Stock acquired as part of an employee stock purchase plan (ESPP) and incentive stock options (ISO) can have significant tax consequences for the recipient employee.
If you don’t know what these plans are, you are not alone. You probably have no reason to know about these concepts unless you or a family member work for an employer that offers these plans. If they do, you probably still do not fully understand them.
Don’t worry, this article is not going to get into the intricacies of what these plans are or what the tax consequences are. There are already a lot of articles and information on this on the intranet. This article focuses on the reporting requirements for how the employer has to report these stocks to the IRS.
These issues are often missed by taxpayers and even by the IRS on audit. The reason is the lack of information. The taxpayer and IRS are simply in the dark about the transactions. This is about to change.
The IRS has released proposed regulations to implement the recent changes in Section 6039. These Regulations require corporations to report the transfer of stock upon the exercise of stock acquired as part of an ESPP and ISO.
About Incentive Compensation
ESPPs and ISOs are two types of equity compensation programs that companies can offer their employees as a form of incentive and reward. Both ESPPs and ISOs can be valuable incentives for employees, as they offer the opportunity to purchase company stock at a discount and benefit from the company’s success.
Employee Stock Purchase Plans
ESPPs allow employees to purchase company stock at a discounted price, usually at a set percentage lower than the market price.
This can be an attractive benefit for employees, as they have the opportunity to purchase shares of their employer’s company at a lower cost than they would be able to through traditional stock trading.
As noted above, ESPPs can also help to align employees’ interests with those of the company, as employees will benefit from the company’s success through the appreciation of their company stock.
Incentive Stock Options
ISOs, on the other hand, are a type of stock option that is typically only offered to key employees and top-tier management. ISOs are issued on a grant date, which is the date on which the options are awarded to the employee. The employee then has the right to exercise the options at a later date, known as the exercise date, by purchasing shares of the company stock at a predetermined price, known as the grant price.
One of the main benefits of ISOs is that they can offer employees a tax advantage. When the employee exercises the option and purchases the shares, they are only taxed on the difference between the grant price and the fair market value of the stock at the time of exercise. This means that if the stock has appreciated in value since the grant date, the employee can benefit from the increase in value without having to pay taxes on the appreciation until they sell the shares. ISOs can also help align employees’ interests with those of the company.
Employer Taxes on ESPPs and ISOs
Employers generally cannot immediately deduct the stock price for stock issued under ESPPs or ISOs. There are nuances.
For ESPPs, the employer may be subject to taxes on the value of the stock issued to employees, which is typically based on the fair market value of the stock at the time of grant or purchase, as applicable. Employers may also be required to withhold and remit payroll taxes on any compensation related to the ESPP, such as the discount offered to employees on the purchase of company stock. This includes federal income tax withholding, as well as Social Security and Medicare taxes.
For ISOs, the employer generally cannot deduct the cost of ISOs as compensation on their tax return. Unlike some other forms of equity compensation, such as non-qualified stock options, the grant or exercise of ISOs is generally not tax deductible for the employer. However, the employer may be able to take a deduction for compensation expenses related to ISOs if the employee disposes of the shares acquired through the ISO within two years of the grant date or within one year of exercise. In this case, the employer may be able to take a deduction for the amount of compensation expense previously recognized, subject to certain limitations.
Reporting ESPPs and ISOs to the IRS
Because corporations are not able to deduct the costs of ESPPs and ISOs as compensation, many corporations put little effort into providing employees with this information about ESPP and ISO awards. They also do not retain records for this same reason.
This is especially true for stock options granted by under-funded start-up companies and in cases where the company has gone out of business or has been acquired by another company.
The reporting rules did not put priority on this either. Prior to the recent changes to Section 6039, described below, corporations were only required to provide stock transfer information to employees in the year following the transfer.
Not surprisingly, on audit by the IRS for the year in which the stock was eventually sold, which could be many years or decades later, employees (and the IRS) often realize that the employee has not retained these old records.
Changes to Section 6039 & Reporting
Pursuant to the changes in Section 6039, corporations must provide this information to the employee and, now, to the IRS by the 31st of January in the year following the transfer. The Regulations indicate that Forms 3921 and 3922 will be used for this purpose.
The new regulations may make it easier to establish the employee’s tax basis in stock acquired from ESPPs and ISOs. The option period for ISOs can be up to ten years. The option period for ESPPs can be even longer.
Now that this information is to be reported to the IRS, the IRS may be able to use its computer matching program to help ensure that the employee’s taxable gain on the sale of the stock is reported correctly. As a result, this may mean that ESPP and ISO-related audits may increase. This also raises questions such as will the government retain this information, how long the government will retain this information, and can the employee rely on the government to retain this information.
The Importance of Compliance
It is crucial for both employees and employers to comply with the reporting requirements for ESPPs and ISOs. Failure to comply can result in severe penalties and legal consequences.
For employees, compliance with the reporting requirements is important because it allows them to accurately report their taxable income and avoid potential penalties for underpayment or underreporting. By understanding the tax implications of ESPPs and ISOs, employees can make informed decisions about exercising their options and selling the acquired stock. Compliance also helps to establish their tax basis in the stock, which is crucial for calculating capital gains tax on the sale of the stock in the future.
For employers, compliance with the reporting requirements is critical to avoid penalties and legal consequences. Failure to comply with the reporting requirements can result in fines and penalties from the IRS, which can be costly. In addition, non-compliance can result in mistrust between employees and employers, which can lead to lower morale and decreased employee retention.
ESPPs and ISOs can be valuable incentives for employees, but they also have significant tax consequences that must be understood and managed. Employers have administrative and reporting responsibilities related to these types of equity compensation plans. The recent changes to Section 6039 require corporations to report the transfer of stock upon the exercise of stock acquired as part of an ESPP and ISO to both the employee and the IRS, which may help establish the employee’s tax basis in the stock and improve compliance. With the increasing importance of this information to the IRS, it’s essential that employers and employees understand the reporting requirements and implications related to ESPPs and ISOs.