior Equity Plan Consultant at Stock & Option Solutions, Inc. (SOS).

Sarah is an equity plan consultant with over 15 years of experience in equity plans, and more than 15 years of practice in finance and accounting. At Stock & Option Solutions she provides project and on‐site stock consulting for a variety of clients throughout the country. She specializes in equity accounting and acquisitions and has served public companies ranging in size from 200 to 4,000 employees. While a stock plan analyst at Intel Corporation, she led a project that saved the company over $8M in one year.

Sarah received her CEP certification in 2008. She holds an MBA from the Andersen School at UCLA, and is a graduate of Mills College.

Sarah Roberts, a Senior Equity Plan consultant for Stock & Option Solutions, is the presenter for the Level 1 Taxation webinar. Sarah specializes in equity accounting and acquisitions and provides both project based and on‐site support for clients throughout the U.S. Thank you, Sarah, and welcome

IMPORTANT REMINDER

• Watch the Exam Tips recorded webinar if you have any questions about how to study using the CEPI binder materials

• The Reading List IS NOT a complete listing of the topics you need to study (it only goes down two outline levels)

• Refer frequently to the Exam Topics Outline (the “Syllabus”) to see all topics (there are often three to four outline levels)

• Download the new L1 2018 Suggested Best Reading Resource By Topic document

3

So with our topic‐focused format this year, we’ll cover all the general course review statistics in the Exam Tips webinar which was recorded last week. The only reminder I want to give here is that on the reading list appears to be straightforward, turns out to be more complex when you look at the Exam Topics Outline. Always remember, the Reading List only goes down two outline levels, but there are often 3 or 4 levels on the Exam Topics Outline.

Also, new for 2018, I’ve prepared a Suggested Best Reading Resource by Topic document for each of the three study levels. You’ll find that in the Supplemental Documents section for your study level. This resource replaces the year over year comparison of the detailed reading list that I’ve done in past years.

And in the Supplemental Documents for all levels you’ll find the new matrix of all tables, exhibits, and appendices that are assigned in the detailed reading list.

NEXT PAGE

• Basics of Taxation

• IRC Section 83

• IRC Section 422 – ISOs

• IRC Section 423 – ESPPs

• IRC Section 6039

• NSOs

• Restricted Stock

• Special Circumstances

Level 1 – Taxation Topics

4

Syllabus xref verified 2017

The Level 1 exam tests general knowledge of the basic rules and regulations for each core topic, so you won’t need to acquire a deep knowledge of each of these areas but you will be responsible for knowing all of the assigned reading in depth

So, jumping right in to the Level 1 Taxation topic, you’ll remember from the Exam Tips webinar that 33% of the Level 1 questions are on taxation. That makes Taxation the biggest topic in Level 1. Here is the basic checklist we’ll use in this webinar to ensure that we’ve covered all of the assigned topics.

Before I turn the presentation over to Sarah, let’s have a polling question.

And now I’ll turn the presentation over to our Level 1 taxation subject matter expert, Sarah Roberts of Stock & Option Solutions. Thanks, Sarah

NEXT SLIDE

5

L1 Taxation – Terms & Definitions

Stock as Income, Cashless Income (Consider Your Options, chapters 6 and 8)

Tax law says that income includes the value of any stock you receive from your employer. If you don’t pay full price for the stock, the difference between the stock value and what you pay is taxable compensation income. Any gain/loss at later sale is capital gain/loss.

Capital Gain / Loss (Selected Issues, glossary)

Ordinary Income (Selected Issues, glossary)

Textbook xref 2018Syllabus xref 2018910 Basics of Taxation > Terms/Definitions > Capital Gain/Loss909 Basics of Taxation > Terms/Definitions > Types of Income

The first topic is Basics of Taxation, specifically with regard to terms and definitions. The Syllabus narrows it down to two specific terms that they want Level 1 students to know about – Capital Gain/Loss and Ordinary Income.

So first I’ll remind you that the glossaries are extremely helpful and you should tab those out in each of your books so that you can get to them easily. Obviously there are many more taxation terms and definitions that you will need to know to pass your Level 1 exam. I find that it’s better to address terminology as we go along so that you have a context for the use of the term and I’ll point out when terms are used that may be confusing. As usual, please ask questions.

For taxation purposes, there are two types of income that we’ll be looking at in Level 1 –income generated by the work you do and income generated by the assets you hold.

Income generated by the work you do is known as ordinary income or compensation income. Income or loss generated by the assets you hold is known as capital gain or capital loss. Both types of income are taxable at federal, state and local levels which vary according to the tax laws of those jurisdictions. Capital gains generated by assets held over one year are

generally taxed at a lower rate than ordinary income and there are complicated rules about how capital losses can be recognized.

Income from stock can be both of these types.

Any stock that you receive will generate income if you paid less than the value of the stock to obtain it, like when you receive a restricted stock award at no cost or purchase stock at a discount through an employee stock purchase plan. Under those circumstances, the difference between what you pay for the stock and the actual value of the stock on the taxation event will be considered ordinary income or compensation. The taxation event can be either on the purchase date or on the vest date depending on the terms of the acquisition. Then later, when the stock is sold, the change in the stock’s value from the initial taxation event to the sale date will be capital gain or loss.

NEXT SLIDE

Basics of Taxation

• IRC Section 83

• IRC Section 422 – ISOs



• NSOs




6

Syllabus xref 2018

Now we’re moving into a review of the assigned sections of the Internal Revenue Code, beginning with Section 422 which governs incentive stock options.

NEXT SLIDE

IRC Section 422 – ISO Basics

7

Syllabus xref 2018

Here you can see that the Exam Topics Outline gives quite a bit of detail on what you’ll be tested on – you can see on this slide ___ that the subtopic of maintaining ISO status with a change in employment status was moved from Level 2 to Level 1 in 2018.

We’re going to start with the Statutory Requirements so that you’ll have a context for understanding the remaining Section 422 topics.

NEXT SLIDE

IRC Section 422 Incentive Stock Options

• Statutory Requirements

• Plan‐level terms and conditions

• Recipient eligibility conditions

• Individual grant terms and conditions

• Allowable Discretionary Conditions

• Tax Treatment

8

ISO Basics / Statutory Requirements

Reference: The Stock Options Book

sections 3.2, 3

.2.4, 4.3.1, Exhibit 4‐3

Textbook xref 2018Syllabus xref 2018969 IRC 422 > Statutory Requirements > Plan Requirements456 IRC 422 > Statutory Requirements > Eligibility886 IRC 422 > Statutory Requirements > Grant Requirements

A Section 422 Incentive Stock Option is statutorily tax‐qualified. This means that there is a tax statute (IRC 422) that establishes this type of award and sets forth the terms under which an award must be issued in order to qualify for the beneficial treatment provided by the statute.

There are three components to Internal Revenue Code section 422 statutory requirements for incentive stock options:• Requirements about the structure of the Plan• Requirements about who is eligible to receive ISOs• And requirements that apply to individual grantsThe statute allows the application of discretionary conditions as long as they don’t conflict with the statutory requirements and, of course, the statute provides the framework for the tax treatment of this type of option.

NEXT SLIDE

ISO Basics / Statutory Plan Requirements

• Must be written

• Must be adopted by the Board of Directors

• Must be approved by the shareholders within 12 months before or after board approval

• Must state the number of shares available to be granted as ISOs

• Identifies eligible award recipients, i.e., specific employees or class of employees because ISOs are only issuable to employees.

9Referen

ce: The Stock Options Book

section 3.2

Textbook xref 2018Syllabus xref 2018969 IRC 422 > Statutory Requirements > Plan Requirements456 IRC 422 > Statutory Requirements > Eligibility

As surprising as it may seem, some companies issue awards called “negotiated awards” which are outside of a formal equity compensation plan. These awards cannot qualify for ISO status because they are not issued from a written, shareholder approved plan, even if the grant itself says it’s an ISO.

A Section 422 qualified plan must be adopted by the board of directors by formal resolution. The plan must also be approved by the company’s shareholders within 12 months before or after the board approval. However, if the board makes its approval contingent upon shareholder approval, shareholder approval can happen later than 12 months because the contingency means the board adoption isn’t considered to have occurred until shareholders approve.

The written plan must state the number of shares that have been reserved to cover options issued as ISOs under the plan. This number can be stated as a fixed number, a percentage of shares outstanding at the date of plan adoption, or a fixed number of shares increased relative to the number of shares outstanding at adoption based on a defined ratio.

And the plan must identify the employees, or class of employees, that are eligible to

receive the options.

Let’s next look at who can be eligible to receive ISO grantsNEXT SLIDE

ISO Basics / Statutory Recipient Requirements

• Options may be granted only to a person who is an employee of the company (or its parent or subsidiary) on the date of grant.

• For the purpose of all statutory options, “employee” is defined with reference to the common‐law definition of employee as used for purposes of wage withholding under Section 3402 of the Internal Revenue Code.

• A “20 Factor Test” has been assembled based on court cases and IRS rulings to determine whether an employer‐employee relationship exists

• Control of hours, working conditions, work product, power to terminate and W‐2 issuance are the most significant factors

20 Factor Test: http://www.valdosta.edu/finadmin/human_resources/documents/IRSFactorTest_000.pdf

10Referen


section 3.2.4

Textbook xref 2018Syllabus xref 2018456 IRC 422 > Statutory Requirements > Eligibility

Section 422 incentive stock options may only be issued to employees of the issuing company OR employees of the issuing company’s parent company or subsidiary companies.

That person must be an employee on the option grant date. This is important to remember – the board of directors cannot approve an ISO option grant to a person simply because they have accepted an offer of employment and will start employment on a later date. For a person to receive an ISO he must be an employee on the date that the board of directors authorizes the grant.

But how is “employee” defined? In the context of Section 422 ISOs, the IRS defines an “employee” by referring to IRC Section 3402 which is, of course, written in the same vague language as Section 422.

Over the years, a review of legal cases and IRS rulings has produced a list of 20 factors which aid in determining whether an employer‐employee relationship exists. I’ve included the URL for the full list of factors on this slide. The most important issue is who has control over basic work‐related issues – the employer or the person working for the employer.

For exam purposes, the 20 factors can really be boiled down to one question – does the

person receive a W‐2 or a 1099?

So, basically, ISOs and tax‐qualified ESPPs are not available for independent contractors, consultants, or outside directors, because they are not considered to be W‐2 employees under tax law.

In Section 422 Employee DOES include an employee of a parent company or subsidiary company. In a joint venture, the company issuing ISOs must own at least 50% of the joint venture to issue ISOs to those employees. NEXT SLIDE

ISO Basics / Statutory Grant Requirements

• Exercise price must be at least 100% of grant date fair market value

• Shareholders that own more than 10% of the company must have an exercise price of at least 110% of the grant date fair market value and the maximum term of the grant is 5 years from the date of grant

• Must be granted within 10 years of the earlier of board or shareholder approval and cannot be exercisable more than 10 years after grant date

• No limit to aggregate number or value of individual grant, HOWEVER,

• only have an aggregate of ISO options first exercisable as to $100,000 worth of stock in any calendar year based on the grant date fair market value of each award

• Accelerated options are counted toward the $100k limit in the year of acceleration

• Excess converts to non‐qualified stock options

11Referen


sections 3.2.4, 3.2.5, 3.2.6, 3.2.7

Textbook xref 2018Syllabus xref 2018969 IRC 422 > Statutory Requirements > Plan Requirements886 IRC 422 > Statutory Requirements > Grant Requirements456 IRC 422 > Statutory Requirements > Eligibility968 IRC 422 > Statutory Requirements > More than 10% owners

Now for grant‐level requirements.

Individual Section 422 option grants have even more specific requirements.

The exercise price must be the same or greater than the grant date fair market value. The norm is 100% of the grant date FMV, but in the case of stockholders that own more than 10% of the company, the exercise price must be at least 110% of the stock’s fair market value on the grant date. For public companies, the FMV easy to determine. In a non‐public company, setting the price is the board’s responsibility. There is no single correct way to do this.

Valuation must be made in good‐faith. If the IRS finds that the valuation isn’t realistic, ISOs can be disqualified and be treated as NSOs. This would also lead to taxes and penalties under Internal Revenue Code Section 409A, which governs deferred compensation. However, the details of what that means won’t come into play until Level 2, so I won’t elaborate on that further today.

The grant must be authorized within 10 years of the earliest date of the plan approvals (remembering that both the board and the shareholders must approve the plan) and cannot be exercisable for more than 10 years after the grant date. Again, the more‐than‐10% shareholders have stricter terms as their grants must have a maximum term of 5 years after the grant date.

There is no limit to the total number or value of ISOs that any individual can receive, however, the recipient can only have $100,000 worth of ISOs that become first exercisable in any calendar year. This is called the “first exercisable” rule. The $100,000 limit is calculated based on all outstanding ISOs, so where an employee holds multiple ISOs all of the options vesting in the same year are aggregated and count toward that year’s $100k limit. Also any options that are accelerated are added to the calculation for the year of acceleration.

Any options that exceed the $100k limit are immediately converted into non‐qualified stock options.NEXT SLIDE

ISO Basics / Statutory Grant Requirements

• The option may not be transferable and, during the employee’s lifetime, may only be exercised by the employee

• The recipient must be an employee on the grant date and post‐termination exercise periods are maximum:• 3 months after termination of employment,

except• 12 months after disability, or• Until original expiration date by the employee’s

estate if the employee dies

• None of these periods can exceed the original expiration date

12Referen


section 3.2.4

Textbook xref 2018Syllabus xref 2018886 IRC 422 > Statutory Requirements > Grant Requirements456 IRC 422 > Statutory Requirements > Eligibility

Continuing with grant‐level requirements.

Incentive stock options are never transferrable during the life of the recipient and may only be exercised by the employee as long as the employee is alive.

After termination of employment, the employee has 3 months in which to exercise vested ISO awards and still retain their tax‐qualified treatment.

If termination is due to disability the exercise must be completed within 12 months after separation from the company.

And if termination is due to death of the employee, the employee’s estate can exercise the option right up until the expiration date.

Of course, none of these post‐termination exercise periods can go beyond the original expiration date of the individual option.NEXT SLIDE

ISO Basics / Permissible Conditions

• Discretionary conditions may not conflict with Section 422 requirements

• Common acceptable discretionary conditions include:

• Right of repurchase

• Right of first refusal

• Right to pay for exercise with previously owned company stock (e.g., stock swap or net exercise)

13Referen


section 3.2.1

Textbook xref 2018Syllabus xref 2018969 IRC 422 > Statutory Requirements > Plan Requirements

In addition to the specific Section 422 requirements, companies often include other terms and conditions to control the distribution of the company’s stock. Such discretionary conditions are permissible so long as they don’t conflict with the statutory requirements of Section 422.

Some common discretionary conditions include letting the employee use company stock to pay for the exercise of the option, the right of the company to repurchase option shares upon the employee’s termination, and a right of first refusal which means that the company must be given the opportunity to purchase the stock if a stockholder is proposing to sell or transfer the shares to someone else.

NEXT SLIDE

IRC 422 – ISO Basics / Employee Taxation

More Taxation Terminology

• Fair Market Value = the value of a share of stock on any given date

• Gain = exercise date fair market value less exercise price paid (also called “spread”)

• Tax Rates = Published tax rates under the Internal Revenue Code

• Disposition = the sale, gift, or other transfer of stock purchased pursuant to an option

14

Syllabus xref 2018Basics of Taxation > Terms & Definitions

A Section 422 Incentive Stock Option is known as a Tax‐Qualified option, meaning that the gain on the exercise of the option can receive favorable tax treatment if certain requirements are met.Before we get into how that favorable treatment is defined and applied, let’s look at some new taxation terminology.

When talking about exercise price, we mentioned Fair Market Value. You’ll also hear it call it called FMV, it means the value of a share of stock on any given date. In the context of ISOs, you’ll recall that the statute requires us to look at the FMV on the grant date to determine the grant exercise price, and it also requires us to look at the FMV on the date of exercise to determine the gain on the exercise.

The Gain, or spread, is the difference between the exercise price and the fair market value on the date of exercise

You’ll remember at the start of this session that the IRS defines two types of income –ordinary income on wages and compensation, and capital gains which is income on assets. The tax rates for those two types of income vary significantly, with capital gains having a much lower tax rate.

The tax rate applied to income depends on the timing of the disposition of the stock. As

applied to stock obtained by the exercise of an option, disposition includes selling the stock, giving it away, or transferring it.

Now let’s apply these terms to incentive stock optionsNEXT SLIDE

IRC 422 – ISO Basics / Employee Tax Treatment

• Tax benefit on gain

• Gain is not taxed as ordinary income at exercise

• Triggers Alternative Minimum Tax (AMT) review instead

• Treated as Capital Gain at subsequent sale if holding periods are met

• Holding Periods

• 2 years after grant AND

• 1 year after exercise

15Referen


section 3.3

Textbook xref 2018Syllabus xref 2018441 IRC 422 > Employee Tax Treatment > AMT885 IRC 422 > Employee Tax Treatment > Holding Period > Qualified v Disqualified

The tax benefit of ISOs is that the gain on the date of exercise, again, the difference between the exercise price and the fair market value on the date of exercise, is exempt from taxation as ordinary income at the time of exercise, unlike non‐qualified stock options which are taxed on that gain at the time of exercise – we’ll talk more about those in a minute.

In order to qualify for this beneficial tax treatment, the stock must be held for two years after grant AND one year after exercise. Selling stock after these holding periods have been met is known as a Qualified Disposition.

It’s a little more complicated than it sounds, though, because even though the gain isn’t taxed as ordinary income on the exercise date, and even though the gain has the potential to be taxed at the lower capital gains tax rates at the time of sale, the gain can be subject to another form of tax called an Alternative Minimum Tax, and we’ll talk about that in a minute.

If the stock is sold before one of those holding periods is met, then it is known as a Disqualified Disposition and the tax benefit is lost.

If the ISO stock is sold in a disqualified disposition, then the gain on the sale, the difference between what the exercise price and the selling price is taxed as ordinary income and reported on the employee’s W‐2 in the year of sale.

There is special tax treatment for disqualified dispositions if the sale price is less than the stock’s fair market value on the exercise date, but that’s a Level 2 topic.

NEXT SLIDE

Level 1 – ISO disposition

Which of the following is considered a disqualifying disposition of ISO stock if done before the holding periods are met? Transfer of the option shares acquired upon the exercise of an ISO . . .

a. from a decedent to an estate.

b. into “street name.”

c. to a sibling.

d. to the nonemployee spouse incident to a dissolution of marriage.

Go to polling question #1 to answer

16

MODERATOR READS QUESTION

Level 1 – ISO disposition

Correct answer: c ‐ Transfer of the option shares acquired upon the exercise of an ISO to a sibling.

Explanation: A disqualifying disposition occurs when an employee loses the legal power to control or further dispose of the option shares. A transfer to an estate after the optionee has died does not constitute a disqualifying disposition.

17Referen

ce: Selected Issues in Equity

Compen

sation sections 1.5.1, 5.2.1

Textbook xref 2018Syllabus xref 2018451 IRC 422 > Employee Tax Treatment > Dispositions 885 IRC 422 > Employee Tax Treatment > Holding Period > Qualified v Disqualified

The Correct answer is c ‐ Transfer of the option shares acquired upon the exercise of an ISO to a sibling.

A disqualifying disposition occurs when an employee loses the legal power to control or further dispose of the option shares. A transfer to an estate after the optionee has died does not constitute a disqualifying disposition.

Now let’s look at some other types of transactions that are not considered dispositions of ISOs

IRC 422 – ISO Basics / Permitted Transfers

ISO transactions that don’t count as dispositions

• Transfer of ISOs, or shares acquired upon the exercise of an ISO, to an estate after the optionee’s death.

• Transfer of the option shares acquired upon the exercise of an ISO into “street name.”

• Transfer of the option shares acquired upon the exercise of an ISO to the nonemployee spouse incident to a dissolution of marriage.

18Referen

ce:Selected Issues

section 1.5.1,

The Stock Options Book sections 3.2.4,

ch.11 (not on rea

ding list)

Textbook xref 2018Syllabus xref 2018451 IRC 422 > Employee Tax Treatment > Dispositions

ISO transactions that don’t count as dispositions includeTransfer of ISOs or shares acquired upon the exercise of an ISO to an estate after the optionee’s death.

Transfer of the option shares acquired upon the exercise of an ISO into “street name.”

Street name: Remember that means the shares are held in the name of a broker instead of the optionee. This is to make transfer (the sale of the shares) easier. It doesn’t mean the shares no longer belong to the optionee.

Transfer of the option shares acquired upon the exercise of an ISO to the nonemployee spouse incident to a dissolution of marriage.

This means shares that were acquired through the exercise of an ISO, which can be transferred in a divorce without the transfer being considered a disposition of the shares. The same is true for shares that were acquired in an ESPP purchase. The shares are still eligible for preferential tax treatment. However, if the ISOs were unexercised, it would be a different story. In that case, the transfer would disqualify the options, which would subsequently be taxed as NSOs.NEXT SLIDE

IRC 422 – ISO Basics Taxation

ISO taxation on a qualifying disposition

Employee

• All holding periods satisfied – 2 years from date of grant and 1 year from date of purchase

• Capital gains taxes on spread between exercise price and sale price

• Subject to alternative minimum tax (AMT) in year of exercise

Employer

• No tax deduction

19Reference: The Stock Options Book

section 3.3

Textbook xref 2018Syllabus xref 2018451 IRC 422 > Employee Tax Treatment > Dispositions 885 IRC 422 > Employee Tax Treatment > Holding Period > Qualified v Disqualified452 IRC 422 > Employer Tax Treatment > Deduction & Reporting

Now for taxation on a qualifying disposition.

When an employee holds an ISO for the full 2 years from the date of grant AND 1 year from the date of purchase, any sale thereafter is called a qualifying disposition. In a qualifying disposition, there’s no ordinary income element. It’s all long‐term capital gains because the stock has been held for more than a year from exercise. Since there’s no ordinary income to report, the company has no reporting obligation and does not receive a tax deduction. And there’s no AMT trigger because that happened at the time of exercise.

Now let’s talk about AMT.

NEXT SLIDE


Alternative Minimum Tax

• No ordinary income HOWEVER

• ISOs are “tax preference items” so exercise triggers an AMT review for year of exercise

• AMT tax calculated on spread at time of exercise

• AMT amount can be used as credit in future year when no AMT due

• Can avoid AMT application if stock is sold in same year as exercise in disqualifying disposition

• Tax is calculated on gain or loss at time of sale

20Referen

ce: Th

e Stock Options Book

sections 3.4, C

onsider Your Options

chap

ters 16 and 17

Textbook xref 2018Syllabus xref 2018441 IRC 422 > Employee Tax Treatment > AMT 451 IRC 422 > Employee Tax Treatment > Dispositions

Despite the exercise date gain on ISOs being exempt from taxation as ordinary income, exercising an ISO does trigger a review of all income in the year of exercise for the purpose of calculating Alternative Minimum Tax liability.

The AMT is a tax system originally intended to prevent high‐income people from sheltering too much income from their taxes.

Under it, taxpayers calculate their income taxes the usual way, then also under the AMT system, which has a higher deduction (although that phases out the higher your taxable income is), but includes some different items than regular income taxes allow you to deduct or not claim—like real estate taxes, state income taxes. These are called “tax preference items” and the difference between an ISO’s exercise price and the stock’s fair market value on the exercise date is one of them. If the AMT comes out higher than regular income taxes, the taxpayer must pay the higher amount, but the difference between the regular tax and the AMT tax can be used as a tax credit against regular taxes in future years when no AMT is due.

The AMT was originally instituted to apply to high income people but the income limits were only set at $150,000 so it now ends up being applied to middle income taxpayers and

not just the wealthy.

This AMT review can be avoided if the taxpayer sells the shares in the same year that they were exercised. This is especially important when stock prices are falling.

For the exam, don’t worry, you won’t have to calculate any AMT tax liability, but you will need to know how the AMT rules would be applied. A good example is when the dot com bubble burst – in early 2000 stock prices were very high and executives and employees alike were exercising their options with very low exercise prices.

Stock prices started falling in March of 2000 and by the beginning of 2001 the market had crashed and the stock they had purchased with a high value in the first quarter of 2000 now had very little value.

Many people were financially ruined when they went to their tax preparer in 2001 to do their 2000 tax return, only to be told that their AMT liability was huge.

Imagine exercising millions of dollars worth of stock in 2000, that at tax time in 2001 are only worth a few hundred dollars, and being told that your tax for 2000 is based on the value of the stock at the time of exercise. You can’t even sell the stock to make enough money to pay the taxes due.

If those same stockholders had consulted their tax professionals before the end of the calendar year, they might have been advised to sell the stock before December 31st in the year of exercise to create a disqualifying disposition – which would mean no AMT review and the ordinary income would be calculated on the difference between the exercise price and the sales price. There is good detail on this in the Selected Issues book, section 5.2.1.

In a nightmare scenario, many dot com employees who failed to sell their stock before the end of the year and had huge AMT liability, then sold their stock in the following year to try to pay part of the AMT tax, which created a disqualifying disposition in the year of sale, which then recognizes ordinary income on the original exercise in the following year’s taxes but did not get rid of the original AMT liability.

Since then the AMT regulations were scheduled for revision, but to date nothing has been finalized. In 2017, BUT NOT ON EXAM

Let’s take a question on employee taxation of ISOs

NEXT SLIDE


Which of the following is true regarding the exercise of an ISO?

a. The company has no tax reporting obligation in connection with the exercise.

b. The exercise may result in an AMT liability only if the employee does not sell before the end of the year.

c. A Section 83(b) election can be filed for the exercise to defer recognition of income for AMT purposes.

d. The employer corporation is entitled to a tax deduction for the exercise only if the exercise causes the employee to be subject to AMT.

21

MODERATOR READS QUESTIONNEXT SLIDE


Correct answer: b ‐ The exercise may result in an AMT liability only if the employee does not sell before the end of the year.

Explanation: If the employee makes a disqualifying disposition in the same calendar year as exercise, the AMT liability is canceled. If the disqualifying disposition occurs in a different year, the optionee's AMT liability is not affected.


section 3.4.2

Textbook xref 2018Syllabus xref 2018441 IRC 422 > Employee Tax Treatment > AMT 451 IRC 422 > Employee Tax Treatment > Dispositions

The correct answer is b. The exercise may result in an AMT liability only if the employee does not sell before the end of the year.

If the employee makes a disqualifying disposition in the same calendar year as exercise, the AMT review and possible liability is canceled. If the disqualifying disposition occurs in a later year, the optionee's AMT review is automatically triggered.

NEXT SLIDE


Explanations for incorrect answers

a. The company has no tax reporting obligation in connection with the exercise.

The company has an obligation to report the spread at exercise to the employee and to the IRS under Section 6039.

c. A Section 83(b) election can be filed for the exercise to defer recognition of income for AMT purposes.

Filing a Section 83(b) election does not defer the AMT liability, rather it freezes it at the difference between the exercise price and the stock’s fair market value on the date of early exercise.

d. The employer corporation is entitled to a tax deduction for the exercise only if the exercise causes the employee to be subject to AMT.

The payment of AMT does not give rise to an employer tax deduction. The reporting of ordinary income does.

23Referen

ce: Th

e Stock Options Book

sections 9.3, 3

.3 and 3.4.3

Textbook xref 2018Syllabus xref 2018441 IRC 422 > Employee Tax Treatment > AMT

Let’s take a look at some of the incorrect answers.Answer a. The company has no tax reporting obligation in connection with the exercise.THIS IS INCORRECT BECAUSE the company actually does have an obligation to report the spread at exercise to the employee and to the IRS under Section 6039, and we’ll talk about that in a minute.

Answer c. A Section 83(b) election can be filed for the exercise to defer recognition of income for AMT purposes.THIS IS INCORRECT BECAUSE filing a Section 83(b) election does NOT defer the AMT liability, rather it freezes it at the difference between the exercise price and the stock’s fair market value on the date of early exercise. Thus, the early exercise means that for tax purposes the options are treated as if they’re already vested even if the employee won’t be free to sell the shares for some time. We’ll talk more about 83(b) elections in a bit.

Answer d. The employer corporation is entitled to a tax deduction for the exercise only if the exercise causes the employee to be subject to AMT.THIS IS INCORRECT BECAUSE, in fact, the payment of AMT does not give rise to an employer tax deduction. Only the reporting of ordinary income does.

This is a good time to point out the difference between payment and reporting. An

employer only has to report ordinary income in order to take the corporate tax deduction. Whether the employee pays taxes on that amount, or even whether the employer withholds taxes on the income, is completely irrelevant to the ability of the employer to take the tax deduction. Only reporting the ordinary income is required. Let’s look at that a little closer.

NEXT SLIDE

IRC 422 – ISO Basics / Employer Tax Treatment

• On Exercise Date

• No income reported, must provide Form 3921 to both employee and IRS to report the terms of the exercise

• Qualified Dispositions

• Nothing for the company to report

• Disqualifying Dispositions

• Company reports income on W‐2, no withholding required, and

• Takes a tax deduction based on income reported

24Referen


sections 3.3, 9.2.2

Textbook xref 2018Syllabus xref 2018452 IRC 422 > Employer Tax Treatment >Deductions & Reporting

Generally speaking, a company can take a tax deduction for option exercises as employee compensation based on the amount of income that it reports to the employee on an employee’s Form W‐2 or a non‐employee’s Form 1099.

Since ISOs are exempt from ordinary income at exercise, no income is reportable so the company does not receive a tax deduction, even though the company is now required to report the terms of the exercise to the IRS on Form 3921 and provide a copy to the employee.

If the employee meets all the holding requirements and later sells the stock in a qualified disposition, the profit from the sale is capital gain so the company still has nothing to report and there is still no tax deduction.

If the employee sells the stock before the holding periods are met, it’s a disqualifying disposition. Then the company will report ordinary income on a W‐2 based on the difference between the exercise price and the exercise date FMV, or sale price if lower, and can then take a tax deduction in the same amount as the income reported. The company would report it on a W‐2 even if the stockholder is no longer an employee, and there is no withholding required by the company. Remember, ISOs are only given to employees.NEXT SLIDE





Nonqualified Stock Option – Taxation

NSO taxation—optionee

• Ordinary income: Difference between the exercise price and the fair market value on the exercise date

• Capital gain or loss: Difference between fair market value on exercise date and price for which shares are sold

NSO taxation—employer

• Can take tax deduction for amount optionee must include in income upon exercise as reported on W‐2 or 1099

• If optionee is employee, company required to withhold income taxes on spread


sections 2.2, 9

.2.1, Exhibit 9‐1

Textbook xref 2018Syllabus xref 2018518 NSO > Employee Tax Treatment > Recognition of Income – Amount & Timing890 NSO > Employee Tax Treatment > Capital Gain/Loss519 NSO > Employer Tax Treatment > Deductions960 NSO > Employer Tax Treatment > Reporting Requirements715 NSO > Withholding

Let’s contrast the ISO tax treatment with the tax treatment of nonstatutory or nonqualified stock options.

Ordinary income: Recognized at the time of exercise. Difference between the exercise price and FMV on exercise date is called the “spread.”

Capital gain or loss: Long‐term if shares held for more than a year, technically a year plus one day, short‐term if they’re held for less than a year. Recognized in year of sale.

Employer: In general, wages are deductible to employers. NSOs are considered to be compensation, thus the employee pays income taxes and the employer gets a tax deduction. After exercise, when into capital gain or loss territory, employer isn’t involved.

Withholding: However, the company’s tax deduction doesn’t depend on proper withholding. It’s the reporting that counts. Withholding is at federal supplemental withholding rate, which in 2017 was 25% for supplemental income payments of $1 million

or less, and 39.6% for amounts over $1 million. The employer must also report the income on the employee’s or former employee’s W‐2, or on a Form 1099 if the person was never an employee.2018 supplement rates have changed but are not updated in the 2017 textbooks currently in use.

Let’s take a couple of questions now as a review of what we’ve just covered.NEXT SLIDE

Level 1 – Corporate Tax Deduction

On March 1, 2016, an employee is granted an ISO to purchase 1,000 shares at a price of $25 per share. The option vests in full one year after the date of grant. She exercises the option in full on April 4, 2017, when the market value is $34 per share. On March 5, 2018, she sells the shares she acquired by exercising her option at $39 per share. Which of the following is true in 2018?

a. The company is entitled to a tax deduction of $9,000.

b. The company is entitled to a tax deduction of $14,000.

c. The employee recognizes a capital gain of $9,000.

d. The employee recognizes a capital gain of $14,000.

26


Level 1 – Corporate Tax Deduction

Correct answer: a ‐ The company is entitled to a tax deduction of $9,000.

Explanation: Because the employee does not hold the shares for a full year from the exercise date, the sale of stock is a disqualifying disposition and the taxation is the same as if it were an NSO.

The employee must pay ordinary income taxes on the difference between the exercise price and the stock's fair market value on the date of exercise, or $9,000. The employer is thus entitled to a tax deduction equal to that amount reported as income on the employee’s W‐2 in the year of sale. The remainder of the profit from the sale is taxed at capital gains rates, and thus the employer gets no deduction on that amount.

27Reference: The Stock Options Book sections 2.2,

3.3, 9

.2.1, Exhibits 3‐1 & 9‐1

Textbook xref 2018Syllabus xref 2018518 NSO > Employee Tax Treatment > Recognition of Income – Amount & Timing890 NSO > Employee Tax Treatment > Capital Gain/Loss519 NSO > Employer Tax Treatment > Deductions960 NSO > Employer Tax Treatment > Reporting Requirements885 IRC 422 > Employee Tax Treatment > Holding Period > Disqualified vs Qualified

The correct answer is a ‐ The company is entitled to a tax deduction of $9,000.

Because the employee does not hold the shares for a full year from the exercise date, the sale of stock is a disqualifying disposition. The employee must pay ordinary income taxes on the difference between the exercise price and the stock's fair market value on the date of exercise, or $9,000. The employer is thus entitled to a tax deduction equal to that amount.

The remainder of the profit from the sale is taxed at capital gains rates, and thus the employer gets no deduction on that amount. The Stock Options Book, section 3.3 and Exhibit 3‐1 are great references for this.

NSO – Taxation of ISO Disqualifying Disposition

ISO taxation on a disqualifying disposition

Employee

• Income tax: Tax on lesser of spread between exercise price and stock’s fair market value on exercise date or spread between exercise price and stock’s sale price. These are due in year of stock sale

• Capital gain: Difference between fair market value on exercise date and sale price of stock

Employer

• Deduction of amount employee must include in income, if reported on W‐2


3.3, 9

.2.1, Exhibits 3‐1 & 9‐1

Textbook xref 2018Syllabus xref 2018518 NSO > Employee Tax Treatment > Recognition of Income – Amount & Timing890 NSO > Employee Tax Treatment > Capital Gain/Loss519 NSO > Employer Tax Treatment > Deductions960 NSO > Employer Tax Treatment > Reporting Requirements885 IRC 422 > Employee Tax Treatment > Holding Period > Disqualified vs Qualified947 IRC 422 > Employee Tax Treatment > Dispositions > Decline in Value after Purchase

So all of this is the long way around in explaining that disqualified ISOs are treated largely as NSOs, with the exception that income taxes are limited to actual gains, and arise in the year of sale, which may be the year after the year of exercise—it probably wouldn’t be later than that because then it would be a qualifying disposition unless the exercise date was right on the heels of the grant date, like with an early exercised option.

The income tax timing is a practical consideration. Whereas an NSO would be subject to income tax in the year of exercise, the ISO isn’t taxed this way until the disqualifying disposition occurs.

Also for ISO disqualifying dispositions, the ordinary income element is limited to actual gain, so if the stock price drops between the exercise date and the sale date, the sale price is used to calculate income taxes. NEXT SLIDE

NSO – Taxation of ISO Disqualifying Disposition

Disqualifying disposition taxation

• Grant date fair market value, March 1, 2016: $25,000

• Exercise date fair market value, April 4, 2017: $34,000

• Sale date fair market value, March 5, 2018: $39,000

Employee’s tax liability

• Ordinary income tax paid on $9,000 in 2018

• Short‐term capital gains tax paid on $5,000 in 2018

Employer’s tax deduction

• Equals ordinary income reported to employee

• No withholding ever required for ISO, even at DD


3.3, 9

.2.1, Exhibits 3‐1 & 9‐1

Textbook xref 2018Syllabus xref 2018885 IRC 422 > Employee Tax Treatment > Holding Period > Disqualified vs Qualified519 NSO > Employer Tax Treatment > Deductions960 NSO > Employer Tax Treatment > Reporting Requirements715 NSO > Withholding

So going back to the question…The employee must pay ordinary income taxes through their personal tax filing on the difference between the exercise price and the stock's fair market value on the date of exercise, which is $9,000.

The employer is thus entitled to a tax deduction equal to that amount and must report that amount on the employee’s W‐2 in the year of the disqualifying disposition in order to claim the deduction. The remainder of the profit from the sale is taxed at capital gains rates, and thus the employer gets no deduction on that amount.

ISOs have one other limitation beyond plan, grant, and recipient requirements – a maximum limit on the value of shares that can be first exercisable each year. Let’s tackle a question on that before we get to the explanation partNEXT SLIDE

ISO ‐ $100,000 annual limit

An employee is granted an incentive stock option for 25,000 shares. On the date of grant, the stock’s fair market value is $20 per share, on the vesting date the fair market value is $25 per share. All of the options vest one year from the grant date. How many shares are eligible for ISO treatment?

a. zero

b. 4,000

c. 5,000

d. 10,000


30


Correct answer: c ‐ 5,000

Explanation: $100,000 limit on ISOs:

• ISO limit is calculated by the year when the option is “first exercisable.”

• Calendar year measurement.

• Measured by grant date fair market value.

• Exceeding the limit does not disqualify the entire award, only the options that vest over the $100,000 in each year.

• Any options over limit are disqualified and taxed as NSOs (but no withholding required)

In this case $100,000 divided by $20 equals 5,000.

Since all of the options vest in the same year, 5,000 receive ISO treatment, and the remaining 20,000 options are taxed as NSOs.

31

ISO ‐ $100,000 annual limit


section 3.2.6

Textbook xref 2018Syllabus xref 2018970 IRC 422 > Statutory Requirements > Limitation on Size

The correct answer is c – 5,000 shares. IRC 422 places a restriction on ISO grants that says that no more than $100,000 worth of ISOs can become first exercisable each calendar year. The specific wording that you’ll want to remember is “First exercisable.”

Generally the “first exercisable” date is the vest date, but if an ISO is eligible for early exercise, then those options would be considered “first exercisable” on the grant date.

The $100,000 value is measured by the grant date fair market value and all of the ISOs that become first exercisable in the same calendar year are counted together to reach the limit even if they are from more than one grant. But you don’t count ISOs that vested in a previous year but remain unexercised in the current calendar year.

The important thing to remember is that the limit is on the first year they become exercisable, NOT in the year they’re actually exercised. So a company could grant ISOs with a cumulative exercise price of $500,000 that vest 20% per year over five years, and they would all still be ISOs, even if the optionee waited until they were all vested to actually exercise them.

Since this limit applies to an aggregate of ALL ISOs that vest during a single calendar year,

another typical exam question that deals with the application of this limit might include the grant of several ISOs that overlap in their vesting during several calendar years, causing only some of the ISOs to be disqualified in only some of the vesting years.

The timeline template in the supplemental materials area of the prep course website is useful for penciling out the answer to such time‐based questions so be sure to print one out to put into your exam binder to have a visual aid during the exam.

Now let’s take an NSO taxation question before moving on to our next topic. NEXT SLIDE

Level 1 – NSO Taxation

On March 1, 2016, an employee is granted an NSO to purchase 1,000 shares at a price of $25 per share. The option vests in full one year after the date of grant. She exercises the option in full on April 4, 2017, when the market value is $34 per share. On March 5, 2018, she sells the shares she acquired by exercising her option at $39 per share. Which of the following is true?

a. The company is entitled to a tax deduction of $9,000.

b. The company is entitled to a tax deduction of $14,000.

c. The employee recognizes a capital gain of $9,000.

d. The employee recognizes a capital gain of $14,000.

32


Level 1 – NSO Taxation

Correct answer: a ‐ The company is entitled to a tax deduction of $9,000.

Explanation: The employee must pay ordinary income taxes on the difference between the exercise price and the stock's fair market value on the April 4, 2017 date of exercise, or $9,000. The employer is thus entitled to a tax deduction equal to that amount reported as income on the employee’s W‐2 and the employer must withhold employment and social taxes.

The remainder of the profit from the March 5, 2018 sale is taxed at capital gains rates, and thus the employer gets no deduction on that amount.


sections 2.2, 2

.6, 9.1

Textbook xref 2018Syllabus xref 2018518 NSO > Employee Tax Treatment > Income Recog/Timing519 NSO > Employer Tax Treatment > Deductions960 NSO > Employer Tax Treatment > Reporting Requirements715 NSO > Withholding

The correct answer is a ‐ The company is entitled to a tax deduction of $9,000.The employee must pay ordinary income taxes on the difference between the exercise price and the stock's fair market value on the April 4, 2017 date of exercise, or $9,000. The employer is thus entitled to a tax deduction equal to that amount. The remainder of the profit from the March 5, 2018 sale is taxed at capital gains rates, and thus the employer gets no deduction on that amount.

NSO – Taxation at Exercise

NSO taxation on exercise

Employees

• Income tax: Tax on spread between fair market value on exercise date and exercise price. This income is recognizable in the year of exercise.

• Not subject to alternative minimum tax (AMT)

Employer

• Deduction on amount reportable as ordinary income.

• Must withhold income and social taxes


sections 2.2, 2

.6, 9.1

Textbook xref 2018Syllabus xref 2018518 NSO > Employee Tax Treatment > Income Recog/Timing519 NSO > Employer Tax Treatment > Deductions960 NSO > Employer Tax Treatment > Reporting Requirements715 NSO > Withholding

At the time of exercise, nonqualified stock options will be taxed on the spread, which is the difference between the exercise price and the fair market value on the exercise date. The employer will report that spread as ordinary income on either a Form W‐2 or a Form 1099 and the employer will be able to take a tax deduction equal to the amount reported as ordinary income, and the employer must withhold for income and employment taxes.Unlike ISO exercises, the exercise of an NSO does not trigger a review for AMT purposes.NEXT SLIDE

NSO – Taxation at Sale

NQ taxation on sale, subsequent to exercise

Employees

• Capital gains taxes on spread between fair market value on exercise date and sale price

Employer

• No tax deduction beyond that on exercise date

• No reporting requirements

• No withholding for taxes

35

Textbook xref 2018Syllabus xref 2018890 NSO > Employee Tax Treatment > Capital Gain/Loss Basis518 NSO > Employee Tax Treatment > Income Recog/Timing519 NSO > Employer Tax Treatment > Deductions960 NSO > Employer Tax Treatment > Reporting Requirements715 NSO > Withholding

At the time of sale of stock acquired through the exercise of an NSO, the spread between the sale price and the fair market value on the exercise date will be taxed as either a short‐term or long‐term capital gain depending upon how long the stock had been held after exercise and before sale.

Because there is no ordinary income, the employer is not entitled to any tax deduction at the time of sale.NEXT SLIDE

Basics of Taxation

• IRC Section 83

IRC Section 422 – ISOs



NSOs




36

Syllabus xref 2018

Now we’ll move on to Section 423 ESPPs and we’ll start with the statutory requirements. As you can see by this slide, there is a brand new Level 1 subtopic of Section 423 ESPP purchase limits for 2018. If you’ve studied with us before, you’ll know that this is nothing new in our study materials since it’s a statutory requirement.

NEXT SLIDE

IRC Section 423 Employee Stock Purchase Plan

• Statutory Requirements

• Plan‐level terms and conditions

• Recipient eligibility conditions

• Purchase Limit

• Tax Treatment• Employer – Deduction and Reporting

• Employee – General

37

IRC Section 423 – ESPP Basics


chap

ter 5

Textbook xref 2018Syllabus xref 2018483 IRC 423 > Statutory Requirements > Plan Requirements870 IRC 423 > Statutory Requirements > Employee Eligibility971 IRC 423 > Statutory Requirements > Purchase Limit481 IRC 423 > Employer Tax Treatment > Deduction & Reporting Requirements479 IRC 423 > Employee Tax Treatment

A Section 423 employee stock purchase plan issues statutorily tax‐qualified options. This means that there is a tax statute (IRC 423) that establishes this type of award and sets forth the terms under which an award must be issued in order to qualify for the beneficial treatment provided by the statute.

Just like ISOs, there are three components to Internal Revenue Code section 423 statutory requirements for issuance of awards:• Requirements about the structure of the Plan.• Requirements about who is eligible to participate in the ESPP.• And individual purchase limits imposed at the individual levelThe statute allows company discretion as to eligibility and offering and purchase periods, as long as they don’t conflict with the statutory requirements, and, of course, the statute provides the framework for the tax treatment of this type of option.

NEXT SLIDE

IRC 423 – ESPP Basics Statutory Plan Requirements

• Written plan

• Shareholder approval

• Equal rights and privileges

• Employees only

• Eligibility – limited exclusions permitted

• No 5% or greater shareholders

• Not transferable

• $25,000 limit per person, per calendar year

• Aggregate across all related ESPPs (issuer, parent, subsidiary)

• Can be up to $50k if Offering Period overlaps calendar year

• Purchase price – maximum 15% discount

38Referen

ce: The Stock Options Book chap

ter3,and

section 5.1, Selected Issues sections 9.1 thru 9.4

Textbook xref 2018Syllabus xref 2018483 IRC 423 > Statutory Requirements > Plan Requirements870 IRC 423 > Statutory Requirements > Employee Eligibility971 IRC 423 > Statutory Requirements > Purchase Limit

There are two internal revenue code sections that you’ll be hearing about a lot – Section 422 and Section 423 – 422 governs the Incentive Stock Options that we just covered, and section 423 covers options issued under an Employee Stock Purchase plan, also known as an ESPP. The way the IRS calls them both Options can be confusing because they operate differently, so the easiest way to remember which is which is remembering that Section 423 rhymes with ESPP.

If an employee stock purchase plan complies with IRC Section 423, then it is a tax qualified plan. There are ESPPs which do not comply with Section 423 and they are not tax qualified – you’ll learn about those when you get to Level 2.

Level 1 candidates only need to focus on the tax‐qualified type of ESPP. This slide and the next one set forth the statutory requirements for a tax‐qualified ESPP. These are summary descriptions and you should read chapter 3 of The Stock Options Book for a comprehensive understanding of ESPPs. So here we go:

•Plan must be written and must be approved by shareholders within 12 months of plan adoption by the board of directors. The shareholder approval can be 12 months before board approval or 12 months after but must fall within that overall

24 month period.•Equal rights and privileges is a term you’ll often hear. It means that all employees who participate in the plan must be treated the same, with only a few exceptions.•Just like ISOs, only employees are eligible to participate in ESPP programs. This can include employees of the issuing company, a parent company or a subsidiary company and the definition of employee generally follows the common‐law definition as used for purposes of wage withholding under Section 3402 of the code –and you can refer back to the slide above that talks about the 20 factor test.•Must carry an individual purchase limit of $25,000 per calendar year based on the FMV at the time of grant. This is a cumulative limit across all plans active in all related companies during any calendar year. So, for example, if an employee of a subsidiary company is allowed to participate in the ESPPs of both the subsidiary company and the parent company, the employee would be limited to purchase a combined aggregate of $25,000 worth of stock in both plans for a single year. It’s important to note here that the $25,000 limit is based not on the exercise price of the option, which may be discounted, but on the full FMV on the grant date. We have a slide later in the deck that demonstrates the calculation for the $25,000 limit. However, and this is a big however, there is an exception to this annual limit when an ESPP has an offering period that overlaps calendar years – we talked about that in depth in the Level 1 Administration webinar when we talked about offering periods.•The option price may not be less than 85% of the FMV of the stock on the date of grant or the date of exercise (whichever is lowest). There are two relevant points here – the first is that the maximum discount allowed by a tax qualified ESPP is 15%. Using the lesser of the FMV on the grant date or the exercise date is called a lookback provision because it allows the company, on the exercise date, to look back to the grant date and use the FMV on either of those two dates to set the lowest allowable option price.

NEXT SLIDE

Section 423 Option Plan Requirements

• Maximum term – 5 years or 27 months depending on whether there is a lookback or not

• Options expire after

• 5 years if the option price is based on the FMV of the stock on the date of exercise

• 27 months if the option price is based on the lesser of the FMV of the stock on the date of grant or date of exercise

39Referen

ce: The Stock Options Book section

5.2.2, Selected Issues sections 9.1 thru 9.4

IRC 423 – ESPP Basics Statutory Grant Requirements


Unlike ISOs, which have a maximum 10 year term, ESPP Options expire after • 5 years if the option price is based only on the FMV of the stock on the date of exercise

OR• 27 months if the option price is based on the lesser of the FMV of the stock on the date

of grant or date of exercise

Here we can see that the term of the option can be longer if the purchase price of the stock is based on only the FMV on the date of exercise. ESPP options have a predetermined exercise or purchase date, at which time the option either gets exercised or it doesn’t, what this expiration limit does in practice is limit the length of the offering period – and we talked about that in more detail in the plan administration webinar.

Let’s take some questions on this information before moving on

NEXT SLIDE

An employee enrolls in her employer's Section 423 ESPP on January 1, when the market value is $50 per share. There is a specific share limitation in the Plan. Over the next six months, she contributes $6,000 to the plan. Her first purchase occurs on June 30, when the market value is $10 per share. The purchase price is the minimum allowed under Section 423. How many shares can she be allowed to purchase?

a. 141

b. 500

c. 588

d. 705


40

IRC 423 – ESPP Basics Statutory Purchase Limits


Correct answer: b – 500

Explanation: The employee cannot purchase more than 500 shares without exceeding the statutory limit of $25,000 worth of stock in any calendar year. This calculation uses the stock price on the day of grant (the first day of the offering period).

(Math on the next slide)

41Reference: The Stock Options Book section

5.2.2, Selected Issues sections 9.1 thru 9.4


Textbook xref 2018Syllabus xref 2018483 IRC 423 > Statutory Requirements > Plan Requirements971 IRC 423 > Statutory Requirements > Purchase Limit

The correct answer is b – 500 shares. It’s a little tricky because there are two restrictions the question asks you to remember – the $25k limit and also the “minimum allowed purchase price” – and the amount of contributions is the distractor.

Using the stock price on the day of grant (the first day of the offering period), we see that the employee cannot purchase more than 500 shares without exceeding the statutory limit of $25,000 worth of stock in any calendar year. This can be confusing, because it’s separate from the actual purchase price, so you can’t just say, oh, I’ve paid $25,000 for ESPP shares this year, I’m done for the year.

Instead, it’s based on fair market value on the offering date, which may well not be the purchase price. In fact, if the plan has a look‐back feature and the stock price falls a lot during the purchase period, an employee could run up against the $25,000 limit even if her payroll deductions are much less than that amount. An important point in this question is the statement that there is a specific share limitation in the plan – this sets the grant date as the first date of the offering.

In a really complicated ESPP with overlapping offering periods, figuring this out can get quite complex, but don’t worry about having to do that for the exam. For Level 1, you’re far

more likely to be asked a straight‐forward question about how many shares someone can buy in a year, than to have to figure out how many shares someone can buy in overlapping offering periods that straddle calendar years.

They’ll be looking for an understanding that the limit is based on offering date fair market value, as opposed to actual purchase price or discounted value. But do keep in mind that if an offering period does straddle two calendar years, the limit is calculated based on accrual, not on purchase. So the date when the offering begins is when the per share value is calculated and the limit amount is accrued over multiple years if the offering period straddles a calendar year.NEXT SLIDE

Section 423 plan with a six‐month offering period, a 15% discount, and a look‐back feature.

• FMV on first day of offering period: $50

• FMV on last day of offering period: $10

• Purchase price: $8.50

Maximum number of shares that can be purchased: 500 ($25,000 divided by $50)

Amount of payroll deduction needed to buy 500 shares: $4,250 (500 multiplied by $8.50)

See L1 Administration webinar slides for visual explanation of offering periods/purchase periods and $25k limit


sections 5.2.3.1, 5.2.3.2



Let’s look at this example of a Section 423 plan with a six‐month offering period, a 15% discount, and a look‐back feature.• The FMV on first day of offering period is $50 – this is the value you will use to calculate

the $25k limit.• The FMV on last day of offering period is $10 – this is the purchase price, since it is lower

than the grant date FMV.• The Purchase price is $8.50 based on the 15% discount on the purchase price.• The maximum number of shares that can be purchased is 500 (the $25,000 limit divided

by the $50 grant date FMV)• The amount of payroll deductions needed to buy 500 shares is $4,250 (the 500 shares

multiplied by the $8.50 purchase price)

NEXT SLIDE

Excess payroll contribution carryover rules:

• Carry over from one purchase period to another, within the same offering period, is okay (and customary)

• Carry over from one offering period into a new offering period triggers “equal rights and privileges” direct payment by all participants up to the largest carryover amount allowed in that period.

Plan withdrawal must be available or tax laws deem an exercise takes place every time money is withheld from the participant’s paycheck, instead of only at the end of the purchase period.


section 5.2.3.1

IRC 423 – ESPP Basics Carryover and Withdrawal


Any excess contribution funds that have been deducted from the participant’s paycheck for participation in the Plan can either be returned to the participant or carried over to the next offering period. Except for a de minimus fractional share amount, if the company allows an excess contribution carry over for even one participant, all participants must be allowed to make a direct payment into the plan to bring their own contributions up to the same amount as the largest carryover amount allowed in that period.

This rule is another reason why you have to be very clear on the difference between purchase periods and offering periods.

Excess contributions for purchase periods are automatically carried over to the next purchase period in the same offering period, and do not trigger the direct payment situation because the offering periods are all in the same purchase period.

However, carryover of excess contributions from one offering period into a new offeringperiod does trigger the direct payment situation.

In a falling market, like in the last question, most participants would withdraw from the plan during this offering period and enter the new offering period.

Plans should allow participants the discretion to withdraw from an offering period whether or not the stock price is falling. If withdrawal is prohibited, the options granted under the offering period can be deemed to be exercised for tax purposes every time money is withheld from someone’s paycheck, which would be a big administrative headache for both the company and the participants.

Companies do have flexibility on the parameters of allowing withdrawals. Some allow withdrawals or changes to withholding amounts any time during the offering period. Some companies limit how often changes can occur, or allow withdrawals and percentage decreases but not increases during an offering period. Changes in participation level during an offering period can also trigger accounting issues, so the company has to be careful about what it allows.

Most companies also provide for automatic withdrawal from the plan—and return of contributions to the employee—when an employee leaves the company during an offering period. This helps prevent violation of the requirement that all participants in a Section 423 plan be employees of the company.

Which of the following features can a company designing a Section 423 plan include in its plan?

a. Allowing employees, directors, consultants, and other independent service providers of the corporation or its designated parent or subsidiary corporations to participate.

b. Excluding employees whose customary employment is 30 hours or less per week.

c. Limiting employees to purchasing no more than $30,000 worth of stock per calendar year.

d. Making implementation of the plan contingent upon shareholders approving it within a 12 month timeframe.

44



Correct answer: d ‐ Making implementation of the plan contingent upon shareholders approving it within a 12 month timeframe.

Explanation: Section 423 declares that an ESPP must be approved by the granting corporation's shareholders within 12 months before or after plan adoption – a total of 24 months.

45Referen


section 5.1



The correct answer is d.Making implementation of the plan contingent upon shareholders approving it within a 12 month timeframe.

Section 423 requires that an ESPP be approved by the granting corporation's shareholders within a 24 month timeframe ‐ 12 months before or 12 months after plan adoption. Answer d. is correct because the company can implement a plan feature that is more restrictive than the statute, but not less restrictive.

As for the other answers…

NEXT SLIDE

Explanations for incorrect answers:

a. Allowing employees, directors, consultants, and other independent service providers of the corporation or its designated parent or subsidiary corporations to participate.

Section 423 plans are just for employees.

b. Excluding employees whose customary employment is 30 hours or less per week.

Employees whose customary employment is 20 hours or less can be excluded from the plan.

c. Limiting employees to purchasing no more than $30,000 worth of stock per calendar year.

No employee may purchase more than $25,000 worth of stock for each calendar year based on the stock’s fair market value on the first day of the offering period.

46


Referen


section 5.1


– Answer a: Which says “Allowing employees, directors, consultants, and other independent service providers of the corporation or its designated parent or subsidiary corporations to participate.” is just plain wrong. The people this answer describes aren’t all employees and Section 423 plans are only for employees.

Answers B and c: are close but no cigar.

Answer b. “Excluding employees whose customary employment is 30 hours or less per week.” is incorrect because although participation in a Section 423 plan must be limited to employees, only those who work 20 hours or less a week, have a tenure of less than 2 years with the firm, work less than 5 months per year, or are considered "highly compensated" employees as defined in Section 414(q) of the Internal Revenue Code can specifically be excluded.

Answer c. “Limiting employees to purchasing no more than $30,000 worth of stock per calendar year.” is incorrect because the Code limits purchases under a Section 423 plan to $25,000 per year based on stock's fair market value on the first day of the offering period, not $30,000

• The recipient must be an employee on the grant date and post‐termination exercise periods are allowed by the statute:

• 3 months after termination of employment, except

• After death, exercisable until original expiration date by the employee’s estate

• Automatic withdrawal ‐ in practice most plans refund the participant’s contributions if termination or death occurs before the next scheduled purchase date

• The option are never transferable during the employee’s lifetime and may only be exercised by the employee.

• The stock acquired by the option may be transferred after exercise without triggering a disqualifying disposition under certain special circumstances.

47

IRC 423 – ESPP Basics Statutory Eligibility Requirements

Referen


section 5.1

Textbook xref 2018Syllabus xref 2018483 IRC 423 > Statutory Requirements > Plan Requirements870 IRC 423 > Statutory Requirements > Employee Eligibility

Individual Section 423 grants must also meet specific requirements. The recipient must be an employee on the grant date and post‐termination exercise periods are allowed by the statute:

After termination of employment, statutorily the employee has 3 months in which to exercise an ESPP option and an employee’s estate has until the grant’s expiration date to exercise and still retain their tax‐qualified treatment, that’s the rule. But in practice a plan usually includes an automatic withdrawal provision which refunds the participant’s contributions if termination or death occur prior to a scheduled purchase date.

As long as the employee is alive, the option can only be exercised by the employee. However, the stock acquired by the option may be transferred after exercise without triggering a disqualifying disposition under certain special circumstances, such as death and divorce.NEXT SLIDE

Tax benefit on gain

Holding Periods

• 2 years after grant AND 1 year after exercise

Dispositions – sale or transfer of stock

• Qualified disposition can occur only after completion of BOTH holding periods.

• Disqualified disposition occurs when ONE of the holding periods is not met. It triggers recognition of ordinary income on the difference between exercise price and FMV on exercise date, and capital gain on difference between exercise date FMV and sale price (or the FMV on the date of transfer if the stock is transferred instead of sold)

48

IRC 423 – ESPP Basics > Employee Taxation

Referen


section 5.3.1, Exhibits 5‐3 and 5‐4

Textbook xref 2018Syllabus xref 2018479 IRC 423 > Employee Tax Treatment

Like an ISO award, a Section 423 ESPP option is a Tax‐Qualified option, meaning that the gain on the exercise of the option can receive favorable tax treatment if certain requirements are met.

The tax benefit of ESPPs is that the gain on the date of exercise, which is the difference between the exercise price and the fair market value on the date of exercise, is exempt from taxation as ordinary income at the time of exercise and no gain is recognized until the stock is actually sold.

In order to qualify for this beneficial tax treatment, like ISOs, the stock must be held for two years after grant AND one year after exercise. Selling stock after these holding periods have been met is known as a Qualified Disposition.

If the stock is sold before one of those holding periods is met, then it is known as a Disqualified Disposition and the tax benefit is lost. It triggers recognition of ordinary income on the difference between exercise price and FMV on exercise date, and capital gain on difference between exercise price and sale price (or the FMV on the date of transfer if the stock is transferred instead of sold)

Let’s take a closer look at dispositions NEXT SLIDE

On February 1, 2017, an employee enrolls in his employer's Section 423 ESPP. The market value on his enrollment date is $10 per share. On July 31, 2017, when the market value is $25 per share, he purchases 100 shares. The purchase price is the minimum allowed under Section 423. He sells all 100 shares on August 10, 2018, at $36 per share. Which of the following is true?

a. He recognizes compensation income of $150 in the year of his sale.

b. He recognizes compensation income of $1,650 in the year of his sale.

c. He must report $150 of additional income for AMT purposes in the year of his purchase.

d. His employer is entitled to a tax deduction of $1,650 in the year of his purchase.

49



Correct answer: b – He recognizes compensation income of $1,650 in the year of his sale.

Explanation: The sale is a disqualifying disposition because the shares were not held for two years from the enrollment date. As a result the spread between the purchase price of $8.50 and the price on the exercise date is taxed as ordinary income.

• $25‐$8.50 = $16.50 per share

• $16.50 x 100 shares = $1,650

Although the employer is entitled to a tax deduction equal to the amount the employee recognizes as ordinary income, that amount is recognized in the year of the disqualifying disposition, not the year of purchase and must be reported on a W‐2.

50



sections 5.3.1, 5

.3.2

Textbook xref 2018Syllabus xref 2018479 IRC 423 > Employee Tax Treatment481 IRC 423 > Employer Tax Treatment > Deduction/Reporting

The correct answer is b – He recognizes compensation income of $1,650 in the year of his sale. The sale is a disqualifying disposition because the shares were not held for two years from the enrollment date. As a result the spread between the purchase price of $8.50 and the price on the exercise date is taxed as ordinary income.$25‐$8.50=$16.50 per share$16.50 x 100=$1,650 Although the employer is entitled to a tax deduction equal to the amount the employee recognizes as ordinary income, that amount is recognized in the year of the disqualifying disposition, not the year of purchase.

Section 423 ESPP qualifying disposition of 100 shares

• Enrollment date FMV: $10

• Purchase price: $8.50

• Sale price: $36

Taxation

• Ordinary income: $1.50 per share x 100 shares = $150

• Capital gain: $36 sale price minus $10 cost basis ($8.50 paid plus $1.50 ordinary income) = $26 per share gain x 100 shares = $2,600

SPECIAL NOTES

• Company does NOT receive tax deduction for ordinary income component for a qualifying disposition

51



sections 5.3.1, 5

.3.2


Let’s look at this same scenario but with a qualifying disposition. When ESPP stock is sold, there will almost always be an ordinary income element to report because ESPP stock is sold at a discount. The only time there will be no ordinary income to report is if the stock is sold at below the amount of the grant date discount and that topic has been moved to Level 2 in 2018.

For Section 423 ESPP stock that is sold after meeting the holding requirements, the ordinary income to be reported is the smaller of the grant date discount or the actual gain on the sale. Ignoring actual gain for now, grant date discount means what the discount would be on first day of offering period. In this fact scenario, the offering date discount would be $1.50 for ordinary income tax calculation purposes.

Now it’s important to notice that the grant date discount is the rule, even if the purchase price is different, like when a plan uses a look‐back that allows the discount to be from the first day, which is the grant date, or last day, which is the purchase date, of the offering period. So, even if the stock price was below $10 on the purchase date, for tax purposes, the ordinary income component in this example would still be the $1.50 grant date discount.

Once you’ve calculated the ordinary income component, the remaining amount is taxed as capital gain.

It’s really important to remember that the company gets no tax deduction on the ordinary income element of a qualifying disposition. Let’s look at the company’s tax treatment a little closer. NEXT SLIDE

Exercise Date

• No income reported, must provide Form 3922 to both employee and IRS to report the terms of the exercise

Qualified Dispositions

• Company reports income on W‐2 for grant date discount, no withholding require, and

• No corporate tax deduction available

Disqualifying Dispositions

• Company reports income on W‐2 for actual discount element, no withholding required, and

• Takes a tax deduction based on income reported

52

IRC 423 – ESPP Basics Employer Deduction & Reporting Requirements

Referen

ce: Selected Issues in Equity

Compen

sation section 9.4


Section 6039 specifically requires the company to report the first transfer of the shares to the IRS on Form 3922 and provide a copy to the employee. Since 2011, the triggering transaction for reporting includes transfer of the shares into a stock brokerage account and that has streamlined part of the company’s process.

If the employee meets all the holding requirements and later sells the stock in a qualifieddisposition, the company reports ordinary income in the amount of the grant date discount, like we just discussed, but there is no tax deduction for the company.

If the employee sells the stock in a disqualifying disposition before the holding periods are met, then the company will report ordinary income on a W‐2 based on the difference between the exercise price and the exercise date FMV and can then take a tax deduction in the same amount as the income reported.

The company would report it on a W‐2 even if the stockholder is no longer an employee, and there is no withholding required by the company.

NEXT SLIDE





IRC Section 422 ISO – IRC Section 6039

Tax Reporting for ISOs

• Company is required to furnish information to the IRS and employee upon exercise of an ISO

• Form 3921 is to be used for ISO filings. Very specific fields to be included

• Deadline for the employee reporting is January 31 of the year following the ISO exercise for the employee reporting

• Deadline for IRS reporting is February 28 if via paper forms or March 31 if electronically (required if 250 or more forms)

• Significant penalties for non‐compliance


section 9.3.1

Textbook xref 2018Syllabus xref 2018422 IRC 6039 > Reqs/Tracking > ISOs

Let’s talk about Section 6039 reporting requirements in a little more depth

Internal Revenue Code Section 6039 requires the company to furnish information to the IRS and to the employee related to the exercise of ISOs and the first transfer of ESPP stock.

This slide shows the high‐level requirements for ISO reporting on Form 3921 under Section 6039. Section 9.3 of The Stock Options Book gives a numbered list of the specific fields to be included in the 3921 reporting, we’ll look at that on the next slide. Other requirements include reporting on very specific deadlines with significant penalties for failure to comply with the statute, especially where willful failure is shown – but those deadlines and penalties are in the Level 2 curriculum.

For purposes of Level 1, Section 6039 tax reporting for ISOs is triggered by the ISO exercise. A Form 3921 must be generated for each individual ISO exercise and must be provided to the employee by January 31st of the calendar year following the year of exercise.

The company will file all Forms 3921 with the IRS in the calendar year following the year of exercise: • By February 28 if the company is filing paper forms (maximum 249 total forms), or • By March 31st if filing electronically on the IRS FIRE system. Electronic filing is required

for 250 or more forms.

NEXT SLIDE

Tax Reporting for ISOs ‐ Form 3921. Reports on participants who’ve exercised ISOs must include:

• Company’s name, address, and tax ID number (also of company whose stock is being transferred if it’s a different entity)

• Name, address, and identifying number of transferor

• Date of option grant

• Exercise price per share

• Exercise date

• FMV on exercise date

• Number of shares to which title transferred pursuant to exercise

54

IRC Section 422 ISO – IRC Section 6039


section 9.3.1

Textbook xref 2018Syllabus xref 2018422 IRC 6039 > Reqs/Tracking > ISOs

The Level 1 reading focuses on the specific data points to be reported in the Form 3921 for ISO exercises under Section 6039 for ISO exercises transacted in the prior calendar year. This slide ___ sets out the exact data points that appear on the Form 3921.

For each unique ISO award exercised, the company will report the total number of options exercised and only report ISO exercises from qualified ISOs. The report does not exclude shares withheld to pay for taxes or the exercise itself. If the ISO was split at grant because of the $100,000 first‐exercisable award limit, the company would not report on exercises of the NSO split portion of the award.

Likewise, if the shares are sold in the same year as the exercise in a disqualifying disposition, then the company would not report on the original exercise because the ISO is no longer qualified. So if the grant itself loses preferential tax treatment for any reason, maybe exercised beyond three months from termination, or if ISOs are transferred in a divorce before exercise for example, then those ISO exercises are not required as part of that reporting. So remembering that ISOs cannot be transferred other by situations of death to the estate, any other transfer will be considered disqualifying and any subsequent exercise will not be reported on Form 3921.

IRC Section 423 ESPP – 6039 requirements

Tax Reporting for ESPPs

• Company is required to furnish information to the IRS and employee upon first transfer of legal title of shares purchased under a 423 Plan. If shares are immediately deposited into a brokerage account, the deposit is considered “first transfer.”

• Form 3922 is to be used for ESPP filings. Very specific fields to be included

• Deadline for the employee reporting is January 31 of the year following the first transfer of the shares

• Deadline for IRS reporting is February 28 if via paper forms or March 31 if electronically (required if 250 or more forms)

• Significant penalties for non‐compliance

• Need to track disqualifying AND qualifying dispositions


section 9.3.2

Textbook xref 2018Syllabus xref 2018871 IRC 6039 > Reqs/Tracking > ESPPs

This slide ___ shows the high level filing requirements for ESPP reporting on Form 3922. The requirements are virtually the same as the ISO reporting requirements except for two distinguishing features:

First, Section 6039 tax reporting for ESPP purchases is triggered not by the purchase, like with ISOs, but instead is triggered by the first transfer of legal title. That sounds less burdensome, but in reality it works out to be the same because if the ESPP shares are immediately deposited in a broker account on the purchase date (and they almost always are) then that is considered the first transfer of legal title under Section 6039.

The second distinguishing feature of ESPP reporting under Section 6039 is that the company must continue to track the ESPP shares until they are sold so that the company can report the ordinary income of the discount element on the employee’s W‐2. This is true even if the employee is no longer an employee at the time of sale, and even though the company receives no tax deduction because of a qualifying disposition.

NEXT SLIDE

Tax Reporting for ESPPs ‐ Form 3922. Reports on “first transfer” of ESPP shares must include:

• Name, address, and identifying number of transferor

• Company’s name, address, and tax ID number

• Date of option grant

• Stock’s FMV on grant date

• Exercise price per share

• Exercise price per share determined as if the option were exercised on the grant date

• Exercise date

• FMV on exercise date

• Date legal title of shares transferred by transferor

• Number of shares to which legal title was transferred

56

IRC Section 423 ESPP – 6039 requirements


section 9.3.2

Textbook xref 2018Syllabus xref 2018871 IRC 6039 > Reqs/Tracking > ESPPs

And this slide ___ shows the data points to be reported in the Form 3922 for the “first transfer” of ESPP shares. Again, the fields are virtually the same as for Form 3921 with a few important exceptions.

You’ll notice that there are a lot of the same data points for reporting on the previous form, but the odd thing here is the item that says the exercise price per share determined as if the option were exercised on the grant date.

What does that mean?

With ESPP shares you have the actual exercise price which is the purchase price and that’s either a discount of the purchase date FMV, or a discount from the beginning of the offering period, and it’s going to be the lower of the two if there’s a look back provision.

So the tricky part is that you can have an ESPP where the discount is based upon the purchase date FMV, but the Form 3922 still has to report the discount based on the grant date, which is the first date of the offering period – as if there were no lookback.

And another interesting bullet point is the date in which the legal title of shares was transferred by the transferor, that usually is the date of purchase, when the shares get

transferred into the brokerage account, but in section 9.3.2 of The Stock Options Book it talks about some other potential possibilities.

And, as we mentioned before, the final 6039 regulations require the tracking of alldispositions of ESPP shares, without regard to whether the disposition was qualifying or disqualifying.

IRC 83 – Recognition of Income

• Timing: Income is usually taxed when there is no longer a substantial risk of forfeiture

• Restricted Stock – after vesting or after vesting is guaranteed by retirement eligibility

• Stock Options – after exercise AND vesting or after vesting is guaranteed by retirement eligibility

• Amount: The taxable income is the difference between the amount paid and the FMV of the stock on vest date

• Acceleration of tax event: A taxpayer can elect to accelerate the recognition of the income and pay taxes while there is still a substantial risk of forfeiture by filing an 83(b) election


sections 2.3, 2

.4

Textbook xref 2018Syllabus xref 2018959 IRC 83 > General Understanding887 IRC 83 > 83(b) Elections > Income & Tax Implications636 IRC 83 > 83(b) Elections > Election Procedures

Now let’s talk about IRC Section 83, which governs when taxable income is recognized, and how and why a shareholder might want to file an 83(b) election.

Internal Revenue Code Section 83 governs when income is recognized upon the transfer of property in connection with the performance of services, and when taxes are paid on that income. Generally speaking, income is usually recognized when there is no longer a substantial risk of forfeiture of the property transferred and taxes are due and payable at that time.

For restricted stock, which we’ll talk about next, that means after the stock has vested or after the vesting is guaranteed by retirement eligibility.

For stock options, it means after the options are exercised AND the stock has vested or the vesting is guaranteed by retirement eligibility. This is an important distinction because, as you’ll remember, restricted stock is a contractual right to the stock but a stock option is only the contractual right to buy the stock.

So with a restricted stock grant you become the owner of the shares right away even

though you have to wait for them to vest before you are no longer at risk of losing them. Whereas with a stock option, you don’t own the stock until you exercise the option. This purchase and vesting requirement would seem to exclude stock options because the right to exercise is controlled by the vesting of the option – right? You can’t exercise until the option vests. In most cases. But in some cases you can do what’s called an “early exercise” which means that the option can be exercised before it vests.

In both of those cases, receiving restricted stock or doing an early exercise of a stock option, the stock remains subject to a substantial risk of forfeiture until it vests. That means that upon receipt of the stock, either by award or exercise, the property has been transferred, but there is still a risk of forfeiture until the completion of the vesting conditions so no tax is due until the vesting conditions are completed.

On the date that the property, for our purposes the property is the stock…on the date that the stock is vested, the taxable income is measured as the difference between what you paid for the stock, if anything, and how much the stock is worth on the vest date.

So basically you don’t have to recognize the income or pay the taxes until the stock is vested. At the time of recognition, the income is all ordinary income, no matter how long you’ve actually held the stock.

Being able to wait to pay the taxes seems like a good thing until you consider that sometimes it can be months or years before the vesting conditions are met and the stock value can really appreciate or go up a lot during that time, and all of that income would be taxed at ordinary income tax rates instead of the significantly lower capital gains rates. Well that’s not good.

IRC 83 – Benefit & Risks of an 83(b) election

Benefit of filing 83(b) election

• The purpose of filing an 83(b) election is to freeze the ordinary income component of the award for taxation purposes – meaning that the taxable income will be measured between the payment price and the FMV on the date of award instead of between the payment price and the FMV on the date the risk of forfeiture lapses.

• It is most beneficial to accelerate the recognition of income in this way when

• The exercise or purchase price is very low, and

• The underlying stock is expected to appreciate significantly before the award vests

Risk of filing 83(b) election

• No revocation or refunds if stock is later forfeit before vesting


section 6.2

Textbook xref 2018Syllabus xref 2018887 IRC 83 > 83(b) Elections > Income & Tax Implications

Section 83 gives stockholders who are waiting for their stock to vest a mechanism by which they can accelerate the recognition of the income and pay taxes at the time of grant or early exercise. That gets the capital gains holding periods running and, even better, it freezes the ordinary income element for taxation purposes.

With an 83(b) election filing, the taxable income is measured between the purchase price (if any, because sometimes restricted stock grants are given without any purchase price) and the fair market value on the date of the award or early exercise.

Think of it like this – if you work for company that has a very low stock price and the company expects that the stock price is going to go very high before your award vests, then freezing the ordinary income amount now could be a really good idea. And, in fact, that’s what many start‐up and early stage company executives do.

Needless to say, with every investment decision there are benefits and risks to consider. First of all, once the 83(b) election is made it can only be revoked in the most unusual circumstances and with the permission of the IRS.

The biggest risk to consider is that if for some reason the stock doesn’t vest and you later forfeit it – say because you find a new job and you leave the company – or if the stock price

drops and it’s worth less at vest than when you filed the 83(b) election, you don’t get a refund of the taxes you paid when you filed the 83(b) election.

IRC 83 – Filing an 83(b) election

83(b) election filing requirements

• There is no official form, you just make a written statement with the required information and send it certified mail, return receipt

• Election must be made within 30 days of grant (RSA) or exercise (early exercise options)

• File original form with IRS office where the taxpayer files tax return

• One copy to the company (company will include in W‐2 income and take a tax deduction)


section 2.4

Textbook xref 2018Syllabus xref 2018636 IRC 83 > 83(b) Elections > Election Procedures

The most important point for the taxpayer is that the election must be made within 30 days of receiving a restricted stock grant, or within 30 days of the early exercise.

The most important point for the company is that whatever amount the taxpayer recognizes, the company will include that in their W‐2 income and can then take a tax deduction for the income reported.

IRC 83 – Filing an 83(b) election

An 83(b) election includes

• Your name, address, and taxpayer identification number

• A description of each property for which you are making the choice

• The date or dates on which the property was transferred and the tax year for which you are making the choice

• The nature of any restrictions on the property

• The fair market value at the time of transfer (ignoring restrictions except those that will never lapse) of each property for which you are making the choice.

• Any amount that you paid for the property

• A statement that you have provided copies to the appropriate persons


section 2.4

Textbook xref 2018Syllabus xref 2018636 IRC 83 > 83(b) Elections > Election Procedures

As noted, there is no official 83(b) election form. You simply make a written statement with the required information and send it to the Internal Revenue Service in a specific manner. This slide ___ lists the information that an 83(b) election must include.

Now let’s take a question on 83(b) elections just to cement this information.

Level 1 – 83(b) Election

On June 15, 2017, an employee is granted an RSA for 100,000 shares. The exercise price is $9 and the grant date FMV of the stock is $10 per share. The stock will vest in full one year after the date of award. She accepts the award at grant and files a Section 83(b) election. The FMV on June 15, 2018 is $16 per share. How much compensation income must she recognize and when?

a. $100,000 in 2017

b. $100,000 in 2018

c. $160,000 in 2018

d. The employee does not recognize any compensation income in either 2017 or 2018, only capital gain


61


Level 1 – 83(b) Election

Correct answer: a ‐ $100,000 in 2017

Explanation: When filing an 83(b) election, the employee will pay ordinary income taxes on the spread between the fair market value at grant and the award price. Filing the 83(b) election avoids ordinary income tax on any appreciation between the date of award and the date of release, but does not avoid ordinary income tax on the difference between the fair market value on the date of award and the exercise price.

An 83(b) election may also be filed when early exercising an option award. The ordinary income will be the difference between the fair market value on the date of the exercise and the exercise price.


section 6.2

Textbook xref 2018Syllabus xref 2018887 IRC 83 > 83(b) Elections > Income & Tax Implications

The correct answer is a. $100,000 in 2017For restricted stock awards, the stock is issued at grant, even though there are vesting terms attached to the award and the award recipient doesn’t become the owner of the stock until the vesting is completed.

The taxation of restricted stock awards is governed by Internal Revenue Code Section 83, which says that the taxation event happens when a “substantial risk of forfeiture” no longer exists, which basically means on the future vest date. However, a restricted stock award recipient can choose to move the taxation event up to the grant date, before vesting occurs, by filing what’s called an 83(b) election.

If the employee files a Section 83(b) election within 30 days of exercise, she freezes the ordinary income element of the award as if it were already vested, and pays income taxes on the spread between the grant price and the fair market value on the grant date, then any later price change is capital gain or loss. There are no additional tax event at vesting.

The advantage of this is that it allows the award recipient to freeze the compensation element at a small amount. If this is done within a few days of a restricted stock grant, the ordinary income element would be minimal. The disadvantage is that if the award recipient later forfeits the unvested stock because his relationship with the company ends before the

award vests or for some other reason, he has paid taxes on a forfeited award and there’s no way to get the money back.

On a related note, an 83(b) election can also be filed on a stock option that is exercised before the vesting date. In that case, the ordinary income element of the award will be based on the spread between the exercise price and the fair market value on the exercise date. And, of course, the 83(b) election must be filed within 30 days of the exercise.

Restricted Stock – Tax Treatment

Employee Tax Treatment

• Restricted Stock is taxed at vesting, unless an 83(b) election is filed.

• The spread between the purchase price and the vest date FMV is taxed as ordinary income.

• If an 83(b) election is filed, spread at time of grant (if any) is taxed as ordinary income.

• Subsequent gain on sale is taxed as capital gain.

Employer Tax Treatment

• The employer can take a tax deduction for compensation reported to the stockholder.


sections 6.2, 6

.3, Exhibit 6‐1

Textbook xref 2018Syllabus xref 2018676 Restricted Stock > Employee Tax Treatment495 Restricted Stock > Employee Tax Treatment > 83(b) election108 Restricted Stock > Employer Tax Treatment > Deduction528 Restricted Stock > Employer Tax Treatment > Reporting & Withholding

Now let’s talk about tax treatment of Restricted Stock. There have been no changes to this topic since last year.

Restricted Stock is taxed at vesting, unless an 83(b) election is filed.

If an 83(b) election is filed, the spread or “bargain element” at time of grant is taxed as ordinary income. • If the shares are simply granted at no cost to the recipient, then the bargain element is

the full grant date fair market value. • If the restricted stock grant requires a purchase price, then the amount reported will be

the difference, if any, between the purchase price and the grant date fair market value. • If the restricted stock recipient pays the full fair market price, then there is no taxable

amount to report but the 83(b) election should still be filed to avoid taxation at vesting and ensure that any future appreciation in the value of the shares is taxed as capital gain.

If no 83(b) election is made at the time of grant, then the spread between the purchase

price and the vest date fair market value is taxed as ordinary income as we saw on that last question.

Any ordinary income, whether recognized at the time of vesting or at the time of filing an 83(b) election, is reported by the company on a W‐2 or 1099 and the employer can take a tax deduction for the compensation reported.

Once ordinary income reporting has been triggered, either through filing the 83(b) election or on the W‐2 at vesting, the company has no further tracking or reporting obligations, and any subsequent gain on the sale of the stock is taxed as capital gain.

NEXT SLIDE

Level 1 – RSA Taxation

An employee receives a restricted stock award for 1,000 shares. The cost to him is $10 per share, the FMV on the grant date is $50 per share. No 83(b) election is filed. The award vests in full when the fair market value is $75 per share. He sells all of his shares three months later, when the stock is trading at $60 per share. Which of the following correctly describes the taxation of the transaction?

a. $40,000 in ordinary income and a capital loss of $15,000

b. $65,000 in ordinary income and a capital loss of $15,000

c. $50,000 in capital gain

d. $60,000 in capital gain

64


Level 1 – RSA Taxation

Correct answer: b ‐ $65,000 in ordinary income and a capital loss of $15,000

Explanation: The ordinary income recognized by the employee is the difference between the stock's FMV on the vesting date and the purchase price paid for it. Any subsequent change in value is capital gain or loss.

The company receives a tax deduction for income reported as compensation on W‐2 or 1099, and must withhold taxes for employees.


section 6.2

Textbook xref 2018Syllabus xref 2018676 Restricted Stock > Employee Tax Treatment108 Restricted Stock > Employer Tax Treatment > Deduction528 Restricted Stock > Employer Tax Treatment > Reporting & Withholding

The correct answer is b ‐ $65,000 in ordinary income and a capital loss of $15,000Restricted stock shares are taxed when they vest unless the employee makes a Section 83(b) election, which is not the case here. So he pays income taxes on $65,000 in gain at vest and can claim a $15,000 capital loss upon sale.

The company can take a tax deduction on the $65,000 on the general principal that employer can take tax deduction for any amount that recipient must claim as ordinary income as long as the income is properly reported on a W‐2 Form for an employee or 1099 for non‐employee. If the recipient is an employee, the company must withhold taxes at vesting if there’s no 83(b) election, or at grant if an 83(b) election is filed.

In this case, the employee did not make a Section 83(b) election, but if he had, he’d pay income taxes on $40,000 at grant and have a $10,000 capital gain when he sold the stock. The employee is taxed at grant if the shares vest immediately or if he or she makes an 83(b) election. Otherwise, the employee pays ordinary income taxes when the restrictions lapse at vesting. One distinction here: employees can file an 83(b) election on a restricted stock award. However, if the grant is in the form of restricted stock units, the 83(b) election isn’t possible because the stock isn’t issued until vest.

RSA – Effect of 83(b) election, or not

Benefit of filing 83(b) election ‐ Restricted Stock example

• A company founder receives 1,000,000 shares of stock for his investment of $10,000 at par value of $0.01 per share. The company is new, so par value is a reasonable benchmark for the FMV of the stock.

• The underlying stock is subject to reverse vesting and the founder has to stay with the company for four years before he will own the stock without restrictions.

• The stock is selling for $15 per share four years after purchase.


section 6.2

Textbook xref 2018Syllabus xref 2018676 Restricted Stock > Employee Tax Treatment495 Restricted Stock > Employee Tax Treatment > 83(b) election

Let’s take a closer look at the effect of filing an 83(b) election upon receipt of a restricted stock award. Again, filing an 83(b) election is discretionary on the part of the award holder and the reasons to file an 83(b) election will vary according to the tax situation of the award holder.

Here’s a simple example of how filing an 83(b) election affects the taxation of a restricted stock award. In start ups, restricted stock is a common way to evidence the founders’ investment in the company, as you’ll see by this example, filing an 83(b) election can also protect the appreciation of the stock and the founder’s investment.

In this scenario•A company founder receives 1,000,000 shares of stock for his investment of $10,000 at par value of $0.01 per share. The company is new, so par value is a reasonable benchmark for the FMV of the stock.•The underlying stock is subject to reverse vesting and the founder has to stay with the company for four years before he will own the stock without restrictions.•The stock is selling for $15 per share four years after purchase.

RSA – Effect of 83(b) election, or not

Benefit of filing 83(b) election ‐ Restricted Stock example (continued)

• With an 83(b) election, the income is measured at the time of purchase. The founder has paid $10,000 for $10,000 worth of stock so when he files the 83(b) election within 30 days of purchase, there is $0 taxable income to recognize on the date of filing. The later vest date is a non‐taxable event because the income was recognized at purchase.

• Without an 83(b) election, on the vest date, the founder paid $10,000 for shares which are now worth $15,000,000 at vest (1,000,000 shares X $15 per share) so he has taxable income of $14,990,000 ($15,000,000 less $10,000 purchase price).


section 6.2

Textbook xref 2018Syllabus xref 2018676 Restricted Stock > Employee Tax Treatment495 Restricted Stock > Employee Tax Treatment > 83(b) election

With an 83(b) election, the income is measured at the time of purchase. Crediting his capital investment in the company as consideration for the stock, the founder has paid $10,000 for $10,000 worth of stock so when he files the 83(b) election within 30 days of purchase, there is $0 taxable income to recognize on the date of filing. The later vest date is a non‐taxable event because the income was recognized at purchase.

Without an 83(b) election, on the vest date, the founder paid $10,000 for shares which are now worth $15,000,000 at vest (1 million shares X $15 per share) so he has taxable income of $14,990,000 ($15,000,000 less the $10,000 purchase price paid).

Here you can see that by NOT filing an 83(b) election at the time of the award, the founder ends up with a huge amount of taxable income and will likely be forced to sell some of his shares in order to pay for the taxes.

As a founder, selling stock could adversely affect his voting power as a shareholder. If the founder HAD filed the 83(b) election, he could keep the stock and not have to pay taxes until the stock is sold at his own timing.

Basics of Taxation

IRC Section 83


IRC Section 423 – ESPPs

IRC Section 6039

NSOs

Restricted Stock



68

Syllabus xref 2018

Now let’s take a look at our final Taxation topic: Special Circumstances. The CEPI has moved the 423 ESPP Leave of absence and disability topics from Level 2 to Level 1 this year.

Special Circumstances – Death & ISOs

Death

• Transfer to estate without restrictions

• Taxes incur to estate

• Estate calculates AMT liability in year of exercise

• ISO holding periods and employment requirements are waived


section 11.1

Textbook xref 2018Syllabus xref 2018898 Special Circumstances > Death > IRC 422

Recent students have said that there was only one exam question on death and leave of absence, so I’ve left these for last and we’ll just talk about the very basics because, as you’ll remember, these subjects were dealt with in more detail in the administration webinar. So, generally speaking,

In the circumstance of Death, when an employee dies while holding tax‐qualified options, the options transfer to the decedent’s estate without restrictions. Neither employment requirements nor holding periods will be enforced.The estate will have to calculate AMT liability in the year of exercise, and any taxes, whether capital gains, income taxes, or AMT taxes, become the responsibility of the estate.

NEXT SLIDE

Special Circumstances – Leave of Absence

Leave of Absence. Tax consequences upon exercise depend upon type of award and timing of exercise and LOA.

IRC 422 ISOs. No guaranteed right to return to work:

• On 91st day of LOA, participant is considered terminated for ISO purposes.

• Unvested ISOs become NSOs and vested ISOs have 90 more days in which to be exercised as ISOs.

• After that 90+90 day period, all ISOs become NSOs and are taxed as NSOs when exercised.

IRC 423 ESPPs.

• If leave lasts longer than 90 days and no guaranteed right of reemployment, the right to participate in a 423 Plan could be forfeited.

• Leaves of less than 3 months do not disqualify participant.

70Reference: Selected Issues sections

1.4.3, 9.3.6

Textbook citation verified 2017Syllabus xref verified 2017902 Special Circumstances > LOA > IRC 422 ISOs894 Special Circumstances > LOA > IRC 423 ESPPs435 IRC 422 > Maintaining ISO Status > Changes in Employment

For a Leave of Absence, tax consequences upon exercise depend upon type of award and timing of exercise and LOA.• For Section 422 ISOs, if there is no guaranteed right to return to work: On the 91st day of

LOA, participant is considered terminated for ISO purposes. Unvested ISOs become NSOs and vested ISOs have 90 more days in which to be exercised as ISOs. After that 90+90 day period, all ISOs become NSOs and are taxed as NSOs when exercised.

• For a Section 423 ESPP, the statute requires continuous employment from the date of grant, so the enrollment date – which is usually the offering date, until three months before the date of purchase. Given that eligibility requirement, the employee could forfeit the right to participate if the leave is longer than 90 days and there is no contractual or statutory right of reemployment, because it would be considered a termination for tax purposes.

So, to reiterate, the leave is NOT a disqualifying factor as long as the leave is either:• Under a federal, state or other statutory leave program, or• Provides a contractual right of reemployment, or• Is no longer than three months.

ISOs – Maintaining ISO Status

Change in employment status

• Employee to Consultant: unvested awards become NSOs immediately, vested awards have 90 days to be exercised as ISOs

• Termination: 90 days post‐termination, then convert to NSOs

• Disability: 12 months from date of disability

• Death: until award expiration, must be exercised by estate

• Pre‐exercise transfer: disqualifies award

• Post‐exercise transfer: permissible to ex‐spouse per divorce decree

Reminder: Tax Withholding

• No withholding required on exercise for ISO awards, especially FICA/FUTA. (also, Exhibit 9‐1)

71Reference: The Stock Options Book, section 12.1

Textbook xref 2018Syllabus xref 2018435 IRC 422 > Maintaining ISO Status > Changes in Employment

Our last slide is on maintaining ISO status when undergoing a change in employment status.Since ISOs are only for employees, a change in status will change how long the award will remain an ISO. If an employee becomes a consultant, and the ISO isn’t immediately cancelled, then unvested awards become NSOs immediately in order to continue vesting. The optionee will have 90 days to exercise the vested options and still receive ISO treatment. On the 91st day the vested options will become NSOs.

If it’s a simple termination, and not a change from employee to consultant, then the optionee, again, has 90 days in which to exercise the vested ISOs and after which the vested options will be treated as NSOs.

Whenever disqualified ISOs are exercised as NSOs, they become subject to taxation upon exercise. The company, however, only has a regulatory obligation to report the spread, but does not have any withholding obligations because the award was originally an ISO.

If the termination is due to disability, the statutory period for exercise extends to 12 months after the date of disability. And if it’s due to death, the award may be exercised by the estate of the deceased optionholder up until the award’s original expiration date. We just talked about death and disability on the two prior slides so look back to them for more detail.

And, finally, any transfer of an ISO award before the option is exercised automatically disqualifies the award. After the ISO has been exercised, the shares can be transferred to a former spouse pursuant to a domestic relations order without affecting the tax‐qualified status of the shares. And, of course, the former spouse will have to abide by the ISO holding requirements for the eventual sale of the stock to receive the tax benefits of the ISO status.

Basics of Taxation

IRC Section 83


IRC Section 423 – ESPPs

IRC Section 6039

NSOs

Restricted Stock

Special Circumstances


72

So we’ve covered all of the Level 1 taxation topics. NEXT SLIDE

Questions ?

Achaessa James, CEPNational Center for Employee Ownership

1629 Telegraph Ave., Suite 200Oakland, CA 94612‐3445

510‐208‐[email protected]