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.
The IRS and the Social Security Administration have announced the COLAs for next year. That’s COLAs as in “cost of living adjustments” (in case you were wondering what the IRS and SSA have to do with soda pop).
A Quiet Year
Some years are quieter than others when it comes to tax-related changes. At this time last year we were looking at changes to FIT withholding rates, FICA withholding rates, a new Social Security wage cap, new Medicare taxes, a threshold increase relating to highly compensated employees, plus last minute tax legislation at the start of the year to restore some FIT withholding rates to 2012 levels. I count at least seven NASPP Blog entries on the tax rate changes that went into effect (and didn’t go into effect after all) at the start of 2013.
What a difference a year makes! Things are a lot quieter this year. At the federal level, it looks like the only change that impacts stock compensation is the Social Security wage cap. Bad news for Jenn and I since now we’ll have to come up with other ideas for six more blog entries but good news for you since you won’t have to sort through and implement a bunch of tax rate changes over the holidays.
FICA
As noted, the wage cap for Social Security tax purposes will increase to $117,000, up from $113,700 last year. The tax rate remains the same at 6.2%, so this increases the maximum Social Security withholding to $7,254 per employee. Incidentally, the SSA estimates that about 10 million workers will pay higher taxes as a result of the increase.
As far as I know, the Medicare rates and the threshold at which the additional Medicare tax applies will remain the same in 2014.
Highly-Compensated Employees
The threshold at which an employee is considered highly compensated for purposes of Section 423 will remain at $115,000 in 2014. (Section 423 allows, but does not require, highly compensated employees to be excluded from participation.)
When the Finance Bill 2007 extended India’s Fringe Benefit Tax (FBT) to include equity compensation, companies scrambled to respond. The Finance Bill uprooted tax-favorable plans, changed the valuation method, and required employers to pay the tax. Companies had to determine how to accommodate the new tax (many passed the tax through to employees) and make the estimated tax payments.
Now, all that may be turned upside down. India’s Finance Minister has proposed to abolish the FBT beginning retroactively as of April 1, 2009; and not just for equity compensation, but for all FBT items.
What we do know this means is:
Equity compensation will be treated as perquisite income, valued at exercise for options, purchase for ESPP, and at vest for restricted stock.
Employers will be required to withhold income tax on equity transactions, but social insurance contributions most likely will not be required.
The further sale of shares will be subject to capital gains tax.
The questions this leaves unanswered are:
What valuation method will be acceptable; will companies still be required to use a merchant bank valuation?
Will there be any tax-favorable plans like those that existed prior to FBT on equity compensation?
Since the abolition of FBT is retroactive to April 1, 2009, how should transactions that have taken place since then be handled?
What also remains to be seen is whether or this will ultimately be easier or more difficult to administer than FBT. Employers who have already accommodated the FBT will once more need to confirm that grant agreements are adequate and make tax payments to the government. Employers who were not passing the FBT through to employees will now need to implement tax withholding on equity compensation. However, if the proposal eliminates the need to use merchant bank valuations, streamlining valuations to be more consistent with other country methodology, it would certainly make things easier! Stay tuned for more updates as clarifications become available.
The abolition of FBT in India may be a welcomed change, but the proposed updates to taxation of equity compensation in Australia have been met with overwhelming opposition. This upset proposal in the 2009/2010 Australian Federal Budget was to tax options at grant. Recently, we have heard that the proposal has been modified to allow a deferral of taxes until there is no longer a risk of forfeiture and there are no longer disposal restrictions attached to the shares. This, like the FBT change, will be a retroactive change to taxation of equity grants.
Belgium, in an effort to provide some relief in these difficult economic times, has proposed an opportunity for companies to extend the term of underwater options for up to five years without incurring additional individual income taxes due for the option-holder. Outside of this opportunity, extending the term of an option would constitute the grant of a new option; options are taxable at grant in Belgium. Options eligible for this treatment must have a grant date from January 1, 2003 through August 31, 2009. U.S. companies willing to take the expense hit for such an extension should keep an eye out for the final version of the Belgian Economic Recovery Act.
Stay Current
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It can take a considerable amount of effort, not to mention legal advice, to correctly report income and withhold taxes on your globally mobile employees. In the spirit of keeping this short, I’m going to talk about some of the issues around double taxation and employee mobility in the context of a U.S. company and a U.S. citizen.
Double Taxation
All income made by a U.S. citizen is taxable in the U.S., regardless of where the income was earned. Additionally, the company has the withholding and reporting obligations with regards to income and income tax. This means that a conservative approach to withholding on income from equity compensation for your U.S. employees who are working abroad would be to withhold U.S. income tax on the entire amount. The local tax authority in the country in which your mobile employee resides may also require reporting and withholding on that same income, creating double taxation for the employee. This issue was addressed in 2004 by the Organisation for Economic Co-Operation and Development (OECD) in their paper on the taxation of mobile employees. In this paper, the OECD calls for tax treaties that help alleviate the burden of double taxation by sourcing the income based on where it was earned. Although the paper, and other recommendations by the OECD, is non-binding to any country, it has influenced the way equity compensation income is addressed in tax treaties.
Tax Treaties
Fortunately, many countries have treaties in place that provide a protocol for income tax obligations on income that may be sourced to more than one country. In fact, the U.S. has entered into income tax treaties with over 60 countries. You can find them all on the IRS website HERE. These treaties are typically for the individual and do not necessarily relate to your company’s obligation as an employer to report and/or withhold. They often permit the individual to receive a foreign tax credit on income that was earned outside of the U.S. and is also taxed in the other country. Some employers, at the recommendation or approval of their own tax advisors, apply these tax credits proactively to equity compensation income that was “earned” outside the U.S., using a pro-rata arrangement to allocate income that was earned while the employee was still in the U.S.
Totalization Agreements
Income tax is not the only tax that companies need to consider when dealing with globally mobile employees. Social taxes also apply, and may be handled differently than income tax arrangements. Double taxation is also an issue with social taxes like the U.S. social security tax and Medicare; this is called dual coverage since social taxes are typically designed to cover an individual or their families in retirement, illness, disability, or death. The issue of dual coverage is costly for both your mobile employees and your company, since most countries have an employer-paid portion of social taxes. To address this issue, the U.S. has entered into “Totalization agreements”. These agreements allow the individual and the company to source the entire amount of equity income to one country or the other, per the agreement (you can’t choose which country to contribute social taxes to). You can find all the countries with which the U.S. Social Security Administration (SSA) has Totalization agreements on the SSA site HERE. If your company is planning to rely on a Totalization agreement for some or all of your mobile employees, you will need to ensure that each employee has a certificate of coverage issued from the country in which the employee will be paying social taxes. In the U.S., the certificate of coverage can be requested from the SSA by your company on behalf of the employee.
Multiple Sourcing Periods
What all this means is that if your company decided to proactively apply both the income tax treaties and the Totalization agreements, there may be several ways in which income is allocated. Even though this is advantageous to your mobile employees because they will not need to pay now and true-up their tax obligation when they file their income tax returns, it does mean that you will need to communicate very clearly with your employees and your Payroll department. Essentially, your company will need to report a different amount of income in Box 1 of the W-2 than is in Box 3 and Box 5 (see our Tax Withholding and Reporting portal for more on U.S. tax withholding). Additionally, if you are sourcing the income pro-rata, the sourcing may be applied differently in the U.S. than in the other country. In the U.S., it’s generally accepted that the sourcing is from grant to vest for options, but in some countries it may be grant to exercise.
Key Resources
There are, of course, many additional considerations for tax withholding for your mobile employees. You can find additional resources in the NASPP Global Stock Plans portal, in our Document Library, and on the Discussion Forum (search for the keyword “mobile”). You can also see what other companies are doing by reviewing our 2006 and 2008 International Stock Plan Design and Administration Surveys, co-sponsored by Deloitte. Until the full 2008 survey is available on our site, you can catch the highlights in the archive of our recent webcast, Top Trends in Stock Plans for Overseas Employees.
You should already be registered for our 17th Annual NASPP Conference. If you haven’t, act now – the early bird rates end this Friday. If global mobility is a topic you want to hear more about, be sure to sign up for the workshop “Traveling with Equity” at the Conference!
Tax season in the U.S. is fast approaching, and now is the time to consider how you are helping your employees understand the tax implications of their equity compensation. Like most stock plan administration processes, educating and communicating with your employees about stock plan participation and taxes should be an ongoing, year-round process and should be customized for different employee populations.
The impact of equity compensation can be confusing and intimidating for employees, but it doesn’t need to be. I’m sure that many of you have experienced the frantic barrage of calls that come in as the individual tax filing deadline approaches. If you reach out to your international HR folks, you will find that they experience a similar frenzy as they attempt to help employees who are trying to file their tax returns. Even though I can certainly sympathize with employees, this can be a burden on the time resource for not only stock plan services, but also the HR and payroll departments. Once you have the employee (or their tax preparer!) on the phone, it is difficult to offer information without stepping over the line and offering actual advice. It’s much easier to tackle this problem in advance, on paper, and with the blessing of your legal department!
If you find that you are getting a large number of employees asking the same question, this is an indication that you are missing some opportunity to educate your employees. There will always be those who do not read their notices, listen to your explanations, or take advantage of any education you make available. There will also always be some employees who have done their part, but still are not able to understand or have a complicated situation that does not appear to be covered in any of your examples. However, a large percentage of the questions that stock plan administrators and HR receive at tax time can be reduced by better employee education. You should be collecting and sharing questions and “standard” answers in preparation for tax season. If at all possible, it is very helpful to have a database of sorts that is accessible to those at your company who will be answering questions with example questions and answers so that there is consistency in the information employees are receiving. Even if the best answer is “I’m sorry, this really is something you will need to ask your tax preparer”, everyone who answers that question should know to respond in this way.
The first step in creating a solid employee education program for tax implications is to identify your different employee populations both in the U.S. and internationally. Then, you will want to identify what information you can provide to these employees that will help them file their individual tax returns. You should employ advice and help from tax advisors with local expertise, and coordinate with your local HR and payroll resources. Once you feel comfortable that you know what information each employee population may need, you will want to determine the best strategy for getting the information to them. Some populations will be comfortable with obtaining information online (and have access), others may need hard-copy handouts and face-to-face interactions. There may be situations where translation is needed.
Don’t be shy about taking every opportunity to remind employees about basic tax information. The first opportunity that you have to communicate the income and tax impact for you stock plans is during the on-boarding process. As part of the hiring or on-boarding process, employees who are eligible for equity compensation should receive or have access to information on income and tax withholding along with any other information you distribute about your stock plans. The company intranet is a great place to keep information posted as well, especially if you have a way to distinguish between participants employed in different countries. As part of the new hire process, make sure that employees know what resources are available.
Seminars or smaller meetings throughout the year–especially if you can make them mandatory–are a great way to increase visibility for your stock plans, solicit feedback from your employees, and provide information about tax time. It is especially helpful if you can make arrangements to have 3rd party financial advisors available to take questions or meet with employees individually. Examples can be very helpful for employees. If you have a few examples for situations, then employees can determine which one (if any) they fall under. For instance, if you have a 423 qualified ESPP program in the U.S., then an example of the purchase and then both a qualified and disqualified sale of shares will help employees understand the implications of either choice.
Finally, there is tax time. When you send out W-2s (or the equivalent in other countries) to employees, you have either their full attention, or their tax preparer’s. If possible, a short FAQ on income and tax withholding enclosed with the W-2 can be a great way to provide some information to employees. At the very least, you will be able to alert the employee to the fact that their taxes may be impacted by their equity compensation.
So – take a moment to review your employee education program and see if you are taking advantage of these opportunities to get employees comfortable with the basic impact of their equity compensation on their personal income taxes.