Executive Compensation Tax: Options, Stock Grants and Bonuses

This is the first in a series of two articles discussing executive compensation taxation. This article covers some of the tax implications of options, stock grants and bonuses. The second article provides tax insights on employee benefit plans. Read it here.

Tax News You Can Use | For Professional Advisors

Jane G. Ditelberg, Director of Tax Planning
Anthony Rodriguez, Director of Retirement Planning

The first quarter often brings with it executive compensation decisions, including raises, bonuses and equity compensation grants. The varied forms of executive compensation have tax implications that affect the relative value of each benefit. This guide provides an overview of the tax treatment for common forms of executive compensation, including salary and bonus, stock options, restricted stock awards, restricted stock units and deferred compensation. Understanding the taxation of these types of compensation, including the tax rates and the time at which the tax is incurred, is a vital step in maximizing the value of the benefits to the executive.

At a glance

Executives at both public and private companies are compensated using a variety of techniques. Some methods are designed to encourage high performance or to align the executive’s financial incentives with those of their employer, while other methods are attractive for their tax treatment or cash flow impact.

Cash compensation: salary and bonus

Salary and bonus payments are taxed as ordinary income at the time of receipt, and federal, state, and local income and payroll taxes will apply. For bonuses that are paid together with a regular paycheck, the employer withholds from the bonus in accordance with the employee’s filing status and W-2 exemptions. Cash bonuses paid separately (not aggregated with payroll) are subject to separate withholding rules—typically 22% for amounts under $1 million and 37% for amounts over $1 million. Depending on the size of the bonus, the executive’s marginal tax rate may be higher than 22%, in which case this withholding method will likely be insufficient to cover their entire tax liability. Executives and their tax preparers should review withholding and expected income to determine whether additional estimated income tax payments are necessary to avoid penalties.

Restricted stock awards

A restricted stock award (RSA) is a payment in the form of restricted shares that transfers the stock to the recipient upon grant, subject to vesting restrictions. Unlike stock options, RSAs come with voting and dividend rights immediately since the recipient actually owns the stock upon grant. The value of the stock is taxed as ordinary income for federal and state income tax and payroll tax purposes when the restriction lapses (i.e., vests). Upon sale, subsequent gains or losses receive capital gains or loss treatment. Section 83(b) of the Internal Revenue Code permits recipients of an RSA to elect to pay ordinary income tax on the value of the stock at grant, rather than at the time of vesting, with subsequent stock appreciation or loss being treated as a long-term capital gain or loss upon sale. Dividends on restricted stock are treated as wages (subject to tax as ordinary income) unless the 83(b) election is made. If elected, the dividends are eligible for qualified dividend treatment and taxed at a lower rate.

A restricted stock unit (RSU) is similar to an RSA. The difference is that with an RSU there is no transfer of shares until the RSU vests, and unlike a stock option, it is not the right to buy the shares. Instead, the RSU can be redeemed for shares or settled for cash in lieu of stock at the time of vesting. Whether received in shares or in cash, the receipt is treated as compensation and taxed as ordinary income. If the RSU is settled in shares, the later sale of those shares will be treated as capital gains, and the rate will be determined based on how long after vesting the shares are held before sale. 83(b) treatment is not available for RSUs.

Deferred compensation plans

Deferred compensation plans allow the executive to postpone the receipt of a portion of their cash compensation, and thus delay payment of tax. For performance-based compensation, the taxpayer must make the deferral election by June 30 of the year preceding payment, while for other types of compensation, the executive has until December 31 of the calendar year preceding the payout.

Stock options

Stock options come in two flavors — incentive stock options (ISOs) and non-qualified stock options (NQSOs). The type determines both the timing of the tax (at the grant/exercise date, at the disposition of the stock, or both) and the characterization of the income as ordinary income or capital gain/loss. Unlike restricted stock, holders of stock options do not receive dividends or have voting rights prior to vesting.

Incentive stock options — Incentive stock options (ISOs) are generally taxed when the acquired stock is disposed of (sold or transferred), rather than when the option is granted or exercised, and the tax treatment depends on whether the disposition is qualified or disqualified. A qualified disposition is stock disposed of more than two years after the grant date and more than one year after exercise. A disqualified disposition is one that does not meet the holding period requirements of a qualified disposition and is therefore taxed as ordinary income. However, the difference between the option strike price and the stock value on the exercise date is included in alternative minimum tax (AMT) income. Unlike NQSOs, ISOs are subject to a $100,000 annual exercisable grant limitation. When deciding when to exercise ISOs the holder needs to consider both the AMT exposure and the capital gains treatment.

Non-qualified stock options — The most widely granted options are non-qualified stock options (NQSOs). NQSOs are taxed as ordinary income when the holder exercises the option to purchase shares, which must happen after the vesting date. The taxation on the disposition of those shares depends on the executive’s holding period. If the stock is held for 12 months or less, the difference between the sale price and the exercise price (price paid to acquire the stock under the terms of the option) is a short-term capital gain, taxed at ordinary income tax rates. If the stock is held for more than 12 months, the gain is a long-term capital gain, taxed at lower capital gain tax rates.

If you have questions about the taxation of executive compensation, please contact your Northern Trust advisor.

This article is the first in a two-part series. The second article focuses on employee benefit plans, including the different taxation for defined contribution plans, pension plans, and non-qualified employee benefit plans. Read the second article here.