Taxation of US Stock Option Plans

This article discusses stock options given to an employee of a US company. This is a very basic overview of a few share option schemes with a focus on US taxpayers in the UK. There are nuances to these schemes so please assume that every sentence starts with “In most circumstances…”.  The information in this article is very general and should not be considered as tax advice. Please contact us directly for advice on your personal tax affairs.

 

Terminology

Grant –                      The date that the employer awards the stock option to the employee stating that they will have the option to buy shares in the future. 

Vest –                          This is the date that the option will become available to exercise.

Exercise –                  The action of using the option to buy shares. This can be a taxable event.

Vesting Period –   The period between grant date and vest date.

Exercise Period – The period over which the option can be exercise before they expire.

Option Gain –         The difference between the grant and exercise price.

Basis –                       This refers to the price at which the employee is deemed to have purchased the shares. Please note that this may differ to what they have actually paid. Discussed later.

Earnings period – This is the period over which the Option Gain is earned for the purposes of employment compensation.

 

In a previous article, we discussed how employees can be granted a stock award which may vest over a number of years. These Restricted Shares are a grant of stock directly in a company which are delivered to the employee at the fair market price (FMV) on the vest date. Stock Options are slightly different and instead give the employee the option to buy shares in the company at a pre-determined price during a specified period.

Written simply, a stock option doesn’t seem to be a benefit to an employee. How can buying a share in a company create a taxable benefit? This is because the Stock Option allows the employee to buy shares at a pre-determined discounted price, often the market value on the grant date. If the market value of the company stock appreciates to the vest date, then the employee can buy the shares at less than the market value, thereby creating a benefit.

The pre-determined price is more commonly referred to as the “Strike Price” or “Exercise Price”. The difference between the exercise price and the market value on the date of exercise is the benefit and is referred to as the Option Gain. The taxation of the option gain differs, depending on the type of scheme under which it is granted.

Stock Options are most commonly seen in start-up companies or quickly growing tech companies, where the shares are granted at a low value. The hope is that the company will go public, and they can buy marketable shares at minimal cost.

For US tax purposes, there are two main types of Stock Option; Non-Qualifying Stock Options (NSO) and Incentive Stock Options (ISO). Both of which have different tax treatment.

 

Non-Qualifying Stock Option (NSO)

This is the most common form of option. The grant and vest of the shares follow the description above and neither of these are taxable events. When the Option is exercised, the option gain is subject to income tax (up to 45% in the UK and 37% in the US).

This is usually a payroll event and shares are often sold to cover the income tax liability. There are other ways to cover the income tax liability which will be stipulated in the option agreement. This is not discussed further here.

At exercise, the employee buys the shares at the pre-determined price. Although they are likely to have paid less than the market value for the shares, their cost basis is the fair market value (FMV) on the date of exercise. This is because the employee has paid income tax based on the FMV.

When the employee sells the shares, they will only be subject to capital gains tax if the shares have appreciated in value from the date of exercise.

TIP: Following the sale of shares issued after exercising an NSO, it is a good idea to check the basis of your shares reported on Form 1099. Many brokerages will only be aware of the exercise price and not the Option Gain that has been taxed via payroll. The cost basis should be rectified on a corrected Form 1099 or directly on the tax return.

 

Incentive Stock Options (ISO)

An ISO is a tax-preferred option scheme. There is no US tax to pay at grant, vest, or exercise if the shares are held for more than one year following the exercise date and two years from the grant date.

HOWEVER: This must also be granted under an approved UK share option plan to maintain preferential tax treatment for UK tax purposes. If this is an unapproved UK option plan, then there will be a UK income tax charge at exercise.

Assuming this is an approved plan, the benefit to an ISO is that the shares have been purchased at the exercise price and there is no income tax to pay on the option gain. It should be noted here that significant option gains can give rise to an Alternative Minimum Tax (AMT) charge, albeit lower than ordinary income tax rates.

The basis in the shares is the exercise price because there has been no income tax charge on exercise. Instead, the increase in value (option gain) is subject to Capital gains Tax when the shares are sold (up to a rate of 20% in the UK and slightly more in the US if paying NIIT).

Other stock option and purchase plans are available in the US and UK, but these are not discussed further here. Please feel free to contact us directly if you would like more information on your specific stock plan.

 

Considerations At Exercise

You may already be wondering, “what if the market value of the stock decreases?”. In this situation, it may not be beneficial for the employee to exercise the option and buy shares for more than their market value.

The exercise period allows the employee to hold the option for a certain amount of time. During this time the stock my appreciate at which point exercising the option may become more advantageous.

If the option reaches the end of its exercise period and has yet to be exercised, it will expire. This does not give rise to any taxable event.

TIP: It is strongly recommended that you seek advice from an investment professional to discuss strategies for exercising options in the allowable time frames.

 

The Earnings Period

For UK and US tax purposes, the earnings period of a Stock Option is the period from the grant date to the exercise date. This period is defined in the UK/US tax treaty and differs to other countries which may tax stock options over the vesting period.

As with many internationally mobile employees, this earnings period may be made up of periods of US and UK employment or residency. In this this scenario, there may be a UK and US payslip produced reporting the same option gain.

At PJD Tax Consultants Ltd, we are well versed in the taxation of stock awards covering multiple jurisdictions. Please feel free to get in touch to discuss your employer’s stock plan and the options available to you.