Many cash-strapped companies pay compensation in the form of company stock or stock option rather than cash. This method became popular when long-term employees of Internet start-up companies became millionaires via the stock holdings they accumulated in exchange for taking a smaller take-home pay check. The IRS views compensation in stock -- even it cannot be easily sold -- as income and expects to collect taxes on this income event.
The IRS expects you to report earnings on your taxes as ordinary income whether the compensation is in the form of cash or even company stock. If you have accepted stock, you can expect to pay taxes on the value of the services you performed. This is difficult if the stock you receive is worthless or has no active market or resale value, leaving you with a higher income tax liability that must be paid in cash despite accepting noncash payment for services. The picture is usually clearer when the stock received has an active market value on the stock exchange, since there is a definitive value and you can sell to obtain the cash for the income tax liability.
If you acquire stock as a full-time employee – whether it be through a stock grant or a stock option award – your employer may withhold the corresponding amount from your paycheck to cover the required withholding amount. This situation is sometimes exacerbated when the stock award is restricted and cannot be sold for at least one year or if you opted to exercise nonqualified stock options rather than lose them. You may find yourself holding stock you cannot immediately sell for cash and have a significantly lower paycheck to cover the withholdings. Some companies have plans to aid with this higher withholding burden, but often you may have to dip into savings or take out a loan to provide the IRS with the cash it is expecting.
Once you sell your stock, the IRS will expect you report the transaction on Schedule D regardless of its market value at the time of acquisition. For instance, if you accepted stock in a start-up company, you may have avoided paying income tax on the initial issuance of stock, but not the capital gains. The amount of capital gains is determined by subtracting the value of the stock at the time you acquired it from the gross proceeds you received from the sale. If the capital gains amount is negative, you may be able to deduct this amount when you file your taxes.
Alternative Minimum Tax
The alternative minimum tax (AMT) was designed to collect taxes from very wealthy filers or high earners who would take advantage of tax benefits to avoid paying taxes at all. This may be the most complex tax issue related to stock based compensation. This AMT can come heavily into play when exercising incentive stock options you received rather than cash for providing services. If the total difference between the exercise price – the amount you pay to buy the stock through the stock option – and the strike price is large enough, it may be trigger the AMT.
If cashing in on your stock options is a big financial win for you, the AMT may simply be a necessary evil as the IRS expects to tax you on all of your earnings. However, depending on the size of the gain and your income, you could end up with a significantly higher tax liability than you were expecting. The situation can be more dire if the stock options you exercised do not have an underlying resale market – leaving you unable to sell the stock to pay the AMT liability incurred from the transaction.
Many states impose an intangible tax on assets that are over certain thresholds. This tax is usually expressed in a form of a percentage of the total asset value. If you have received enough stock for services, depending on its value, you may find yourself over the intangible tax limit and be required to pay tax on this stock as well as on other intangible assets you own, such as other stocks, bonds or money market accounts.
- Fairmark: Withholding on Stock Compensation
- Morse Barnes-Brown Pendleton PC: Stock Options and Restricted Stock
- National Center for Employee Ownership: Stock Options and the Alternative Minimum Tax (AMT)
- Smart Money: The Alternative Minimum Tax (AMT)
- Fairmark: Top Ten Things that Cause AMT Liability
- Fairmark: Alternative Minimum Tax 101
- IRS: Schedule D
- IRS: Form 6251, Alternative Minimum Tax--Individuals