Section 421: Tax Treatment for Employee Stock Options

Section 421 of the U.S. tax code governs the rules for employees who receive stock options, allowing for favorable tax outcomes if certain conditions are met. The tax treatment depends on the type of stock option plan and the employee’s actions after receiving and exercising the options. Tax implications can occur when options are granted, when they are exercised to purchase shares, and when the acquired shares are sold.

Qualifying Stock Option Plans

For employees to receive tax treatment under Section 421, stock options must be granted through either an Incentive Stock Option (ISO) plan or an Employee Stock Purchase Plan (ESPP). These plans have distinct requirements outlined in Sections 422 and 423 of the Internal Revenue Code, respectively.

Incentive Stock Option plans are often offered to key employees. For an ISO plan to qualify, it must be a written document approved by the company’s shareholders within 12 months before or after the plan’s adoption. The plan must specify the maximum number of shares that can be issued and which employees are eligible to receive them. The exercise price of the option must be at least the fair market value (FMV) of the stock on the day the option is granted.

The value of ISOs an employee can receive is also limited. The aggregate fair market value of stock for which ISOs are first exercisable in any calendar year cannot exceed $100,000, valued at the time of the grant. Any amount over this limit is not treated as an ISO. Furthermore, the option must be exercised within 10 years from the date it is granted.

Employee Stock Purchase Plans are broad-based and offered to most employees of a company. Like ISOs, an ESPP must be a written plan approved by shareholders. It allows employees to purchase company stock at a discount, which can be up to 15% of the stock’s fair market value. The plan must prevent any employee who owns 5% or more of the company’s stock from participating, and no employee can accrue the right to purchase more than $25,000 of stock per calendar year, based on the FMV at the grant date.

Employee Holding Period Requirements

To secure the tax treatment of Section 421, an employee who acquires stock through a qualifying plan must adhere to holding period requirements. These rules dictate how long the employee must own the shares after the option is granted and after it is exercised. Failing to meet these timeframes results in a loss of preferential tax status.

There are two holding periods that must both be satisfied. First, the employee must not sell the stock within two years from the date the option was granted. Second, the employee must not sell the stock within one year from the date they exercised the option to purchase the shares. Both conditions must be met for the sale to be a “qualifying disposition.”

For example, an option is granted on January 1, 2023, and the employee exercises it on June 1, 2024. To meet the requirements, the employee cannot sell the shares before June 1, 2025 (one year after exercise) and also not before January 1, 2025 (two years after grant). Since the one-year-from-exercise date is later, the employee must hold the shares until at least June 1, 2025.

The sale of stock before both of these holding periods are complete is known as a “disqualifying disposition,” which has different tax consequences.

Tax Consequences of a Qualifying Disposition

When an employee meets both holding period requirements, the sale of the stock is a qualifying disposition, leading to specific tax outcomes. At the grant date, when the employee first receives the option, there is no regular tax event and no income is recognized.

At the exercise date, when the employee purchases the shares, no income is recognized for regular tax purposes for a qualifying ISO or ESPP. However, the exercise of an ISO can trigger the Alternative Minimum Tax (AMT), a separate tax calculation for certain individuals. The difference between the stock’s fair market value on the exercise date and the price the employee paid (the “bargain element”) is considered income for AMT purposes.

If an employee pays AMT due to an ISO exercise, they may be able to claim an AMT credit in future years to offset their regular tax liability. This credit can be used in years when their regular tax is higher than their AMT.

Finally, when the stock is sold after the holding periods are met, the transaction is treated as a long-term capital gain. The gain is calculated as the difference between the sale price and the exercise price paid for the shares. Long-term capital gains are taxed at lower rates than ordinary income.

Tax Consequences of a Disqualifying Disposition

A sale of shares before satisfying both the two-year from grant and one-year from exercise holding periods is a disqualifying disposition. This action changes the tax treatment, causing a portion of the profit to be taxed as ordinary income rather than as a capital gain.

For a disqualifying disposition of shares from an ISO, the amount of ordinary income is the lesser of two amounts: the fair market value of the stock on the exercise date minus the exercise price (the “bargain element”), or the final sale price minus the exercise price. Any additional gain is treated as a capital gain, which will be short-term or long-term depending on whether the stock was held for more than one year after the exercise date.

For example, an employee exercises an option to buy stock at $10 per share when its fair market value is $30. Six months later, they sell the stock for $35 per share. The bargain element is $20 ($30 FMV – $10 exercise price), and the total gain on the sale is $25 ($35 sale price – $10 exercise price). The ordinary income is the lesser of these two figures, which is $20, and the remaining $5 is a short-term capital gain.

For a disqualifying disposition of shares from an ESPP, the amount treated as ordinary income is the difference between the stock’s fair market value on the purchase date and the discounted price the employee paid. Any additional gain is a capital gain. The employer must report the ordinary income portion on the employee’s Form W-2.

Reporting to the IRS

Properly reporting transactions from employee stock option plans involves several forms for both the employer and the employee. The employer provides informational forms to the employee, who then uses that information to complete their tax return.

For the exercise of an ISO, the employer must send the employee Form 3921, Exercise of an Incentive Stock Option. For stock purchased through an ESPP, the employer provides Form 3922, Transfer of Stock Acquired Through an Employee Stock Purchase Plan. These forms report information such as the grant date, exercise price, and the fair market value of the stock on relevant dates.

The employee uses the information from Form 3921 or 3922 to report the sale of the stock on Form 8949, Sales and Other Dispositions of Capital Assets. It is important to correctly calculate the cost basis, which may need to be adjusted to include any ordinary income recognized in a disqualifying disposition. The totals from Form 8949 are then carried over to Schedule D, Capital Gains and Losses, which is filed with Form 1040.

If the exercise of an ISO resulted in an AMT liability, the employee must also file Form 6251, Alternative Minimum Tax—Individuals, for the year of exercise. To claim a credit for AMT paid in a prior year, the employee uses Form 8801, Credit for Prior Year Minimum Tax.