Last week, I covered the basic rules that apply for tax purposes when options are exercised or awards pay out after an individual has changed status from employee to non-employee or vice versa. Today I discuss a few more questions related to employment status changes.
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. It this case, it’s questionable whether the award is truly payment for consulting services.
A few questions to ask to assess the nature of the consulting services former employees are performing include whether the former employee has any actual deliverables, who is monitoring the former employee’s performance and how will this be tracked, and will the award be forfeited if the services are not performed.
If the services aren’t substantive, it’s likely that all of the compensation paid under the award would 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.
Is the treatment different for an executive who becomes a non-employee director?
Nope. The same basic rules that I discussed last week still apply. The only difference is that I think it’s safe to presume that the services performed as an outside director will be substantive (unless the director position is merely ceremonial).
What about an outside director who is hired on as an executive?
The same basic rules still 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-MISC, 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 that I described last week. As I noted, 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 that 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.
So 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 non-employees 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.
Finally, When In Doubt
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 probably going to be 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—not even the basic rules I reviewed last week. This is a practice that has developed over time based on what seems like a reasonable approach.
For today’s blog entry, I discuss how stock plan transactions are taxed when they occur after the award holder has changed employment status (either from employee to non-employee or vice versa). This is a question that I am asked quite frequently; often enough that I’d like to have a handy blog entry that I can point to that explains the answer.
The basic rule here is that the 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 non-employee, the income is not subject to withholding and is reportable on Form 1099-MISC.
Where an award continues vesting after a change in status, the income recognized upon settlement (exercise of NQSOs or vest/payout of restricted stock/RSUs) is 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-MISC.
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 of 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 or not the employment relationship exists at the time the payments are made.
What is the precise formula used to allocate the income?
There isn’t a precise formula for this. We asked Stephen Tackney, Deputy Associate Chief Counsel of the IRS, about this at the NASPP Conference a couple of years ago. He thought that any reasonable method would be 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. 15 months later, the employee changes to consultant status.
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 15 months into that 24-month period, so 62.5% (15 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, $6,250 is subject to withholding and reported on Form W-2. The remaining $3,750 is reported on Form 1099-MISC 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 41.7% 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 25% of the second tranche would be attributable to services as an employee (three 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 going to consultant status as well as consultants changing to employee status).
Read “Employment Status Changes, Part II” to learn about additional considerations and complexities relating to changes in employment status.
As is often the case at this time of the year, a lot of tax related questions have been popping up in the NASPP Q&A Discussion Forum lately. For today’s blog entry, I try to quickly answer some of the questions I’ve seen the most frequently.
Former Employees You have to withhold taxes on option exercises by and award payouts to former employees and report the income for these stock plan transactions on a Form W-2, no matter how long it has been since they were employed by the company. The only exceptions are:
ISOs exercised within three months of termination (12 months for termination due to disability).
RSAs paid out on or after retirement (because these awards will have already been taxed for both income tax and FICA purposes when the award holders became eligible to retire). Likewise, RSUs paid out on or after retirement that have already been subject to FICA are subject to income tax only.
If the former employees did not receive regular wages from the company in the current year or the prior calendar year, US tax regs require you to withhold at their W-4 rate, not the supplemental rate. In my experience, however, few companies are aware of this and most withhold at the supplemental rate because the W-4 rate is too hard to figure out.
Changes in Employment Status Where an individual changes status from employee to non-employee (or vice versa) and holds options or awards that continue to vest after the change in status, when the option/award is exercised/paid out, you can apportion the income for the transaction based on years of service under each status. Withhold taxes on the income attributable to service as an employee (and report this income on Form W-2). No withholding is necessary for the income attributable to service as a non-employee (and this income is reported on Form 1099-MISC).
Any reasonable method of allocating the income is acceptable, so long as you are consistent about it.
Excess Withholding I know it’s hard to believe, but if you are withholding at the flat supplemental rate, the IRS doesn’t want you to withhold at a higher rate at the request of the employee. They care about this so much, they issued an information letter on it (see my blog entry “Supplemental Withholding,” January 8, 2013). If employees want you to withhold at a higher rate, you have to withhold at their W-4 rate and they have to submit a new W-4 that specifies the amount of additional withholding they want.
Also, withholding shares to cover excess tax withholding triggers liability treatment for accounting purposes (on the grant in question, at a minimum, and possibly for the entire plan). Selling shares on the open market to cover excess tax withholding does not have any accounting consequence, however.
ISOs and Form 3921 Same-day sales of ISOs have to be reported on Form 3921 even though this is a disqualifying disposition. It’s still an exercise of an ISO and the tax code says that all ISO exercises have to be reported.
On the other hand, if an ISO is exercised more than three months after termination of employment (12 months for termination due to disability), it’s no longer an ISO, it’s an NQSO. The good news is that because it’s an NQSO, you don’t have to report the exercise on Form 3921. The bad news is that you have to withhold taxes on it and report it on a Form W-2 (and, depending on how much time has elapsed, it might have been easier to report the exercise on Form 3921).
FICA, RSUs, and Retirement Eligible Employees This topic could easily be a blog entry in and of itself, but it doesn’t have to be because we published an in-depth article on it in the Jan-Feb 2014 issue of The NASPP Advisor (“Administrators’ Corner: FICA, RSUs, and Retirement“). All your questions about what rules you can rely on to delay collecting FICA for retirement eligible employees, what FMV to use to calculate the FICA income, and strategies for collecting the taxes are covered in this article.
Employee equity compensation income is reported on a W-2, and non-employee equity compensation income is reported on a 1099-MISC. But, what happens when a person has been both during the vesting period of the grant?
Fully Vested Grants
When an employee terminates his or her employment relationship with the company, but continues to be a service provider, the income reporting and tax withholding requirements change. If the individual does holds only fully vested grants at the point of the status change, then the income reporting and tax withholding is straightforward. Any income from exercises on grants that vested while the individual was an employee is reported on a W-2 and subject to income tax and FICA withholding, even if the exercise is executed when the individual is a non-employee. Likewise, any income from grants that vest after the employment relationship terminated is reported on a 1099-MISC and is not subject to income tax or FICA withholding.
Partially Vested Grants
If that same employee held unvested grants that continue vest after he or she has become a non-employee, then the income should be allocated pro-rata between employee and non-employee income. Any income from shares that are attributable to the period of time when the individual was an employee should be treated as employee wages, while shares that vest after the individual became a non-employee service provider will be treated as non-employee compensation.
Let’s take the example of an employee who becomes a consultant for the company after 600 shares of an option for 1,000 shares have vested, and the option continues to vest while the individual is a consultant. If the individual exercises all 1,000 shares after the option is fully vested, then income from 600 shares is reported as wages on a W-2 and income from the remaining 400 shares is reported as income on a 1099-MISC. If the individual instead exercised only 800 shares, then the company could use the “first-in, first-out” (FIFO) method to attribute the income, allocating 600 shares as earned under the employee relationship and 200 as earned under the consultant relationship.