Taxation When Employment Status Has Changed
December 14, 2022
How are stock plan transactions taxed when they occur after the award holder has changed employment status (either from employee to nonemployee or vice versa)? Today's blog entry answers this question.
Fundamental Tax Principle for Employment Status Changes
The fundamental principle here is that the tax 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 nonemployee, the income is not subject to withholding and is reportable on Form 1099-NEC.
Thus, where an award continues to vest after a change in status, the income recognized upon settlement (exercise of NQSOs or vest/payout of restricted stock/RSUs) may be 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-NEC.
Fully Vested Awards
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 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 the employment relationship exists at the time the payments are made.
Income Allocation Formula
What is the precise formula used to allocate the income?
There isn't a precise formula for this. Any reasonable method is 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 and the employee changes to consultant status 22 months later.
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 22 months into that 24-month period, so 92% (22 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, $9,200 is subject to withholding and reported on Form W-2. The remaining $800 is reported on Form 1099-NEC 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 61% 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 83% of the second tranche would be attributable to services as an employee (ten 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 changing to consultant status as well as consultants changing to employee status).
Can the entire portion of the award vesting after the change to nonemployee status be treated as nonemployee compensation?
I'm not sure this would be considered reasonable. Equity awards are earned for the services performed throughout the vesting period, not merely the services performed on the final day of the vesting period. In my example above, 83% of the second vesting tranche elapses before the award holder changes to a nonemployee. I think it might be a little disingenuous to claim that this tranche is fully compensation for services performed as a nonemployee.
Nature of Consulting Services
Is it necessary that the consulting services be substantive?
When employees change to consultant status an important consideration is whether the consulting services are truly substantive. Sometimes the "consulting services" former employees are providing are a little (or a lot) loosey goosey (to use a technical term). For example, sometimes employees are allowed to continue vesting in exchange for simply being available to answer questions or for not working for a competitor. In these cases, it's questionable whether the award is truly payment for consulting services.
When evaluating whether the consulting services are substantive, consider the following questions:
- Has the former employee entered into a formal consulting contract with the company?
- Is there a defined time frame over which the consulting services will be performed?
- Does the former employee responsible for any defined deliverables?
- Who is monitoring the former employee's performance and how will this be tracked?
- Will the award be forfeited if the consulting services are not performed?
If the services aren't substantive, it's likely that all the compensation paid under the award will be attributable to services performed as an employee (even if vesting continues after the employee's termination) and subject to withholding/Form W-2 reporting.
Executives and Outside Directors
What if the former employee was an executive? Are the rules different?
Theoretically, no, but I think that executive consulting arrangements are likely to be subject to considerably more scrutiny from your auditors. Moreover, in my experience, companies are less likely to enforce forfeiture requirements for former executives who fail to fulfill their consulting commitments. Consider carefully whether the company is truly prepared to enforce the forfeiture provisions when evaluating whether the consulting services are substantive.
Is the treatment different for an executive who becomes a nonemployee director?
Again, theoretically no. But this arrangement is also likely to receive considerable scrutiny from your auditors. On one hand, directors provide a tangible service to the company, under a formally documented arrangement with clear deliverables to be performed over a specified period. On the other hand, if the former executive, now director, steps down from the board prematurely, will the company be prepared to cancel his/her unvested awards?
What about an outside director who is hired on as an executive?
The same principles apply, except in reverse. For options and awards that fully vested while the individual was an outside director, you would not need to withhold taxes and you would report the income on Form 1099-NEC, even if the option/award is settled after the individual's hire date.
For options and awards granted prior to the individual's hire date but that vest afterwards, you'd use the same income allocation method as described above. There are several reasonable approaches to this allocation; make sure the approach you use is consistent with what you would do for an employee changing to consultant status.
What about a situation where we hire one of our consultants?
This often doesn't come up in that situation, because a lot of companies don't grant options or awards to consultants. But if the consultant had been granted an option or award, this would be handled in the same manner as an outside director who is hired (see the prior question).
What if several years have elapsed since the individual was an employee?
Still the same; the rules don't change regardless of how much time has elapsed since the individual was an employee. The IRS doesn't care how long it takes you to pay former employees; if the payment is for services they performed as employees, it is subject to withholding and has to be reported on a Form W-2.
Even if several years have elapsed since the change in status, you still have to assess how much of the option/award payout is attributable to services performed as an employee and withhold/report appropriately.
What if the individual is subject to tax outside the United States?
This is a question for your global stock plan advisors. The tax laws outside the United States that apply to nonemployees can be very different than the laws that apply in the United States. Moreover, they can vary from country to country. Hopefully the change in status doesn't also involve a change in tax jurisdiction; that situation is complexity squared.
Can we treat all the income as compensation for services performed as an employee?
Yes, this generally should be an acceptable approach. Some auditors may even prefer this approach.
What if we aren't sure what the correct treatment is?
If you aren't sure of the correct treatment, the conservative approach (in the United States—I really can't address the non-US tax considerations) is to treat the income as compensation for services performed as an employee (in other words, to withhold taxes and report it on Form W-2).
What is the US tax reg cite for all of this?
My understanding is that none of this is actually specified in the tax regs. This is a practice that has developed over time based on what seems like a reasonable approach.