US Tax Treatment: Stock Options from Your Foreign Employer

With more and more expatriates working outside the United States, many tax questions arise when an employee is given options to buy stock in the foreign company employer.  Stock options are increasingly becoming an important element of the international executive’s compensation package.  There are wonderful opportunities to be had with stock options, but there are also tax traps involved especially in the international context.  Before digging in, let’s set out some basics.

First, a“non-statutory stock option” is different from what is called a “statutory” stock option. “Statutory” stock options must meet very specific requirements under the US tax law and I have never seen one involved in the context of a foreign employment. A “non-statutory stock option” is what most employees working abroad will receive from their non-US employers as part of their compensation package.  This post will look only at tax issues involved with a non-statutory stock option.

There are different rules with regard to tax consequences when an employee is granted a stock option and when the employee purchases the shares underlying the option through his exercise of that option.  These are set out below.

Grant of Option

If a non-statutory option does not have a so-called “readily ascertainable fair market value” (“FMV”) at the time of the grant, the employee generally does not realize compensation income until the time he exercises that option.  With non-publicly traded companies the options granted generally would not have a readily ascertainable FMV within the meaning of the relevant tax rules. See Treas. Reg. Sec. 1.83-7(a)-(b).  Therefore, in simple terms, when a US taxpayer is granted such options by his employer he is generally not considered to have received compensation income that he would have to report on his tax return.  There is an important caveat to this general rule – a serious possible tax trap lies in Code Section 409A, dealing with nonqualified deferred compensation, which is outside the scope of today’s blog post.  Briefly, Section 409A can apply whenever there is a “deferral of compensation.” Such a deferral occurs when an employee has a legally binding right during a taxable year to compensation that is or may be payable in a later taxable year.  Section 409A issues can arise with the grant of options.

Exercise of Option (Buying the Stock)

In the usual case, the employee will realize ordinary income (compensation income) at the time he exercises such an option.  This is equal to the excess of the FMV of the stock acquired at exercise over the option price paid by the employee.   The foreign earned income exclusion may be applicable to this income assuming the services to which the option relates were performed abroad, since the bargain element inherent in the stock is a kind of “foreign earned income”  – that is, income earned for personal services performed in a foreign country.  Be aware that the sourcing of income for stock options is complicated, however, and depends on a facts and circumstances approach. 

Substantially Nonvested

If the stock purchased by the employee is considered “substantially nonvested” then the employee will not be taxed at the time he exercises the option.  See Treas. Reg. Section 1.83-3(b).  In order for the stock to be considered “substantially nonvested”, two requirements must be met.  The stock must be : (i) “restricted” so as to be “subject to a substantial risk of forfeiture” and (ii) nontransferable.  If these are met, then the employee will not be taxed at the time he exercises the option, but rather, later at the time that either one of those restrictions disappears.  (Please note, only one must disappear, not both, in order to trigger the time of taxation).  The tax will be based on the spread at that later time between the FMV of the stock over the option price paid for the stock (if any).  Assuming the value of the stock has risen in the meantime, the employee will pay higher tax.  This is so  because he will have more compensation income and compensation income is treated and taxed as ‘ordinary income’ with a current maximum rate of 37%. 

In contrast, when the employee realizes income at the time he exercises the option (this would happen because the stock he acquired by exercising the option is not “substantially nonvested”), he would acquire a basis in the stock equal to the FMV of the stock at that time. When the stock is later sold, any future appreciation after the exercise date would generally be taxed as capital gain.  Capital gain rates are very favorable when compared to “ordinary income” tax rates if the gain is taxed as “long term” capital gain (generally at top rates of 15% or 20%). 

A Later Sale of the Stock

Here is what the Internal Revenue Service (IRS) has to say on the issue (page 16 IRS Pub 54):

“Stock options. You may have earned income if you disposed of stock that you got by exercising a stock option granted to you under an employee stock purchase plan. If your gain on the disposition of stock you got by exercising an option is treated as capital gain, your gain is unearned income.  However, if you disposed of the stock less than 2 years after you were granted the option or less than 1 year after you got the stock, part of the gain on the disposition may be earned income. It is considered received in the year you disposed of the stock and earned in the year you performed the services for which you were granted the option. Any part of the earned income that is due to work you did outside the United States is foreign earned income.”

Code Section 83(b) Election

Code Section 83 provides an election through which the employee can change the tax result and pay tax at the time restricted stock is granted rather than at the time of stock vesting.

The election is possible only if the stock he purchases at exercise of the option is, as stated above, “substantially nonvested” (that is, (i) restricted and (ii) nontransferable).   Making the election requires the employee to pay ordinary income tax in the year he exercises the option even though the stock he receives is still restricted and nontransferable (i.e., the (i) and (ii) requirements are satisfied).  Tax is based on the excess of the FMV of the stock at the time of exercise over the amount paid for it.   (The election is still available even if the employee pays full value and there is no bargain element involved.  Treas. Reg. Sec. 1.83-2(a)).  The employee receives a tax basis in the property equal to the FMV at the time of the transfer.  When the restrictions on the stock disappear, the employee pays no additional tax.  When the stock is later sold, any additional appreciation is treated as capital gain.

The advantage of the Section 83(b) election is that it allows the employee (once he has paid ordinary income tax on any “bargain” received at the time of transfer of the stock to him when he exercises the option) to treat the stock as a capital investment for tax purposes.  As a result, he controls the “timing” of future tax consequences which occur when he sells the stock later on. If the sale is at a gain, the individual receives capital gain treatment on that appreciation .  This is a big advantage since long term capital gain rates are much lower than ordinary income rates. 

The downside of the election is that the employee must pay tax up front assuming the value when he exercises the option is higher than the price he pays for the stock.  If the stock does not go up in value later on, but takes a downturn instead, the employee can possibly end up paying more tax than he would have otherwise paid when the stock vests.  

Posted May 18, 2023

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