Stock Options and 415 Comp

I had a couple of question regarding nonstatutory stock options.  

A nonstatutory stock option is includable income in the year granted if it is includable in the employees taxable income.  But what exactly are the circumstances that would cause the option grant to be includable or not includable in income, and how is that income generally reported.  I know that it would be on the employee's W-2 at the end of the year, but is it reported as part of their paycheck, for example, when the option is granted?  So if they had a deferral election for a 401(k), the compensation related to the grant would be included in that deferral election, unless the compensation was excluded?

If a plan were to switch from using the W-2 compensation definition to a definition that excludes stock options, would the safe harbor 415 compensation be the better option, since that excludes not only compensation from exercising an option, but also when an option is granted?  

Thank you very much.

There is quite a bit in your question above. But, let's start with the income taxation of NSOs.  I assume that the exercise price of the NSO is not less than the FMV (as defined in the 1.409(A) Treasury Regulations) of the underlying stock on the date the NSO is granted (i.e., it is not a discounted option) so that we are not dealing with potential 409(A) issues. 

If the option itself (not the underlying stock) is not readily tradable on the market (which is almost always the case with compensatory options), the individual granted the option is taxed at the time the NSO is exercised, not date of grant. Options typically have a vesting schedule, and the individual has to wait for the option to vest before he/she can exercise the option. The amount subject to tax is the difference between the value of the underlying stock on the date of exercise minus the exercise price. This is ordinary income for the tax year in which the NSO is exercised and is reported as such in box 12 of the W-2. 

In some cases (if the option plan document or agreement allow) the individual may chose to "early exercise" an NSO--that is exercise the NSO even though it has not vested--by timely filing an 83(b) election. Without getting into the details of the 83(b) election, suffice it to say that if the election is properly made, the difference between the value of the underlying stock at the time of the 83(b) election is made (i.e., at the time of "early exercise") minus the exercise price is ordinary income in the tax year the 83(b) election is made. 

For 415 compensation definition purposes, it is important to differentiate between the "early" exercise of an NSO and the regular or "non-early exercise" (i.e., exercise after vesting--the first scenario I described above). 

1. The W-2 and the 3401(a) require you to include in compensation the amount of ordinary income at time of exercise of the NSO (early or non-early).

2. The 415 simplified compensation safer harbor definition excludes the ordinary income from the exercise of NSO (early and non-early).

3. The current includable compensation safe harbor definition excludes the ordinary income from the non-early exercise of an NSO, but it does include income from the early exercise (from the 83(b) election). 

Gilmore, portions of the reg have never made sense to me. Thankfully, most people today use the W-2 or 3401(a) safe harbor, and so, as FORMER ESQ. says above, the W-2 comp that occurs when the option is exercised will be included, because it will be on the individual's W-2 for both reporting and withholding purposes, when exercised. At least the answer will be clear if the optionee exercises while he or she is still employed by the grantor corporation.

But even with the W-2 or 3401(a) safe harbors, I am not quite sure how the regs are intended to apply if the exercise of the option occurs after an individual terminates employment. The spread will definitely be on a W-2 for the year of exercise, but what about the timing rules for post-employment compensation in 1.415(c)-2(e)? Is the post-severance spread considered "regular pay after severance from employment" under (e)(3)(ii), like a bonus, since the option could have been exercised before severance in almost all circumstances. That's probably the intended answer. But some might see it as a post-severance payment under (e)(3)(iv.

Once you move away from the W-2 and 3401(a) safe harbors, things get more mysterious. Nonqualified option spread is mostly, or perhaps entirely, excluded from 415 comp. First mystery: Why is the general 415(c) definition completely different from the W-2 and 3401(a) safe harbors on this point? Second mystery, why does 1.415(c)(2)(b)(5) tell you to include the value of an option in W-2 comp if it is included in income in the year of grant? Do they mean if the option was vested and the individual exercises in the year of grant? Maybe, but the text here seems pretty clear they are looking at the option itself as being the taxable item in the year of grant, not the spread at exercise, and again as FORMER ESQ states, the option is almost never the taxable item, because even if the stock is publicly traded the compensatory option will have terms different from any traded option on the stock. In fact, I have NEVER seen a compensatory option be includible in income. Moreover, 1.415(c)(2)(c)(2) seems to say you always exclude the spread on exercise of an option, regardless of timing. So my conclusion is that under the general 415 comp definition, nonqualified option spread is never 415(c) comp.

And why is income from an 83(b) election included (1.415(c)-2(b)(6)), but not income under Section 83 due to vesting (1.415(c)-2(c)(2))? Probably because they are thinking of restricted stock, not options, and the 83(b) election has to be made within 30 days, so they figure it's really current wage income, just paid in property.

The general definition of 415 comp that has these mysteries pre-dates the W-2 and 3401(a) safe harbors by many decades. My guess is that when it was first put into the regs,  accounting systems were feeble and there was no internet, so who even knew (in 1964) that if a former employee exercised an option it was reportable on a W-2, or even reportable? And how would you track it? So some of these administrability issues made there way into the regs. Oh for the good old days!

Thank you Former Esq and Luke.

The company was a privately held company that just went public.  I guess they now have some employees exercising stock options.  The client said they would prefer not to have the participants be able to defer from the compensation arising from exercising the stock options.  I'm not sure what they meant by that, as I did not think this was compensation from which a deferral could be made?

For example, when the compensation is recognized, does it appear as part of their payroll?  So would it be subject to a deferral election?

I intend to advise the client that they review with their attorney, but appreciate the additional knowledge you have both provided.

Gilmore, I guess payroll systems might differ, but the spread at exercise of a nonqualified option (NSO) is current FICA and FITW income for employees, so they must have a system for putting the amount into pay stub and withholding (from other amounts, or through broker if the shares are immediately sold in cashless exercise). If they are using the W-2 or 3401(a) safe harbor definition in their 401(k) plan, which they probably are, then it would be comp for deferral purposes and they would apply the individual's deferral election to, and withhold for deposit into the plan, just as they are withholding for their payroll tax deposit and 941, from whatever they are paying the person from which it is convenient to withhold. Occasionally plans will allow special elections for bonuses, but that's rare.

Got it, ok makes sense Luke.  Thanks.  They are currently using W-2 comp.  From the limited information that I received it sounds like perhaps this participant received compensation in the manner that you describe, and since it was their first experience with this scenario, the deferral election was not applied.  This may be a knee-jerk reaction then to the error.  

I really appreciate your help.

Gilmore, one other angle on this. Whenever I review and edit clients' existing stock plans, as well as bonus arrangements, I almost always will see a provision that says that the comp from awards under the plan or arrangement will not be counted as comp for purposes of benefit plans "unless the benefit plan specifically says otherwise." Those provisions are usually pointless, because in almost all cases the benefit plans do specifically say otherwise, just in a nonobvious way.

Luke,  your answer brought to mind a question.  Many award agreements that I review include the statement that the payment upon exercise or vesting will not be counted as compensation for purposes of benefit plans.  Period.  I would think that  language would be ineffective because it would be "trumped" by the typical safe harbor W-2 compensation definition in the 401(k) plan.  What say you?

2 hours ago, Linda Wilkins said:

Luke,  your answer brought to mind a question.  Many award agreements that I review include the statement that the payment upon exercise or vesting will not be counted as compensation for purposes of benefit plans.  Period.  I would think that  language would be ineffective because it would be "trumped" by the typical safe harbor W-2 compensation definition in the 401(k) plan.  What say you?

I very much agree, Linda. Even if in fact the intent of the parties is that the compensation not be counted, the agreement is not part of the plan document. If you can prove the intent of the parties and the employee is an HCE, you might have a relatively easy time in VCP or audit cap (or the employee could even be over the comp limit for the year without the option spread), but it is still a failure to follow your plan document

Per the client, when a participant exercises their stock option the taxable spread is included in their compensation on that day, just as you had stated Luke.  What the HR manager has to do is calculate the payroll tax associated with the compensation and the participant writes a check to the company for the payroll tax, and the company forwards the tax payment on behalf of the participant.

So let's say this happens on a normal payday, and the normal pay would have been $1000, but is now increased by the $20,000 compensation from the stock option.  If the participant's deferral election was 10%, again assuming compensation is defined as W-2 compensation, would the deferral then be $2100, and the participant would need to send that in as cash as well?  Or are the deferrals assumed to be made strictly from the cash portion of the compensation?

Thanks.

2 hours ago, Gilmore said:

So let's say this happens on a normal payday, and the normal pay would have been $1000, but is now increased by the $20,000 compensation from the stock option.  If the participant's deferral election was 10%, again assuming compensation is defined as W-2 compensation, would the deferral then be $2100, and the participant would need to send that in as cash as well?  Or are the deferrals assumed to be made strictly from the cash portion of the compensation?

Gilmore, I am addressing this as a hypothetical, since I cannot comment on an individual situation or provide advice in this forum.

Deferrals must be withheld. Unlike the tax payment, the employee cannot write a check for the amount. So I don't think that is a possible solution.

If the company has set up a cashless exercise program through a broker, it could probably have the broker withhold the elective deferral amount, as its agent, just like the employer may withhold the exercise price and/or FITW and FICA.

If the above does not work, it could withhold from future cash payments in a reasonable manner.

Those are just suggested answers to your hypothetical. Maybe there are other solutions that will be suggested.

Perfect Luke, thank you.