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Stock Options Taxed at Vest?

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November 06, 2017 | Barbara Baksa

Stock Options Taxed at Vest?

Late last week, the House Ways and Means Committee released the Tax Cuts and Jobs Act, which is its first attempt at legislation to implement major US tax reform. At over 400 pages, the bill makes substantive changes to many areas of tax law, including marginal individual income tax rates, standard and itemized deductions for individuals, and the corporate tax rate. The bill also proposes changes that would have a material impact on stock and executive compensation.

Stock Options Taxed at Vest?

In a surprise development, the bill includes language which would make all forms of nonqualified deferred compensation subject to tax when no longer subject to a substantial risk of forfeiture. There would simply no longer be any way to defer taxation of compensation past the point at which it is vested.

The bill specifically defines NQDC to include stock options, SARs, and unit awards. If enacted, taxation of stock compensation would be modified as follows:

  • Stock options and SARs would be taxable at vest.
  • Deferring payout of RSUs would no longer delay taxation of the award; all RSUs would be taxable at vest for both FICA and FIT purposes.
  • Options and awards that provide for accelerated or continued vesting upon retirement would be taxable for FIT purposes, as well as FICA, when the award holder is eligible to retire.

Substantial Risk of Forfeiture

The proposed legislation treats compensation as subject to a substantial risk of forfeiture only if vesting is conditioned on the performance of services. I suspect that this language is intended to clarify that clawback arrangements don't delay taxation. A memo by McDermott Will & Emory notes, however, that the language could be construed to mean that awards in which vesting is conditioned only upon an IPO or CIC would not be considered to be subject to a substantial risk of forfeiture. If so, this would make it very challenging for private companies to offer stock compensation in any form to their employees.

What About ISOs and ESPPs?

That is a very good question that I don't know the answer to. The bill does not appear to include a specific exemption for compensation awarded under Section 422 and 423 but it also doesn't specifically repeal these sections of the tax code.  If ISOs and ESPPs are exempt, these vehicles would be the only way to deliver compensation in the form of stock that wouldn't require taxation at vest. If so, this could be the one change that might bring ISOs back from the brink of extinction. You can color me speechless.

Effective Date

The new rules would apply to compensation attributable to services performed after December 31, 2017 (yes, less than two months away—nothing like giving companies a little time to rethink their entire equity compensation strategy). Moreover, a memo by Baker McKenzie notes that this language means that all currently outstanding but unvested options and awards would be taxable at vest starting next year.

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