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Tax on Stock Compensation

In general, investors purchase when they want to take part in the financial performance of a company.  This type of stock purchase is a type of investment property and receives special tax treatment. This tax treatment is “capital gains tax treatment”. The capital gains tax rate depends on whether the property is held on a short-term or long-term basis. Individuals also obtain stock for other reasons, though.  For instance, it can also be a form of compensation. This blog will examine this alternative stock acquisition strategy.  In it, we’ll discuss the tax implications of receiving stock in lieu of pay and how to handle such stock.

Sometimes stock is a means to retain talented employees. In other cases, stock may be a short-term cash preservation strategy. This latter strategy is a typical tactic by companies dealing with liquidity issues. Companies also offer stock options to employees. Stock options give employees the opportunity to purchase stock at a set price for a given window of time. 

Whenever a person receives stock as compensation from a company, that person should be aware of the potential tax consequences. In this post, we will deal with the taxation of stock issued in lieu of cash (or salary. Then, we will give tips on how to handle this type of compensation. As we will see, the tax implications of stock received as compensation ultimately depend on the specifications of the stock.  

Taxation of Stock Compensation

When stock is issued to employees in lieu of cash, many people may think that this event would be untaxable. Stock is transformable into cash, but stock itself is not a currency. Given this reality, some people might assume that any tax consequences would be deferred until the stock is ultimately sold. But, though such an assumption is logical, it is incorrect. Whenever someone receives anything of value for their labor, the transaction will constitute a taxable event. And since stock is indubitably a thing of value, employees who receive stock will invariably face a tax consequence. The exact consequences depend on the type of stock. The most important differentiation is whether the stock is restricted or unrestricted.  

Unrestricted Stock

Unrestricted stock simply means stock which is able to be freely sold by the employee immediately upon receipt. It also means that the employee obtains the full value and benefits of the stock upon receipt. If an employee receives unrestricted stock, ordinary income tax rates apply immediately upon its receipt. The recipient must also pay the Social Security and Medicare taxes on the value of the stock.

Let’s look at an example.  Suppose an employee receives 100 shares of stock in lieu of pay.  The stock value is $20 per share. In this case, this employee’s tax is the same as if he or she receives $2,000 in cash. The tax paid depends on this employee’s tax rate. And, along with federal income tax, that employee will be liable for Social Security and Medicare taxes. The liability will be based on the full amount of $2,000.  

Types of Restrictions

Companies can place restrictions on stock issued as compensation in order to further company goals or create more desirable outcomes. Companies can develop vesting schedules for stock compensation. Vesting schedules restrict the ability of the recipient to gain full ownership of, or sell, the stock. Typically, vesting schedules are based on time, but they can also be based on other things, such as performance goals. Consider this example: a company issues stock with a 5 year vesting schedule. If the recipient leaves the company before the 5 year period, then the recipient will forfeit the stock. The recipient will still receive dividends while the stock is unvested, however.

What’s more, the stock cannot be sold until it vests. After the vesting period expires, the recipient is able to sell the stock and receive capital gains tax treatment. Dividends received while the stock is unvested are taxed as ordinary income rather than capital gains.  

Handling Stock Compensation: Hold for Long-Term Treatment  

Regardless of whether a person receives restricted or unrestricted stock compensation, the goal should be to obtain optimal tax treatment. This means that recipients of stock compensation should aim for the long-term capital gains tax rate. For unrestricted stock, the formula for obtaining such treatment is simple. The recipient must hold the stock for a minimum of 1 year following receipt. Once the recipient meets this holding requirement, he or she receives the long-term treatment following a sale. The formula for restricted stock is a bit different. The clock for obtaining long-term capital gains tax treatment typically begins when the stock vests. After a vesting period of 5 years, a recipient must wait another year before obtaining long-term treatment.

However, there is an exception to this general rule. A recipient may make an IRC Section 83 election for restricted stock at the time of receipt. A Section 83 election will start the time clock for long-term treatment at the time of receipt. The recipient must also pay taxes on the full fair market value of the stock at that time as well. A Section 83 may be desirable in some cases, but it can be a disadvantage in others.  

Discuss Tax On  Stock Compensation With Our New York City Tax Attorneys

In the future, we will come back and discuss stock options in greater detail. We will cover both incentive stock options (ISO) and non-qualified stock options (NQSO). As you can see, the attorneys at Mackay, Caswell & Callahan, P.C., work hard to bring you useful tax information on a wide variety of topics. If you’re a current recipient of stock as compensation, or are likely to be a recipient in the future, you should consider this information carefully as you should want to obtain the best tax treatment possible. Contact our top New York City tax attorneys if you have a tax matter which requires assistance. 

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