Tax Analysts Blog

Managing the Tax Consequences of Equity Compensation Awards

Posted on Oct 1, 2014

Many public corporations and even some closely held businesses use equity-based compensation awards to attract, motivate, and reward employees. Equity-based compensation includes nonqualified and incentive stock options, restricted stock units, stock appreciation rights, performance shares and units, and dividend equivalent units. Equity compensation allows high-performing employees to share in the profits of the business. That compensation also encourages long-term relationships with the business because many equity compensation plans must vest before the employee receives income from the award. Unvested portions are forfeited if the employee does not meet required performance goals or if employment is terminated before the vesting period is up.

Although equity-based compensation plans may seem like good incentives to employees because they create an ownership culture, they do not come without burdens. In addition to the administrative work of properly structuring an equity compensation plan, there are federal and state tax responsibilities for both the corporation and the employee. Equity-based compensation plans are valuable motivation and retention tools for employers, but can be cumbersome and costly if the tax consequences are not properly addressed.

For example, because of the vesting requirements for most types of equity compensation, awards will be based on an employee's service over several years. During those years, employees may move or be transferred from one state to another. Employees may also regularly work in more than one location. Those moves create compliance burdens for the employer, which is required to withhold state individual income tax for both the state in which the employee is a resident and any other states to which income may be sourced. To properly do so, the employer must know the residency status of employees as well as where employees worked every day during the compensable period that each equity compensation award covers. Many employers lack internal procedures to do that. Many employers also do not have sufficient procedures to properly comply with the patchwork (or absence) of state rules regarding equity compensation.

Still, equity-based compensation is an attractive compensation tool for both public and private companies. Recently, at least two companies have announced services related to equity awards. Institutional Shareholder Services Inc. launched a data verification portal for equity-based compensation plans. TD Ameritrade Inc. announced a partnership with Equity Administration Solutions Inc., a firm that provides cloud-based solutions for the management of equity compensation. While decidedly different, both of these solutions are designed to provide companies and shareholders more flexibility and transparency in managing equity compensation.

As solutions like these are developed, more information will be available to corporations, shareholders, and taxing authorities. From a state tax perspective, employers and employees must be mindful of the nonresident income tax and withholding requirements that may be triggered by an equity-based award.

For example, withholding is generally required when a taxable event occurs from an equity award. A taxable event happens when an equity award is fully vested and payable or when a stock option is exercised. The employee's state of residence when the taxable event occurs will tax any compensation received and the employer would be required to withhold income tax in that state, but if the income from the equity award is attributable to services performed in another state or in multiple states, the employer may also be required to withhold income tax in those states.

That scenario can be particularly difficult for employers because managing nonresident withholding can be administratively onerous. Large organizations and those with employees who frequently travel for work have difficulty tracking the number of days each employee spent in various jurisdictions. Employers also have to keep track of law changes in each state in which they are required to withhold for any employee.

Although states have not historically been aggressive in going after nonresident individuals with equity-based compensation awards, that may change. Some states are still working with tight budgets and most are routinely looking for ways to generate additional revenue. Although practitioners don’t agree about the level of enforcement in the states in this area, it is something that bears watching. States may question whether to follow federal AGI for purposes of calculating an individual's state taxable income. They may also contemplate how income is defined or focus more on exactly how income is being reported on a taxpayer's W-2. All of which leads to the conclusion that employers and employees should be on the lookout for more focus by states on equity compensation.

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