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Taxation When Employment Status Has Changed

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April 14, 2015 | Barbara Baksa

Taxation When Employment Status Has Changed

For today's blog entry, I discuss how stock plan transactions are taxed when they occur after the award holder has changed employment status (either from employee to non-employee or vice versa).  This is a question that I am asked quite frequently; often enough that I'd like to have a handy blog entry that I can point to that explains the answer.

The basic rule here is that the treatment is tied to the services that were performed to earn the compensation paid under the award. If the vesting in the award is attributable to services performed as an employee, the income paid under it is subject to withholding and reportable on Form W-2.  Likewise, if vesting is attributable to services performed as a non-employee, the income is not subject to withholding and is reportable on Form 1099-MISC.

Where an award continues vesting after a change in status, the income recognized upon settlement (exercise of NQSOs or vest/payout of restricted stock/RSUs) is allocated based on the portion of the vesting period that elapsed prior to the change in status.

For example, say that an employee is granted an award of RSUs that vests in one year.  After nine months, the employee changes to consultant status.  The award is paid out at a value of $10,000 on the vest date.  Because the change in status occurred after three-fourths of the vesting period had elapsed, 75% of the income, or $7,500, is subject to tax withholding and is reportable on the employee's Form W-2.  The remaining $2,500 of income is not subject to withholding and is reportable on Form 1099-MISC.

What if the award is fully vested at the time of the change in status?

In this case, the tax treatment doesn't change; it is based on the award holder's status when the award vested. For example, say an employee fully vests in a award and then later terminates and becomes a consultant.  Because the award fully vested while the individual was an employee, the award was earned entirely for services performed as an employee and all of the income realized upon settlement (exercise of NQSOs or vest/payout of restricted stock/RSUs) is subject to withholding and is reportable on Form W-2.

This is true no matter how long (days, months, years) elapse before the settlement.  Under Treas. Reg. §31.3401(a)-1(a)(5), payments for services performed while an employee are considered wages (and are subject to withholding, etc.) regardless of whether or not the employment relationship exists at the time the payments are made.

What is the precise formula used to allocate the income?

There isn't a precise formula for this.  We asked Stephen Tackney, Deputy Associate Chief Counsel of the IRS, about this at the NASPP Conference a couple of years ago.  He thought that any reasonable method would be acceptable, provided the company applies it consistently.

The example I used above is straight-forward; awards with incremental vesting are trickier.  For example, say an employee is granted an NQSO that vests in three annual installments.  15 months later, the employee changes to consultant status.

The first vesting tranche is easy: that tranche fully vested while the individual was an employee, so when those shares are exercised, the entire gain is subject to withholding and reportable on Form W-2.

There's some room for interpretation with respect to the second and third tranches, however.  One approach is to treat each tranche as a separate award (this is akin to the accelerated attribution method under ASC 718).  Under this approach, the second tranche is considered to vest over a 24-month period. The employee changed status 15 months into that 24-month period, so 62.5% (15 months divided by 24 months) of that tranche is attributable to services performed as an employee. If this tranche is exercised at a gain of $10,000, $6,250 is subject to withholding and reported on Form W-2. The remaining $3,750 is reported on Form 1099-MISC and is not subject to withholding.  The same process applies to the third tranche, except that this tranche vests over a 36-month period, so only 41.7% of this tranche is attributable to services performed as an employee.

This is probably the most conservative approach; it is used in other areas of the tax regulation (e.g., mobile employees) and is also used in the accounting literature applicable to stock compensation.  But it isn't the only reasonable approach (just as there are other reasonable approaches when recording expense for awards under ASC 718) and it isn't very practical for awards with monthly or quarterly vesting.  It might also be reasonable to view each tranche as starting to vest only after the prior tranche has finished vesting.  In this approach, each tranche in my example covers only 12 months of service.  Again, the first tranche would be fully attributable to service as an employee.  Only 25% of the second tranche would be attributable to services as an employee (three months divided by 12 months).  And the third tranche would be fully attributable to services performed as a consultant.

These are just two approaches, there might be other approaches that are reasonable as well.  Whatever approach you decide to use, be consistent about it (for both employees going to consultant status as well as consultants changing to employee status).

Read "Employment Status Changes, Part II" to learn about additional considerations and complexities relating to changes in employment status.

- Barbara

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