Introduction to Taxes & Compliance for Employee Share Compensation
It is important to know all about the different types of employee compensation and the taxes that affect them.
With your company all set up and the hiring process completed, are you planning to reward your employees with equity compensation for their work in the company? If you are about to offer shares as employee compensation, it is important to be aware about the taxes and compliance rules that follow. For every type of stock option plans, there are different tax rules, forms and obligations, and tax effects differ for each different employee compensation.
So, before you can go ahead with your company, it is important to know all about the different types of employee compensation and the taxes that affect them. In this article, you would understand all about the various compensation, the compliance requirements as per the government and the taxes that affect the various compensation and benefits provided to the employees.
What is Compliance?
First off, it’s important to know what compliance is. Compliance means adhering to the rules and regulations that have been created by the legal authorities. At times, it may be difficult to always follow each and every rule and government regulation. But if you are not able to do this, you may miss the benefits that come with it, and in the end be penalized for it. Basic examples of compliance involves paying taxes on time, whether it be the taxes on employee compensation or income taxes, and getting a business license in your town.
External laws are not the only ones that companies have to follow. It is also vital for them to follow internally designed business policies to make their business better. Compliance requirements increases as the company grows. Hence, the business also has to change the way it complies with the laws as the rules change. By doing this, the company would be able to grow smoothly without the interference of the
Employee compensation options
Employee compensation is basically giving something in return to employees for providing their services to the company. It usually includes offering things like salary, benefits, incentives, & non-cash compensation. And in the world today, there are many companies that are offering not only salaries and bonuses, but also other forms of compensation to their employee. For instance, many companies are offering their employees with stock options as incentives to retain the best talent for a long period of time. There are different options under this as well, such as ESPPs, restricted stock options, ISOs, etc. You would find out more about them below.
Difference in taxes in general for types of employee compensation
Now that you are clear about what employee compensation is, the next thing that to consider is taxes. Employment taxes is something that everyone, including the business, the employees, and even the owner has to pay. The taxes are normally different for the local, state and federal agencies and has to be paid accordingly.
Under the taxes on the employee compensation, there are many types of federal and state withholding, out of which self-employment is also considered for employment tax. Below are some of the main types of taxes that you should have an idea about as you need to periodically make payments to the IRS.
Federal Income Tax Withholding
The very first tax that many know about is the federal income tax, which the employer has to withhold from their employees. And for determining the amount that has to be held, the W-4 form is used where the employee fills out the form during the hiring period of when the employee’s status changes or the employee wants to alter the withholding amount. If the employer does not have a W-4 form, they are not allowed to pay their employees.
The amount is calculated for each pay period for each employee where the gross pay of the employee is needed, and the data on the W-4 form. Other than that, you would need to check about the rules and rates with the IRS, for which a lawyer or tax accountant is the best person to consult.
State Income Tax Withholding
Another tax on employee compensation is the state income tax that the company has to withhold from the employee’s paycheck. But the form used for this depends on the state. Some states prefer to have their own forms while some use the W-4 form that is used for the federal income tax withholding. If you want to collect taxes from your employees for the state, you would need to register with the taxing authority of the state so that you can collect and pay the taxes that are withheld from employees.
Social Security and Medicare (FICA Taxes)
Another tax on employee compensation is the FICA taxes. Every US employer has to deduct the FICA (Medicare and Social Security) tax amounts from the paychecks of each and every employee working for their company, and pay employer and employee portions of this tax. The Medicare portion for employees is 1.45% with no maximum, while the deduction for the Social Security tax is about 6.2% of the total annual maximum payment for the employee.
You would also have to tax the employees for the additional Medicare tax when their overall income rises above $200,000, which is 0.9% of the gross income of the employee. Hence, as soon as the income of the employee gets to $200,000, you would have to gather 2.35% from the paycheck of the employee for the rest of the year.
Other than these taxes, you too as an employer would have to pay some taxes.
- The 1.45 percent for the Medicare portion has to be matched, where there is no need to contribute to the additional Medicare tax, and
- The 6.2 percent for the Social Security portion, with no maximum, has to be matched by you.
Workers Compensation Benefit Funds
This is another one of the taxes on employee compensation, where the employer needs to pay into state-run funds that offers advantages for the employees who have incurred injuries or illness during their work. This compensation is paid for by the employer contributions to the compensation funds of the state workers, and are governed by compensation laws. You would have to check with the government agency of your state to know more details on this or consult a lawyer in the area.
Self-employment taxes is also one of the taxes on employee compensation as they are just like FICA taxes (also called SECA taxes). They are the Medicare and Social Security taxes for self-employed individuals, where the additional Medicare tax is also needed, just like the employees.
This tax is different from the other types of taxes on the employee compensation, as it is not withheld from the employee or paid by the employer. The tax is placed on the total income of the business and the amount is paid by the owner in their tax return.
The tax rate of this is 2.9% for Medicare, and 12.4% for Social Security for the annual minimum. This means that you would pay the Social Security and Medicare taxes for the employee and employer (you). Moreover, if the income during the year is more than $200,000, you would also have to pay the added Medicare tax at 0.9%.
Fortunately for you, the IRS gives you a break. You would be able to deduct about half the amount that you give under this tax on your tax return file’s first page, so that you can calculate the adjusted gross income. For this, you need to finish the Schedule SE to get the deduction.
Tax effects of ISO, NSO, NQSO
From the beginning of this article, you learned about employee compensation. Under this, there is equity compensation where shares are given to the employees to reward them for their hard work. ISOs & NSOs are types of equity compensation where the employers offer their employees an option to buy the company stock with some sort of built-in discount or tax advantage. These options are normally offered to those who are seniors in the company.
There are two types:
- Incentive Stock Options (ISOs)
- Non-qualified Stock Options (NSOs or NQSO)
ISO is an employee stock option that has a tax benefit when it is exercised, and it is not necessary to pay income tax on it then. Alternatively, they are taxed at the capital gains rate. ISOs are offered to employees as an encouragement so that they can stay longer with the business and give the best to grow and develop the company.
They are used along with the salary or even in place of a salary. Moreover, ISOs are the reason why many new hires are attracted towards businesses. There are two kinds of dispositions for ISOs:
- Disqualifying Disposition: This is the sale of ISO stock which doesn’t meet the prescribed holding period requirements.
- Qualifying Disposition: This is the sale of ISO stock which takes place at least two years after the grant date and after one year when the options were exercised. These two requirements have to be met for the sale of the stock to be classified under the qualifying disposition.
ISO taxation is complex as compared to the other taxes on employee compensation, but it has a lot of tax benefits as well, which also makes it stand apart from the others. Moreover, the tax effects is based on when the shares are sold or transferred. Here are some things to remember:
- In case you hold the share for a long time before making a qualifying disposition (e.g. sale or gift), the profits made due to the exercise price is taken as capital gain.
- In case you don’t wait long and make a disqualifying disposition, the ordinary compensation income and any capital losses or gains would vary based on the relationship between the sale price, the market price at the time of exercising the share, and your exercise price.
- The difference in the exercise price and the fair market value is called the spread, and it might trigger alternative minimum tax (AMT) if you hold the stock during the calendar year of exercise. And when it comes to tax planning of the ISOs, AMT is a significant factor that has to be considered.
- With ISOs, at exercise or during a later sale, you have no Medicare or Social Security tax and no withholding at all.
NSO & NQSO
Another type of employee compensation is the NSO (non-qualified stock options), which is also called the NQSO. They are stock options that don’t qualify for the special treatment as compared to incentive stock options. This means that the NSOs do not meet all that is required to be qualified as an ISO.
Unlike ISOs, the taxes on this type of employee compensation is different as NSOs can be issued to anyone. This includes all the members of the board, vendors, consultants, and the employees of the company. The gains/losses on the shares upon exercise by the receiver is categorized as ordinary income. This is equal to the abundance of the FMV (fair market value) of the stock at the time of the exercise over the exercise price of the stock option.
Moreover, the company is obligated to withhold the employment and income taxes during the exercise period. The company would also get a tax deduction that is equal to the amount of the ordinary income recognized by the recipient. Based on the grant’s terms, the NSO could even be subjected to the penalty provisions in Section 409A of the Code for deferred compensation.
Tax effects of Restricted stock & RSU
Another type of employee compensation is the restricted stock options and the RSUs. Let us now understand each of them along with their effects on taxes.
What Is Restricted Stock?
Restricted stock are the unregistered shares of ownership which are given to the corporate affiliates, like the directors and executives of the corporation. These stocks are non transferable and have to be traded by following Securities and Exchange Commission (SEC) rules. The stocks become available after a granted vesting schedule, which can last for several years, depending on the company and state in which it is incorporated in. The restricted stock is also known as the “Section 1244 stock” or the “Letter stock.”
What Are Restricted Stock Units?
The RSUs, also called restricted stock units, is an employee compensation where the company stock is issued to the employees. This is usually done via a vesting plan and a distribution schedule upon staying with the same company for a particular length of time or after achieving specific performance milestones.
With the RSUs, the employee would be able to get an interest in the company stock, but they would not have any tangible value until the shares have been vested. The shares in the RSUs are given the FMV when they vest, and are taken as ordinary income. Moreover, a part of the share is withheld with the owner to pay the income taxes. The remaining shares are then given to the employee where they can either keep it or sell it, depending on their desire.
How are they taxed?
The effects of taxes on these employee compensation – restricted stock and RSUs are both different as compared to the other kinds of stock options. The RSUs have tax consequences on the date of sale or exercise, while the restricted stock are taxable when the vesting schedule is completed. The complete amount of the stock that is vested is take as ordinary income in the vesting year for the restricted stock plans.
This amount is found by subtracting the exercise price or original price of the stock (which can also be zero) from the FMV of the stock on the date when the stock is completely vested. This difference has to be reported as ordinary income by the shareholders. Nonetheless, in case the shareholder sells the stock after holding on to it for a while, if there is any difference between the fair market value and the sale price on the vesting date, it is reported to IRS as a capital gain or loss and is taxed accordingly.
Tax effects on SARs
SARs (stock appreciation rights) offers the right financial equivalent of the rise in the value of a particularized amount of shares over a specific period. The SARs can be exercised at any time after they have been vested and are not normally issued together with stock options (either NSOs or ISOs). This is to assist in financing the purchase of the options and/or the payment of tax in case there is any due upon the exercise of the options. And it is due to this that the SARs are sometimes called “tandem SARs.”
The greatest advantage of this plan is the flexibility, which also acts as a challenge. The flexibility means that they can be designed in multiple way, but this leads in making many decisions about issues, like which person gets how many shares, the rules for vesting, rights to participate in corporate governance (if any), rights to interim distributions of earnings, eligibility, restrictions on selling shares (when awards are settled in shares), and liquidity concerns.
For SARs, when the right to benefit is exercised, that is when the employees are taxed. During this time, the value of the benefits minus any compensation paid for it (usually, there is none) is taxed as ordinary income to the employee. Moreover, this amount is deductible by the employer in their tax returns. In case the benefit is settled in shares, the total gain is taxable at exercise, even in case the shares have not been sold. Any following gain on the shares is taxed as capital gain.
Tax effects on ESPP, ESOP
The ESPPs and ESOPs are also a part of the employee compensation plans. Below are the details and effects of taxes on these employee compensation plans.
ESPPs is an employee stock purchase plan that is a program operated by a company through which the employees who participate can buy the shares of the company at a discounted price. The employees pay for the stocks through their payroll deductions, that is collected from the offering date to the purchase date. On the date of the purchase, the corporation would use the gathered amount to buy the shares on behalf of the participating employees.
The ESPPs come under two categories: qualified and non-qualified. The qualified ESP plans need the authorization of the shareholders before the plan is implemented and the participants get equal rights in the plan. For the qualified ESPP, the offering period is no more than 3 years and there are limitations on the maximum amount of discount that is allowed.
The non-qualified plans don’t have the same amount of limitations as the qualified plans. Nevertheless, the non-qualified plans don’t have any tax benefits of the after-tax deductions like the qualified plans have.
Furthermore, there are two stock sales from the qualified ESPP, and they are:
- Qualifying disposition – That has tax favorable treatments.
- Disqualifying Disposition – That does not have any tax benefits.
The qualifying dispositions has to meet two requirements:
- The stock has to be held for at least a 1-year period after the date of purchase.
- The stock has to be held for at least a 2-year period after the date of offering.
When the above two are met, the discount on the purchase price is reported as normal income, and for any of the excess profits that is between the sales price and purchase price, is taken as capital gain. On the other hand, the disqualifying disposition has a requirement where the spread has to be between the purchase price (with the discount added), and the closing price of the stock on the purchase date (despite whether or not there is a look-back period). This spread would be taken as ordinary income.
All in all, the taxation rules for ESPPs are complicated. Normally, the qualifying dispositions are taxed in the year when the stock is sold. And for any discount on the stock price, the discount amount is taxed as ordinary income. On the other hand, the remaining gain is taken as long-term capital gains and taxed accordingly. Unqualified dispositions can have the complete gain taxed at the ordinary income taxation rates.
ESOPs, known as the employee stock ownership plan is a qualified defined-contribution employee compensation plan that was created to fund principally in the stock of the sponsoring employer.
This means that the the company sponsoring the ESOP, the participants, and the selling shareholders would all get multiple tax benefits. And it is due to this, many companies usually use the ESOP plans as the corporate-finance strategy as well as to retain employees by aligning their interest with those of the shareholders.
There are multiple vital tax advantages, out of which the following are the most important:
- Employees don’t have to pay any tax on the contributions to the ESOP. They only need to pay tax on the distributions, which is at a highly favorable rate. This can be done by rolling over the distributions in an IRA or any retirement plan. But if the amount is touched before the retirement age, there is a penalty of 10%.
- Dividends can be used to have the tax deducted. It could be reasonably used to repay the ESOP loan, reinvested by employees or passed through to the employee, which is when it can be tax-deducted.
- The ownership percentage by the ESOP in S-corporations is not subject to the income tax at the federal level, and mostly at the state level too. In short, there is no income tax on the 30% of profits of an S-corporation with 30% of stock held by an ESOP holding, and no income tax on profits of the s-corporation completely owned by ESOP. But it has to be kept in mind that the ESOP has to get the pro-rata share, before the company makes any distributions to the owners.
- In an c-corporation, sellers can get a tax deferral. This is as soon as the ESOP owns 30% of the company shares, where the seller can reinvest sale’s profits in other securities. This would help defer any tax on the gains.
- ESOP can loan money to purchase shares and this amount is tax deductible, regardless of the use.
- Cash contributions made for ESOPs are tax-deductible.
- Contributions of stock are tax-deductible.
It should be noted that these contributions have particular limitations, although they usually never cause an issue for the business.
Now that you are clear with the taxes on employee compensation and the specific tax effects of each of these employee stock options, you are better informed about choosing the one that is most suitable for you and your business. Depending on the type of tax plan you choose, there are different tax benefits as well as disadvantages that you would encounter. Hence, it is better to choose the one that would be beneficial to both you as well as your employees.
Furthermore, there are various forms that need to be filed with the IRS when stock options are offered. For that, it is important to know all about the various forms and how you need to file them, so that you do not have to face penalties with the IRS. Check out the next articles if you are not sure what tax forms you need to file for your compensation plans that you are offering!