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.
At the same time that the IRS released regulations designed to clarify which restrictions constitute a substantial risk of forfeiture under Section 83 (see my blog entry “IRS Issues Final Regs Under Section 83,” March 4), a recent tax court decision casts doubt on the definition in the context of employees that are eligible to retire.
Background
As my readers know, where an employee is eligible to retire and holds restricted stock that provides for accelerated or continued vesting upon retirement, the awards are considered to no longer be subject to a substantial risk of forfeiture, and, consequently, are subject to tax under Section 83. This also applies to RSUs, because for FICA purposes, RSUs are subject to tax when no longer subject to a substantial risk of forfeiture and the regs in this area look to Section 83 to determine what constitutes a substantial risk of forfeiture.
Although there’s usually some limited risk of forfeiture in the event that the retirement-eligible employee is terminated for cause, that risk isn’t considered to be substantial. As a practical matter, at many companies just about any termination after achieving retirement age is treated as a retirement.
Austin v. Commissioner
In Austin v. Commissioner however, the court held that an employee’s awards were still subject to a substantial risk of forfeiture even though the only circumstance in which the awards could be forfeited was termination due to cause. In this case, in addition to the typical definition of commission of a crime, “cause” included failure on the part of the employee to perform his job or to comply with company policies, standards, etc.
Implications
Up until now, most practitioners have assumed that providing for forfeiture solely in the event of termination due to cause is not sufficient to establish a substantial risk of forfeiture, regardless of how broad the definition of “cause” is. Austin seems to suggest, however, that, in some circumstances, defining “cause” more broadly (e.g., as more than just the commission of a crime) could implicate a substantial risk of forfeiture, thereby delaying taxation (for both income and FICA purposes in the case of restricted stock, for FICA purposes in the case of RSUs) until the award vests.
On the other hand, there are several aspects to this case that I think make the application of the court’s decision to other situations somewhat unclear. First, and most important, the termination provisions of the award in question were remarkably convoluted. So much so that resignation on the part of the employee would have constituted “cause” under the award agreement. There were not any special provisions relating to retirement; all voluntary terminations by the employee were treated the same under the agreement. In addition, the employee was subject to an employment agreement and the forfeiture provisions of the award were intended to ensure that the employee fulfilled the terms of this agreement.
Finally, the decision notes that, for a substantial risk of forfeiture to exist, it must be likely that the forfeiture provision would be enforced. I think that, for retirees, this often isn’t the case–the only time a forfeiture provision would be enforced would be in the event of some sort of crime or other egregious behavior. Termination for cause is likely to be met with resistance from the otherwise retirement-eligible employee; many companies feel that, with the exception of circumstances involving clearly egregious acts, it is preferable to simply pay out retirement benefits than to incur the cost of a lawsuit.
Never-the-less, it is worth noting that 26% of respondents to the NASPP’s recent quick survey on retirement provisions believe that awards held by retirees are subject to a substantial risk of forfeiture.
Back in May, the Senate Finance Committee published a report of possible ways that the tax treatment of employee benefits might be changed as part of the tax reform project that the Committee is working on. Today I take a look at some of the strategies they are considering.
These strategies were suggested by witnesses at hearings that the Committee held, as well as by various bipartisan commissions, tax policy experts, and members of Congress. Not all members of the Committee agree on which direction constitutes “reform” for the tax code (e.g., whether tax reform should reduce the deficit or lower tax rates), so some of the ideas are contradictory. It’s sort of a grab bag of tax reform.
Section 162(m)
The report suggests expanding the group of employees whose compensation is subject to the deduction limit under Section 162(m); applying the limit to all stock compensation, including stock options; and reducing the maximum deduction companies are entitled to. If this all sounds familiar, it’s because it’s already happening for health insurance providers (see my blog “CHIPs: More Than a Cheesy TV Show“). If Congress goes in this direction, I have to believe that the IRS might take it one step further and implement the allocation rules that they have proposed for health insurance providers as well. This could have a pretty significant impact on stock plan administration.
An alternative suggestion to all of these ideas is to repeal Section 162(m) altogether. With all the media outrage over executive compensation, I’d be pretty surprised if this is the direction Congress takes. But, never say never–I’ve been surprised many times in my life.
Section 409A and Deferred Compensation
Despite the draconian rules under Section 409A, deferred compensation continues to be a point of controversy. The report suggests requiring all non-qualified deferred compensation to be taxed when earned. Which would make it “nondeferred compensation” or just regular compensation. Essentially the ability to defer taxation on any compensation outside of a tax-qualified plan would be eliminated. If deferrals aren’t eliminated entirely, then perhaps the amount of compensation that can be subject to deferral might be limited.
Or, rather than eliminating the ability to defer compensation, an alternative suggestion is to require companies to pay a special investment tax on earnings attributable to non-qualified deferred compensation. If the compensation hasn’t been paid out, then the company is presumably earning a return on the unpaid amounts and could be paying a special tax on that return. I can only begin to imagine the complicated rules that would apply to stock compensation under this approach. I foresee lots of NASPP Conference sessions.
The report also suggests repealing Section 409A altogether, repealing it for only private companies, or repealing the 20% penalty.
Stock Options
As noted above, the report suggests making stock options subject to Section 162(m) without exception. Use of full value awards had already outpaced usage of stock options–this would be just another nail in the coffin.
The report also suggests eliminating incentive stock options; I can’t see many public companies shedding a tear over this, but private companies might be bummed. Hopefully this idea wouldn’t be extended to include ESPPs, however.
And, you guessed it–Senator Levin’s proposal (“Senator Levin, Still Trying“) on limiting corporate tax deductions for stock options to the amount of expense recognized for them rears its ugly head in the report as well.
In today’s blog I’m going to deviate a bit from our normal format and invite you to take a little quiz. Don’t worry, nobody’s keeping score except for you, so this is just for fun. Why a quiz, you ask? Have you ever wondered where to find something in the massive IRS Tax Code? Many of us have memorized the names and basics about various tax code sections that apply to stock compensation (e.g. Sections 421, 422, 423, 424, 83, 162 and so on). Or, you’ve heard of some pending regulations, but aren’t really sure whether there’s a pending regulation that covers your area of interest? I personally found it fairly straightforward to memorize the basics about all the major tax code sections, but what I find more challenging is keeping on top of all the subsequent revenue rulings and other guidance that emerges from the IRS. If you’re having the same challenge, you’ll want to be sure to visit our new Tax Code portal. It’s simple and concise – there’s a list and description of the various tax code sections, as well as related rulings and other interpretive guidance that apply to stock compensation. Call it a tax code crib sheet, if you may. Wait! Before you check it out, pause for a moment, in that spirit, to take the Tax Code Challenge!
Tax Code Challenge:
1. Where would you find information about the procedures to revoke an 83(b) election?
a. In Code Section 83(b)(2)
b. The IRS had not provided guidance on any specific procedures
c. Section 83 of the Code is clear that an 83(b) election may never be revoked for any reason
d. In Revenue Proc. 2006-31, which became effective June 13, 2006
2. Which revenue ruling provides guidance on the treatment of dividends and dividend equivalents on restricted stock and restricted stock units for 162(m) purposes?
a. There is no revenue ruling that covers dividends/dividend equivalents
b. Revenue Rul. 2012-19
c. Revenue Rul. 98-34
d. There is no revenue ruling, but there are proposed regulations pending on this topic
3. Which of the following reflect pending regulations?
a. Rules relating to the additional medicare tax
b. Rules related to valuing employee stock options that have been gifted for estate planning purposes
c. Rules regarding new information disclosures for Section 6039 related information returns
d. There are no pending revenue rulings that would affect stock compensation
The answers are listed below. If you knew all of the answers – great! You’re a tax guru. For the rest of us that may have been stumped by one or more questions, a visit to the Tax Code portal may help gain clarity in this area.