Why Does the Illinois State Tax Form Ask About Employer Security?

Illinois tax forms include a question about employer securities because stock-based compensation and investment income have unique tax implications. This applies to employees receiving company stock through options, restricted stock units (RSUs), or employee stock purchase plans (ESPPs), as well as those earning dividends or capital gains from employer stock. The state ensures these earnings are reported correctly to prevent errors that could lead to additional taxes or audits.

State-Level Qualification of Employer Stock

Illinois tax law treats employer stock differently based on how it is acquired and whether it meets state qualifications. The Illinois Income Tax Act generally follows federal tax principles but has its own rules for determining when and how employer stock is taxed.

For employees with incentive stock options (ISOs), Illinois conforms to federal tax treatment, meaning no state tax is due at exercise. However, if the stock is sold in a disqualifying disposition—such as selling before the required holding period—any income recognized may be subject to Illinois tax. Nonqualified stock options (NSOs) are taxed at exercise, with the difference between the exercise price and fair market value treated as Illinois-source income.

RSUs are taxed when they vest, not when granted. Employees must report the fair market value of the stock as income in the year of vesting, even if they do not sell the shares. If an employee relocates between the grant and vesting period, Illinois may only tax the portion earned while the individual was a resident.

ESPPs add another layer of complexity. If an ESPP meets Section 423 of the Internal Revenue Code requirements, the discount received at purchase is not taxed until the stock is sold. Illinois follows this federal treatment, but if the stock is sold in a disqualifying disposition, the discount portion may be considered Illinois taxable income.

Wage vs Investment Distinctions

Illinois tax law differentiates between wages earned from employment and investment income from holding securities. Compensation for services, such as salaries and bonuses, is categorized as earned income and subject to state income tax withholding. Investment income, such as capital gains, is taxed when realized—when a stock is sold or generates a return.

Stock-based compensation can blur the line between wages and investments. When employees receive stock options or RSUs, the value of these awards is considered part of their earnings. Illinois follows federal tax treatment in considering stock received as compensation to be taxable as ordinary income once it is no longer subject to forfeiture. If an employee must meet conditions like continued employment, the stock is not immediately taxable. Once those conditions are met, the fair market value of the stock is treated as income, even if the employee does not sell it.

Stock compensation that qualifies as earned income is also subject to Social Security and Medicare taxes under the Federal Insurance Contributions Act (FICA). This includes NSOs and RSUs when they become taxable. However, investment income, such as capital gains from selling stock, is not subject to payroll taxes.

Dividends vs Capital Gains

Owning employer stock can generate income through dividends and capital gains, which have distinct tax treatments under Illinois law.

Dividends are distributions of a company’s earnings to shareholders, typically paid quarterly. Illinois follows federal tax rules in treating qualified dividends as taxable income but does not offer a lower tax rate on them. While the IRS taxes qualified dividends at long-term capital gains rates, Illinois taxes all dividend income at the state’s flat income tax rate of 4.95% (as of 2024).

Capital gains are realized when an employee sells shares for more than their purchase price. The taxable gain is determined by subtracting the stock’s cost basis—typically the original purchase price or the fair market value when acquired—from the sale price. Unlike the federal system, which distinguishes between short-term and long-term gains, Illinois taxes all capital gains at the same 4.95% rate, regardless of the holding period.

Employees who reinvest dividends through a dividend reinvestment plan (DRIP) must still report them as taxable income in the year they are issued, even if the dividends are used to buy more shares instead of being received as cash.

Documentation for Share Transactions

Accurate record-keeping is essential when dealing with employer stock, as Illinois tax authorities may require documentation to verify income calculations. Employees should maintain brokerage statements detailing stock purchases, sales, and transfers. These statements typically include trade dates, purchase prices, and proceeds from sales, all necessary for determining taxable income. Without these records, employees may struggle to substantiate their cost basis, potentially leading to higher tax liabilities.

Form 1099-B, issued by brokerage firms, reports proceeds from stock sales and whether cost basis information was provided to the IRS. While brokers must report cost basis for most stock acquired after 2011, employees should verify that their records align with what is reported. Any discrepancies can lead to errors on state tax returns, potentially triggering an audit. Employees who receive employer stock through direct issuance rather than a brokerage account may need to rely on grant agreements or employer-provided statements to establish their cost basis and holding period.

Adjustments for Stock-Based Compensation

Illinois tax law requires specific adjustments for stock-based compensation, particularly when state and federal tax treatment differ. Employees who receive stock options, RSUs, or other equity compensation must ensure they correctly adjust their Illinois taxable income.

One common adjustment involves stock option deductions. Under federal law, employers can deduct the compensation expense associated with nonqualified stock options when exercised. However, Illinois disallows this deduction when calculating state taxable income, meaning employees may need to adjust their reported wages.

If an employee relocates between the grant and vesting period of RSUs, Illinois may require an apportionment of income based on the time spent working in the state. This can reduce taxable income for individuals who moved out of Illinois before their stock vested.

Illinois also mandates certain additions and subtractions to federal adjusted gross income (AGI) when calculating state taxable income. For example, if an employee receives stock as compensation and later donates it to charity, the federal deduction for the charitable contribution may not be fully recognized at the state level.

Nonresident and Part-Year Filers

Employees who live outside Illinois or move in or out of the state during the tax year face additional complexities when reporting employer stock transactions. Illinois taxes income earned within the state, meaning nonresidents and part-year residents must determine how much of their stock-based compensation is attributable to Illinois.

For nonresidents, the key issue is whether income from employer stock is sourced to Illinois. If stock options were granted while the employee worked in Illinois but exercised after relocating, the state may still claim a portion of the income as taxable. The apportionment formula typically considers the time spent working in Illinois during the vesting period relative to the total time before exercise. An employee who worked in Illinois for half of the vesting period may owe state tax on 50% of the income from the exercised options.

Part-year residents must allocate their stock-based income based on their residency status during the year. If an employee moves out of Illinois before RSUs vest or before selling employer stock, only the portion earned while a resident is subject to Illinois tax. Proper documentation, such as employment agreements and stock grant details, is necessary to substantiate residency-based allocations and avoid potential disputes with Illinois tax authorities.