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If you have stock options you could be in for a big surprise because the various tranches of stock options can qualify for the QSBS 100% capital gains tax exclusion depending on when the stock holding period starts, whether the company is a qualified business, and when the stock is ultimately sold.
What is a Stock Option?
Stock options were once issued solely to upper management; they are now gradually offered to rank-and-file workers and have become a significant component of employee compensation. Options motivate employees to help the company grow in the long-term and vesting elements of options encourage employees to remain with the company during these critical periods. Options also align employee and owner interests, all of whom share the desire to see the company succeed and the share price increase.
By way of express definition, a stock option is a contract between two parties that gives the investor the right, but not the obligation, to purchase or sell the underlying stock at a fixed price and within a given period.
QSBS paired with stock options can save an employee from up to 100% in capital gains taxes upon the ultimate sale of the stock.
Stock Options and Incentives that Qualify for the QSBS Exemption?
There are various types of compensatory equity securities and profits interests that can qualify for QSBS, each having its peculiarities;
- NON-QUALIFIED STOCK OPTIONS (NQSOs): A non-qualified stock option (NQSO) is a stock option not eligible for special favorable tax treatment under the US Internal Revenue Code. Thus, the term “non-qualified” refers to the tax treatment. Once you exercise your non-qualified stock option, the difference between the stock price and the strike price is taxed as ordinary income.
- INCENTIVE STOCK OPTIONS (ISOs): Incentive stock options (ISOs) are eligible for preferential tax status under the Internal Revenue Code and are not subject to Social Security, Medicare, or withholding taxes, provided they comply with the requirements in the tax code.
- RESTRICTED STOCK UNITS (RSUs): Under the Restricted Stock Units Plan, the employee is granted the right to receive shares on a predetermined date, subject to the occurrence of a specified event or specified conditions.
- STOCK APPRECIATION RIGHTS (SARS): While SARs are not technically employee stock options, companies often use them in the same way. SARs offer cash payments to workers equal to the appreciation of the company’s stock over a period. Thus, unlike other options, SARs provide workers with equity upside down without being exposed to any negative consequences.
- EMPLOYEE STOCK OWNERSHIP PLAN (ESOP): is a form of employee benefit plan that allows employees to own stock in the company. ESOPs provide various tax advantages to the sponsoring organization, the selling shareholder, and the participants, making them eligible plans. Companies also use ESOPs as a corporate-finance tool to balance their workers’ interests with those of their shareholders.
When does the QSBS Timeline Start for Stock Options?
For taxation, stock options do not qualify for the QSBS tax treatment until the stock has been issued either through a vesting timeline, through exercising the options or making a Section 83(b) election. Thus, the timing of the stock’s exercise would factor in the type of stock options, the revenue forecast, and the plan to make use of the tax advantages. If a corporation gives out stock options as part of its compensation package, the employee earns a share of the company’s ownership. However, the shares must usually vest first, which means the employee must typically work for the company for some time if they wish to become an owner.
Stock options, like ISOs or NSOs, do not yet provide actual shares of stock. Instead, provide the right to exercise (purchase) on a predetermined number of shares at a predetermined price in the future. RSUs, on the other hand, are potential stock options issued by the employer. Unlike stock options, you do not need to buy them; instead, you must simply wait for them to vest. You may be required to remain at the company for a certain period, and you or the company may be required to meet a particular milestone for these shares to vest.
RSUs are eligible for the Section 83(b) election, which allows taxpayers to prepay payroll taxes on the RSUs’ current fair market value. For tax purposes when a Section 83(b) election is made the taxpayer is considered to own the asset (i.e. stock), which is the same consideration as receiving newly issued shares. The election starts the QSBS clock. Section 83(b) election must be filed with the local IRS office within 30 days after your receipt of restricted stock, upon the exercise of stock option, or the date the profits interest is granted as in the case of SARs. Except where the mailing is postmarked within the 30 days and the 30th day falls on a weekend or a holiday, in that case, the deadline is the next business day.
What are the pros and cons of exercising stock options early?
Pro: The ability to prepay the tax obligation early on a low valuation basis, assuming that the equity value will rise in the following years.
Con: However, if the business’s value decreases, the taxpayer would have overpaid taxes by prepaying higher stock valuations.
Pro: Section 83(b) election starts the QSBS timeline on the date of the election for the RSUs or SARs instead of waiting until vesting.
Con: If the employee leaves or the company is acquired early before the stock is vested the prepaid taxes will not be refunded if the unvested stock is lost or canceled.
What happens if the company is merged or acquired before the five years?
The IRC has a non-recognition rule in Section 1202, in cases where the stock has been held for more than six months but less than five years. Section 1045 provides that a taxpayer can rollover gains from the sale of QSBS held for more than six months. To do so, the taxpayer must buy new QSBS within sixty days of purchase and make an election on their tax return. In most cases, the holding period of QSBS acquired in a Section 1045 rollover transaction is extended. This means that when QSBS is held for less than five years is sold; the proceeds can be rolled over into new QSBS stock with a continued holding period (i.e. nothing has changed in terms of QSBS status).
For a qualified rollover to take place:
- The taxpayer must own the original QSBS for at least six (6) months before selling it, ignoring any carryover (or tacked) holding period that might apply. It is also worth noting that multiple rollovers are possible.
- Within 60 days of the sale, the taxpayer will reinvest the entire sales proceeds (not just the gain) in replacement QSBS. The gain rolled over will be the proceeds rolled over minus the basis in the original QSBS. Not all of the proceeds must be rolled over.
- The substitution QSBS must meet the eligible trade or company criteria (discussed above) for at least six (6) months after the taxpayer’s acquisition.
- The taxpayer correctly elects deferral by making an election on or before the due date (including extensions) for filing the tax return for the year in which the QSBS is sold.
If the company is merged, then the QSBS will be maintained if the merger is a Section 351/368 tax-free transaction. However, it must control the QSBS corporation (i.e. at least 80 percent of the voting power and at least 80 percent of the number of shares of the other issued shares, as provided under Section 368). Suppose the QSBS is exchanged for newly issued QSBS. In that case, it retains its holding period and continues to allow QSBS eligible stock price appreciation. When QSBS is exchanged in a Section 368 transaction for non-QSBS, the holding period will still be maintained, but any additional stock appreciation will not be considered for the QSBS exemption. Therefore, the only gain eligible for the QSBS exemption is the unrealized gain with the Section 368 transaction.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.