Coming to America: avoiding US tax disasters on stock options

September 2020 | SPOTLIGHT | CORPORATE TAX

Financier Worldwide Magazine

September 2020 Issue

Among the most common forms of equity award granted by multinational companies are stock options, which give employees and other service providers the economic benefit of the increase in value of the company’s stock over a base (or ‘exercise’) price. Options are popular, in part, because they provide direct alignment between pay and company performance, at least as measured by changes in stock price. Unfortunately, granting options can have surprising and unintended US tax consequences if timely and proper attention is not paid to managing option grants to US taxpayers. This article provides an overview of the critical US tax consequences associated with option grants to prospective US taxpayers and suggests strategies for maximising the benefit of the award and avoiding potential penalties.

Background

US income tax rules divide options into two categories – tax-favoured incentive stock options (ISOs) and nonqualified options. While ISOs provide the potential for more favourably taxed capital gain treatment, there are significant technical requirements that need to be satisfied and many multinational option arrangements will not meet those requirements. As a result, many option grants by multinational companies will end up taxed in the US as nonqualified options.

Nonqualified options are generally not subject to US tax until exercise. At exercise, income inclusion is based on the spread between the exercise price and the fair market value of the underlying stock. The spread is taxed as compensation income – that is, ordinary income tax plus employment taxes. Further appreciation or depreciation is taxed at capital gain rates. If an individual is a non-resident alien on the date of exercise – that is, not a US citizen or green card holder and not residing in the US for a certain number of days during the year – the spread amount included at exercise is prorated under the so-called ‘lookback’ rule, based on the number of working days spent in the US during the vesting period. Under the lookback rule, workers who have no other contact with the US, except for time spent in the US during the vesting period, are subject to US tax, even if the option is neither granted nor exercised while the individual is in the US.

Overlaying these rules are a set of complicated tax requirements that nonqualified options be designed and administered in a way that is either exempt from or compliant with US Internal Revenue Code Section 409A. If an option is subject to, but not compliant with, Section 409A, the option holder recognises compensation income each year as the option vests and thereafter until the date of exercise or the date the option expires, if earlier, on the difference between the exercise price and the 31 December fair market value of the stock (or the fair market value on the date of exercise or expiration, if earlier), less any amount previously included in income. The amount included in income is also subject to a 20 percent excise tax and an additional premium interest penalty tax.

The interaction between Section 409A and the lookback rule is unclear. It appears, absent guidance from the US Internal Revenue Service (IRS), that non-residents who come to the US during the vesting period could be subject to Section 409A penalties, even if they return to their home country prior to exercising the option. And because Section 409A requires that the full spread amount be included in income, an option holder may not obtain the benefit of the favourable proration the lookback rule provides if an option violates Section 409A.

Problems for multinational companies

Multinational companies may not be aware of or think to consider US tax consequences when establishing equity compensation plans, and many features common to their option plans are problematic under Section 409A – including using an exercise price below ‘fair market value’ (generally as determined by a third party, independent valuation or in the case of a publicly traded company, the public price) as of the date of grant (generally, the date of board action) and providing for a reduction in the exercise price for regular cash dividends or distributions. The situation is made more difficult in that many multinational companies are not aware of which service providers are, or might become, subject to US tax.

To further complicate matters, once an option is granted, and particularly once it begins to vest, it is often not possible to make adjustments to avoid negative tax consequences under Section 409A. The IRS’s position is that an option that violates Section 409A by its terms cannot be fixed, unless action is taken in the year prior to the year the option begins to vest, or through a formal, and relatively unhelpful, correction programme. That said, where a vested option granted to a US non-resident is modified prior to the individual coming to the US, there is a good argument that the option should be treated as compliant with, or exempt from, Section 409A, although there is no guidance from the IRS on this position.

Strategies for multinational companies

The following strategies may be useful in avoiding adverse US tax consequences if the action is taken before vesting or prior to the holder becoming subject to US tax.

Cancel and grant a new option. One alternative is to cancel the existing option and grant a new option. If the original option is underwater (exercise price above fair market value), the new option can either use the original exercise price or be repriced to current fair market value, although repricing may present accounting and securities law concerns and must be permitted under the equity plan. For in-the-money options (exercise price below fair market value), the new option would need to keep the original exercise-price to preserve the built-in gain. While granting an option with an exercise price below fair market value can be problematic under Section 409A, it is possible to do so (within limits) with a carefully structured option that is exercisable only on pre-specified dates permitted under Section 409A. This includes, for example, on termination of employment, on a change in control or in a particular year. While this approach limits the optionee’s ability to choose when to exercise, the experience of many (particularly private) companies is that most option holders exercise only on one of these events in any case.

Cancel and grant restricted stock. Another strategy is to cancel the original option and issue restricted stock subject to the same vesting requirements as the option. While a restricted stock grant removes the optionality of when and whether to receive equity, a stock award is not subject to Section 409A. Although not necessary, the company could adjust the number of shares and consider requiring payment for the stock at the exercise price of the original option. If payment presents a cashflow problem, the company may, subject to securities law requirements, loan the money using a partially recourse note. If the stock is awarded subject to restrictions, the holder can make a so-called Section 83(b) election within 30 days of the grant and include the value of the stock as compensation income (less any amount paid) at grant. If the election is made while the holder is a non-resident, this avoids US tax on compensation altogether. Otherwise, as the stock vests, the holder will recognise compensation income based on the then fair market value of the stock (after application of the lookback rule).

Reprice. For options that are otherwise exempt from Section 409A but for a failure to meet the rigorous fair market value requirements, one alternative may be to reprice the option to the fair market value as of the original date of grant, if permitted under applicable accounting, securities law and equity plan rules. While under Section 409A repricings are generally viewed as new grants for which the exercise price must be determined as of the date of the repricing, repricing to the original grant date value should generally be permitted prior to the year of vesting. Whether a repricing avoids negative US tax consequences after vesting but before coming to the US is an open question.

Accelerate vesting and exercise. One final approach is to accelerate vesting and have the option holder exercise prior to becoming subject to US tax. While this approach does not correct Section 409A failures for US citizens and residents, it should avoid adverse tax results for non-residents who later become subject to US tax. As long as the option holder does not work in the US during the vesting period, the lookback rule will provide that none of the option income is subject to US tax. And if the non-resident is not subject to US tax jurisdiction while the option vests, Section 409A penalties described earlier should not apply. For this approach to work, however, it is not sufficient to only accelerate vesting. Rather, the option holder must also exercise prior to entering the US, since a vested option that violates Section 409A by its terms would, at least absent further guidance from the IRS, become immediately taxable under Section 409A and subject to its penalty provisions.

Conclusion

While the US tax regime presents many ‘traps’ for multinational companies, with careful, advanced planning there are ways to avoid negative consequences with options that might not otherwise be exempt from or compliant with Section 409A. The timing of implementing these strategies is critical. Once the option is vested and the employee is subject to US tax jurisdiction (as a citizen, green card holder, resident or non-resident working in the US), the IRS is generally unforgiving in allowing issues to be resolved.

Amy E. Sheridan is a partner at Sullivan & Worcester. She can be contacted on +1 (617) 338 2897 or by email: asheridan@sullivanlaw.com.

Amy E. Sheridan

Sullivan & Worcester