1.861-19: Allocating Stock-Based Compensation Deductions

U.S. Treasury Regulation 1.861-19 provides a framework for multinational companies to allocate and apportion their deductions for stock-based compensation. The regulation’s core purpose is to match the deduction for employee compensation with the income generated by their work, attributing costs to the geographic locations where employees performed services. This process is a component of calculating a company’s foreign tax credit limitation, a mechanism under the Internal Revenue Code that prevents double taxation on income earned abroad.

For a company operating both in the United States and abroad, this means separating a single deduction amount into U.S. source and foreign source components. This allocation has direct financial consequences on a company’s global effective tax rate. The regulation governs how to determine the amount of the deduction, the time period over which the related services are performed, and how to divide the deduction based on where those services took place. In early 2025, the regulation was expanded to also provide rules for sourcing income from cloud computing transactions, though its stock-based compensation rules remain a focus for multinational companies.

Scope of Covered Compensation

The rules apply to various forms of stock-based compensation (SBC) where an employee receives equity as part of their pay. The specific character of the award determines certain aspects of the tax treatment, but they all fall under this allocation framework for foreign tax credit purposes. Common types include:

• Non-statutory stock options (NSOs). An NSO grants an employee the right to purchase company stock at a predetermined price, known as the exercise price, after a certain period of service. The employer’s deduction is the difference between the fair market value of the stock when the option is exercised and the exercise price.
• Incentive stock options (ISOs). These offer certain tax advantages to the employee. An employer generally does not receive a tax deduction for ISOs unless there is a disqualifying disposition, which occurs if the employee sells the stock before meeting specific holding period requirements. If a deduction does arise, it is subject to these allocation rules.
• Restricted stock units (RSUs). These are a promise by the company to grant an employee a specific number of shares at a future date, provided conditions like continued employment are met. The company recognizes a compensation deduction equal to the fair market value of the shares on the vesting date.
• Employee stock purchase plans (ESPPs). These plans allow employees to buy company stock, often at a discount, through payroll deductions. The discount element is treated as compensation and must be allocated.

Required Information for Allocation

To allocate its stock-based compensation deduction, a company must gather specific data for each grant. This information is necessary for compliance and substantiation. The primary document for each award is the grant agreement, which legally outlines the terms and conditions of the stock compensation. The necessary information includes:

• The grant date, vesting schedule, and specific vesting dates, which together define the service period.
• The number of shares or units included in each grant and the exercise price for stock options.
• The fair market value of the underlying stock on specific dates, such as the exercise date for options or the vesting date for RSUs, to determine the deduction amount.
• Comprehensive records of where the employee performed services during the service period, distinguishing between workdays in the United States and foreign jurisdictions.

The Grant-Based Allocation Method

The default method for allocating stock-based compensation deductions is the grant-based approach. This method links the deduction directly to the service period associated with a specific grant. The process begins by determining the total compensation deduction allowed for a stock award, which is recognized for tax purposes in the year the employee exercises a stock option or vests in an RSU.

The next step is to identify the applicable service period. Under the grant-based method, this period runs from the date the stock award is granted to the date it fully vests. For example, if an employee receives a grant of RSUs on January 1, 2023, that vests in full on January 1, 2026, the service period is the three-year period between those dates.

The company must analyze where the employee worked during that specific service period. The deduction is then apportioned between U.S. and foreign sources based on the ratio of workdays in each location. If the total deduction for an RSU grant is $90,000 and the employee worked two-thirds of the three-year service period in the U.S. and one-third in Germany, then $60,000 would be allocated to U.S. source income and $30,000 to foreign source income.

Consider an employee granted non-statutory options on 1,000 shares on March 1, 2022, with the options vesting on March 1, 2025. The employee exercises all the options on June 1, 2025, when the stock’s fair market value is $50 per share and the exercise price is $20 per share. The total compensation deduction for the company is $30,000 (($50 – $20) x 1,000).

During the three-year service period from March 1, 2022, to March 1, 2025, the employee spent 75% of their workdays in the U.S. and 25% in the United Kingdom. Consequently, the company would allocate $22,500 of the deduction to U.S. sources and $7,500 to foreign sources. This method requires tracking of employee work locations over multi-year periods, and the allocation is performed on a grant-by-grant basis.

Alternative Vest-Based Election

Taxpayers have the option to use an alternative method known as the vest-based election. This is a formal choice that, once made, must be applied consistently. Instead of looking back at the entire service period from grant to vest, this method focuses on the year of vesting. The allocation is based on the employee’s work location during the tax year in which the award vests.

This can simplify the tracking process, as the company only needs to analyze employee workdays for the vesting year rather than a multi-year period stretching back to the grant date. To make this election, a taxpayer must attach a statement to their timely filed original tax return for the first taxable year the election is to be effective. The election applies to all stock-based compensation awards with a vesting date in the election year and all subsequent years and cannot be applied on a grant-by-grant basis.

This method can be advantageous for companies where employee mobility is high or where historical tracking data is difficult to obtain. For example, if an RSU vests in 2025, the allocation would be based on the proportion of U.S. and foreign workdays in 2025 only, regardless of whether the grant was made in 2022. The choice between the grant-based and vest-based methods depends on a company’s specific facts, such as employee work patterns and record-keeping capabilities.

Record-Keeping and Documentation Requirements

Taxpayers must keep detailed records to substantiate the amount and apportionment of the stock-based compensation deduction. These records are the primary evidence used to defend the company’s tax position during an Internal Revenue Service (IRS) examination. The required documentation includes copies of all grant agreements, which specify the terms of each award, including grant dates, vesting schedules, and the number of shares.

Companies must also retain data supporting the fair market value of the stock used to calculate the deduction. This could include valuation reports or records of public market trading prices on the relevant dates. The taxpayer must also maintain robust records that track the location where employees performed their services, such as detailed calendars or travel logs.

If the taxpayer makes the vest-based election, a copy of the election statement filed with the tax return must be retained. All supporting calculations for the allocation of each grant should also be kept on file.