13.4 Stock Compensation Plans: Options, Restricted Stock, RSUs & ESPPs
Key Takeaways
- Incentive stock options under IRC §422 create no ordinary income at exercise but generate an alternative minimum tax preference equal to the bargain element, and the employer receives no deduction unless the employee makes a disqualifying disposition.
- The ISO $100,000 rule limits the aggregate fair market value of stock — measured at grant — for which options first become exercisable in any calendar year; the excess is treated as a nonqualified option.
- Nonqualified stock options are taxed under IRC §83 as ordinary compensation income on the spread at exercise, are subject to payroll withholding, and generate a matching employer deduction.
- A Section 83(b) election is available for restricted stock but not for restricted stock units, because an RSU is an unfunded promise rather than a transfer of property; the election must be filed within 30 days of transfer and is irrevocable.
- A Section 423 employee stock purchase plan permits a discount of up to 15%, limits each employee to $25,000 of stock per calendar year measured by grant-date fair market value, and produces ordinary income on a qualifying disposition equal to the lesser of the grant-date discount or the actual gain.
Stock Compensation Plans: Options, Restricted Stock, RSUs & ESPPs
Quick Answer: Every equity vehicle is analyzed on three questions: when is the employee taxed, at what character, and does the employer get a deduction? ISOs defer ordinary income entirely (but create an AMT preference and give the employer no deduction). NQSOs are ordinary income on the spread at exercise, deductible by the employer. Restricted stock permits an §83(b) election; RSUs do not. Section 423 ESPPs allow a 15% discount subject to a $25,000 per calendar year limit measured at grant.
1. Stock Options: The ISO / NQSO Divide
| Feature | Incentive Stock Option (IRC §422) | Nonqualified Stock Option |
|---|---|---|
| Eligible recipients | Employees only | Employees, directors, consultants, advisers |
| Tax at grant | None | None, if granted at fair market value |
| Tax at exercise | No regular income tax. The bargain element (FMV at exercise minus strike) is an AMT preference item | Ordinary compensation income on the spread; subject to income tax and FICA withholding |
| Tax at sale (qualifying) | Entire gain over strike price is long-term capital gain if held more than 2 years from grant and more than 1 year from exercise | Capital gain or loss measured from the exercise-date basis |
| Tax at sale (disqualifying) | Ordinary income equal to the lesser of the exercise-date spread or the actual gain; remainder is capital | Not applicable |
| Employer deduction | None, unless a disqualifying disposition occurs — then a deduction matching the employee's ordinary income | Deduction equal to the employee's ordinary income in the same year |
| Statutory constraints | Ten-year maximum term; strike at least 100% of FMV at grant; shareholder-approved plan; $100,000 annual limit; 10% shareholders need a 110% strike and a five-year term | None of these |
The $100,000 Rule
The aggregate fair market value at grant of stock for which ISOs become first exercisable in any one calendar year cannot exceed $100,000. Options exceeding that ceiling are treated as nonqualified. Note two details candidates miss: the value is measured at grant, not at exercise, and the test looks at when options first become exercisable (that is, the vesting schedule), not when they are actually exercised.
The AMT Trap
An employee who exercises ISOs and holds the shares to reach long-term capital gain treatment may owe alternative minimum tax on a paper gain in the exercise year. If the stock then falls before sale, the AMT liability remains while the economic gain has evaporated. A same-year disqualifying disposition eliminates the AMT preference by converting the transaction to ordinary income — sometimes the better answer, and the kind of trade-off an RPA 1 scenario asks candidates to evaluate.
2. Restricted Stock, RSUs & the §83(b) Election
| Restricted Stock | Restricted Stock Unit (RSU) | |
|---|---|---|
| What is transferred | Actual shares, subject to forfeiture and transfer restrictions | An unfunded contractual promise to deliver shares (or cash) later |
| Default taxation | Ordinary income when the substantial risk of forfeiture lapses (vesting), measured by FMV at that time | Ordinary income at settlement, generally at vesting |
| §83(b) election | Available. Elect to include the FMV at transfer, less any amount paid, in income immediately | Not available — §83 applies to transfers of property, and a mere promise is not property |
| Dividends before vesting | Generally taxed as compensation absent an §83(b) election; as dividends if the election is made | Dividend equivalents, if any, are compensation |
| FICA timing | At vesting, or at transfer if §83(b) is elected | At vesting, even where share delivery is deferred — the special timing rule under §3121(v)(2) means FICA can be due before income tax |
Mechanics and Risk of the §83(b) Election
The election must be filed with the IRS no later than 30 days after the transfer of the property, and it is irrevocable absent IRS consent. It converts a future ordinary-income event measured at vesting-date value into a current one measured at the (usually much lower) transfer-date value, and it starts the capital-gains holding period immediately.
The risk is symmetrical and often understated: if the shares are later forfeited, the employee gets no deduction for the income previously recognized, and if the stock declines, tax was paid on value that never materialized. The election is therefore most attractive when the transfer-date value is low, the vesting horizon is long, and the expected appreciation is large — the classic early-stage-company fact pattern.
Retirement-eligibility trap for RSUs. Where an award vests on the earlier of a service date or retirement eligibility, the substantial risk of forfeiture may lapse when the employee becomes retirement-eligible, which can accelerate FICA — and, depending on design, income — before any shares are delivered.
3. Section 423 Employee Stock Purchase Plans
An ESPP is the broad-based, rank-and-file equity vehicle. To qualify under IRC §423:
- Participation must be open to substantially all employees, with permitted exclusions for those with less than two years of service, part-time or seasonal employees, highly compensated employees, and 5% shareholders (who must be excluded).
- The purchase price may be no less than 85% of fair market value — a maximum 15% discount — measured at the beginning or the end of the offering period. Plans using the lower of the two implement a lookback.
- No employee may accrue the right to purchase more than $25,000 of stock per calendar year, measured by fair market value at grant (the offering start), not at purchase.
- The offering period may not exceed 27 months where the price is based on the ending FMV, or five years where it is set at the beginning.
- The plan must be shareholder approved, and rights must be nontransferable.
Taxation
No tax at grant or at purchase. On a qualifying disposition — more than 2 years after the grant (offering) date and more than 1 year after the purchase date — the employee recognizes ordinary income equal to the lesser of (a) the discount computed at the grant date, or (b) the actual gain on sale; the remainder is long-term capital gain, and the employer receives no deduction. On a disqualifying disposition, ordinary income equals the full discount measured at purchase, and the employer receives a matching deduction.
Worked example. Grant-date FMV $40; purchase-date FMV $60; 15% lookback discount so the purchase price is $34. The employee sells three years after grant and two years after purchase at $75. Qualifying disposition: ordinary income is the lesser of the grant-date discount ($40 × 15% = $6) or the actual gain ($75 − $34 = $41), so $6 is ordinary income. Basis becomes $34 + $6 = $40, and the remaining $35 is long-term capital gain. Had the employee sold immediately after purchase, ordinary income would have been the full purchase-date discount of $60 − $34 = $26.
4. Cash-Settled Alternatives and the §409A Boundary
Stock appreciation rights (SARs) pay the appreciation over a base price, in cash or shares, without requiring the employee to fund an exercise price. Phantom stock credits notional units tracking share value, settled in cash. Both deliver equity-linked economics without diluting ownership, which makes them common in private companies, partnerships, and non-U.S. subsidiaries.
Both are also deferred compensation unless structured carefully. Under the §409A regulations (Section 13.3), a stock right is exempt from §409A only if it is granted on service recipient stock, has an exercise or base price never less than fair market value at grant, contains no deferral feature beyond exercise, and the number of shares is fixed at grant. A discounted option or SAR — including one that is discounted only because the company's valuation was stale — falls into §409A, triggering immediate income inclusion on vesting, a 20% additional tax, and a premium interest charge. This is why private companies obtain contemporaneous independent valuations before every grant.
An employee is granted restricted stock units that vest ratably over four years. The employee wants to file a Section 83(b) election to lock in today's low valuation. What is the correct advice?
Under a Section 423 employee stock purchase plan with a lookback, grant-date fair market value is $40, purchase-date fair market value is $60, and the 15% discount produces a purchase price of $34. The employee sells three years after the grant date and two years after the purchase date at $75. What is the ordinary income?
A privately held company grants stock appreciation rights with a base price set using a valuation that was eighteen months stale, resulting in a base price below current fair market value at grant. What is the consequence?