Tax Advantages for the CEO with Stock
Stock options are often said to be granted to an
"employee" (but they usually aren't awarded to those who
clean the toilets or sweep the
floors). Usually the "employee" is
really the "boss" --- such as the CEO and other company
executives who sit on a corporation's board of directors. They grant
themselves (and each other) stock options.
Many times company stocks are repurchased in stock buy
backs by the company to drive up the stock's share price (less
outstanding shares), increasing the
value of the executive's stock options --- because just paying out dividends
costs more in taxes, whereas tax on capital gains is much less (here
the IRS better explains capital gains and here
the Wall Street Journal better explains stock buy backs).
There are three kinds of stock options: incentive stock options, employee stock purchase plan options, and non-statutory (nonqualified) stock options. Incentive stock options (pay
for performance) are the most popular and are on the rise (here
the Wall Street Journal better explains).
Stocks options often account for the CEOs (and others) major
share of their compensation, so when the say they are looking after
the shareholders, they usually are looking out for themselves (and
other large institutional investors, who may also share their seats
on each others board of directors.)
Incentive stock options (ISOs): The employer (the board of
a corporation) grants to the employee (usually the those on the
company board) an option to purchase stock in the employer's corporation, or parent or subsidiary corporations, at a predetermined price, called the
exercise price or strike price. Stock can be purchased at the strike price as soon as the option
vests (meaning, it becomes available to be exercised,
meaning, they have the right, but not the obligation, to buy or sell
the stocks at a specified price on-or-before a specified date in the
Strike prices are set at the time the options are granted, but the options usually vest over a period of
time (usually for at least one year and because long-term capital
gains are taxed less). If the stock increases in value, an ISO provides employees with the ability to purchase stock in the future at the previously locked-in strike price. This discount in the purchase price of the stock is called the
spread (see below).
ISOs are taxed in two ways: on the spread and on any increase (or decrease) in the stock's value when sold or otherwise disposed. Income from ISOs are taxed for
regular income tax and alternative minimum tax, but are
not taxed for Social Security and Medicare.
Employee stock purchase plan options (ESPPs): Through an ESPP, employees can invest in the company's stock at a discount. When you sell stock bought through an ESPP, your proceeds are divided into three categories, each with their own tax implications. Here's the break down.
- Return of capital: the amount you paid for the shares, which is
non-taxable since you already paid tax when you earned the money.
- Compensation income: the difference between the amount you paid for the shares and the market value of those shares on the purchase date. This represents the income you earned on the ESPP discount, and is
taxed at regular tax rates.
- Capital gain: the difference between your ESPP cost basis and your proceeds from the sale. This represents the income you earned by holding on to the stock. Capital gains are taxed at
capital gains tax rates (20% with a 3.8% surtax for ObamaCare©
to expand Medicaid.)
* How you split the profits between compensation income and capital gain depends on whether your sale is a "qualifying" or "disqualifying" disposition. Usually, qualifying dispositions will shift more of your profits into capital
gains. ( You will need tax attorney to crunch the numbers to your
Non-statutory (nonqualified) stock options: A type of employee stock option which is less advantageous for the employer from a tax standpoint than an incentive stock option (ISO), but which is less restrictive and generally easier to set up and administer. The most important difference is that the exercise of
ISO does not result in a tax burden, while the exercise of a
non-qualified stock option does (except in very specific circumstances).
Here is the "work-around" --- (From Forbes)
"Despite recognizing $1.7 billion in pre-tax book income in 2011,
Facebook anticipated that it would generate a net operating loss
in 2012. How was that possible? Through its employees’ exercise of nonqualified stock options, that’s how."
And Facebook will actually get a $451 million tax credit!
You have to hand it to those tax attorneys, and that's why the
tax code is over 70,000 pages long. But there are still some people
who are trying to convince me that most CEOs are paying the higher
marginal tax rates (and not the lower capital gains tax rate), and
that the CEOs are aren't getting over on anybody.
From IRS Publication 15B (2013) Source:
Wages for social security, Medicare, and federal unemployment taxes (FUTA) do not include remuneration
[compensation] resulting from the exercise of an incentive stock option or under an employee stock purchase plan option, or from any disposition of stock acquired by exercising such an option. The IRS will not apply these taxes to an exercise of an incentive stock option or an employee stock purchase plan option or to a disposition of stock acquired by such exercise.
Additionally, federal income tax withholding is not required on the income resulting from a disqualifying disposition of stock acquired by the exercise of an incentive stock option or under an employee stock purchase plan option, or on income equal to the discount portion of stock acquired by the exercise of an employee stock purchase plan option resulting from any disposition of the stock. The IRS will not apply federal income tax withholding upon the disposition of stock acquired by the exercise of an incentive stock option or an employee stock purchase plan option.
However, the employer must report as income the discount portion of stock acquired by the exercise of an employee stock purchase plan option upon disposition of the stock, and the spread (between the exercise price and the fair market value of the stock at the time of exercise) upon a disqualifying disposition of stock acquired by the exercise of an incentive stock option or an employee stock purchase plan option.
An employer must report the excess of the fair market value of stock received upon exercise of a
non-statutory stock option over the amount paid for the stock option (up to the social security wage base).
An employee who transfers his or her interest in non-statutory stock options to the employee's former spouse incident to a divorce is not required to include an amount in gross income upon the transfer. The former spouse, rather than the employee, is required to include an amount in gross income when the former spouse exercises the stock options.
* IRS SOURCES: See Revenue Ruling 2002-22 and Revenue Ruling 2004-60 for
details. You can find Revenue Ruling 2002-22 on page 849 of Internal Revenue Bulletin 2002-19 at
See Revenue Ruling 2004-60, 2004-24 I.R.B. 1051, available at
For more information about employee stock options, see sections 421, 422, and 423 of the Internal Revenue Code and their related regulations.
Source: IRS - http://www.irs.gov/pub/irs-pdf/p15b.pdf
unemployment, and household data for 2011
* Data on
Social Security disability (SSDI) from 1980 to 2012
gains data from the IRS for FY2007 - FY2011