Investor? Employee? Role Determines Stock Option Tax

Receiving and exercising stock options will give a taxpayer a lot to consider.

When a person who is both an investor in and an employee of a corporation receives options to purchase stock in the corporation, the tax consequences of exercising the option depend on whether that person received the option in the role of investor or the role of employee.

When an employee exercises a nonqualified stock option, the employee recognizes compensation income based on the difference between the value of the stock at the date of exercise and the amount paid to exercise the option. The corporation receives a corresponding compensation deduction.

When an investor exercises an option to purchase stock, the investor does not recognize income. The investor's tax basis in the stock is the amount paid to exercise the option. The corporation receives no tax deduction.

The recent Tax Court case of Allen L. Davis, et al. v. Commissioner, TC Memo 2011-286, Dec. 12, 2011, involved the exercise of stock options by a shareholder-employee of an S corporation. At the date of exercise, the value of the stock exceeded the exercise price by $37 million.

Allen Davis, the shareholder-employee, did not report this amount as income, contending that the transaction was not compensatory to him. However, the S corporation deducted the amount as compensation paid to an employee.

The court concluded that the transaction should be considered compensatory in nature if there was any element of past, present or future compensation in the decision to award the options, regardless of what other noncompensatory reasons might be present.

Since the court found a compensatory element was present, it concluded that Allen must report the income and that the corporation was correct in claiming the compensation deduction.

Read more in TC Memo 2011-286.

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