Tax Withholding and Reporting for Equity Awards

In the United States, stock plan participants may recognize compensation income for tax purposes when they execute transactions involving stock compensation.

In addition, their employer may be obligated to report the income recognized for the transaction to the IRS and may also be required to withhold taxes on income.

This blog focuses on some of the tax withholding and reporting basics for equity awards. Want to learn more? Don’t miss the NASPP’s Equity Compensation Bootcamp, offered in advance of the NASPP Conference. Can make it to Vegas? Check out our on-demand Stock Plan Fundamentals course.

Nonqualified Arrangements

Nonqualified arrangements are those that do not qualify for preferential tax treatment. The two most common types of nonqualified vehicles in use today are nonqualified stock options (also referred to as nonstatutory options) and restricted stock unit awards.

Restricted Stock Units

A restricted stock unit award grants an individual the right to acquire company stock at no cost, conditioned upon meeting the vesting requirements. Each unit is typically equal to one share of stock. Once the award vests, the units convert to shares of stock which are paid out to the award holder. Learn more about restricted stock units in the article “Guide to Restricted Stock and Unit Plans.”

In most cases this payment occurs at the time of vesting. Where this is the case, the award holder will recognize compensation equal to the value of the stock; if the award holder is an employee, this income is treated as wages for both federal income tax and FICA purposes.

Sometimes payment of RSUs is deferred until a date subsequent to the vesting date; the deferral might be for a specified period of time or until a specified event, such as an employee’s retirement. Where this is the case, employees will recognize wages for FICA purposes in the year the award vests but will not recognize wages for federal income tax purposes until the award is paid out. Learn more about this type of RSU in the NASPP article “Deferred Stock Units.”

Nonqualified Stock Options

A stock option grants an individual the right to buy company stock at a specified price (typically the value of the stock on the date of grant) for a specified period for time (typically ten years from the date of grant), conditioned upon satisfaction of the vesting requirements.

Upon exercise of an NQSO, the optionee recognizes compensation income equal to the current spread in the stock (the difference between the value of the stock on the exercise date and the purchase price). If the optionee is an employee, this income is treated as wages for both federal income tax and FICA purposes.

Reporting and Withholding for Nonqualified Awards

Any compensation income recognized in connection with both RSUs and NQSOs is reportable on a Form W-2 for both employees and former employees. For nonemployees, such as outside directors, consultants, and contractors, the company prepares a Form 1099-NEC to report the income.

For employees and former employees, the company is also required to withhold employment taxes, including federal income tax, Social Security, and Medicare, on the exercise even if the shares are not sold. There may be withholding obligations in optionee's state, city, and county as well.

Reporting Compensation Income on a Form W-2

For federal income tax reporting purposes, compensation income for RSUs and NQSOs is aggregated with employees’ other income in the following boxes of Form W-2:

• Box 1 (Wages, tips, and other compensation)
• Box 3 (Social Security wages), if applicable
• Box 5 (Medicare wages and tips).
• Box 12, with code V

Where the transaction is subject to state or local taxation, the income should also be reported in the applicable boxes for these tax authorities:

• Box 16 (State wages, tips, etc.)
• Box 18 (Local wages, tips, etc.)

In addition to reporting the income recognized for RSUs and NQSOs, any taxes withheld with respect to the transactions should be combined with employees’ other withholdings for the year and reported in Boxes 2, 4, 6, 17, and 19, as appropriate.

For additional information on tax withholding and reporting for US stock compensation, view the following NASPP guides:

• US Tax Reporting for Stock Compensation
• US Tax Withholding for Stock Compensation

Incentive Stock Options

Stock options that comply with Section 422 of the Internal Revenue Code are considered incentive stock options. These options qualify for preferential tax treatment, which offers several benefits to the optionee:

• The optionee does not recognize any income for regular tax purposes until the shares acquired under the option are sold. [Note that exercises of ISOs can have alternative minimum tax (AMT) implications, which are outside the scope of this article.]
• If the stock acquired under the option is held for the statutorily-defined period, any income recognized in connection with the ISO is characterized as a long-term capital gain.
• The option is exempt from FICA and income tax withholding, even if the shares are not held for the statutory period.

At the time an ISO is exercised, the company does not have any regular tax withholding or income reporting obligations. However, under Section 6039 of the Internal Revenue Code, the company is required to report the exercise to the IRS on Form 3921 and provide a copy of this form the optionee (see “Section 6039 Filings: A Complete Guide” to learn more).

If the shares acquired under an ISO are disposed of prior to the lapse of the statutory holding period (i.e., a “disqualifying disposition”), the employee will recognize compensation income on the transaction equal to the lesser of the following two amounts:

1. The spread or gain at exercise (i.e., the value of the stock at exercise less the purchase price)
2. The amount realized on the sale (i.e., the sale price or value of the stock at the time of disposition less the purchase price).

Disqualifying dispositions are those that occur within one year from the exercise date of the option or two years from the grant date. Only dispositions that occur after the passage of both time periods are considered qualifying dispositions.

In the event of a disqualifying disposition, the company has an obligation to report the compensation income recognized for the transaction on the employee’s Form W-2. This income is aggregated with the employee’s other wages for the year and reported in Box 1. Because ISOs are exempt from tax withholding and FICA, the company will not withhold any taxes on the transaction and will not report any FICA wages.

A same-day-sale stock option exercise, where the shares are exercised and immediately sold, is considered a disqualifying disposition and the income reporting obligation is triggered.

ISOs Exercised After Termination of Employment

As noted above, ISOs must meet the requirements of Section 422, one of which is that the optionee must be an employee continuously from the time the option is granted until three months prior to the date on which it is exercised. Thus, when ISOs are exercised more than three months after the optionee has terminated employment, the option is no longer considered an ISO and the transaction is treated as an exercise of a nonqualified stock option.

This relieves the company of the Form 3921 reporting obligation, but the exercise will be subject to tax withholding and is reportable on Form W-2 (see discussion of nonqualified stock options above).

This three-month period is extended to 12 months for terminations due to disability and is waived entirely in the event of an optionee's death.

Read our Guide to Incentive Stock Options to learn more about ISOs.