“No soup for you!”
- Let’s start with a great key employee that we are very interested in retaining. We will call him Steve.
- Let’s grant Steve nonqualified options for 50,000 shares. Steve can buy stock at $10/share. As the stock is presently selling at $20/share, this is a good deal for Steve.
- But Steve cannot buy the stock right now. No, no, he has to wait at least 4 years, then he has six years after that to exercise. He can exercise once a year, after which he has to wait until next year. He can exercise as much of the stock as he likes, up to the 50,000-share maximum.
- There is a serious tax trap in here that we need to avoid, and it has to do with Steve having unfettered discretion over the option. For example, we cannot allow Steve to borrow against the option or allow him to sell the option to another person. The IRS could then argue that Steve is so close to actually having cash that he is taxable – right now. That would be bad.
Steve has federal income tax withholding.
Steve has FICA withholding.
Steve has state tax withholding.
Where is the cash coming from for all this withholding?
The easiest solution is if Steve is still getting a regular paycheck. The employer would dip into that paycheck to take out all the withholdings on the option exercise.
It may be that the withholdings are so large they would swamp Steve’s regular paycheck. Maybe Steve writes a check to cover the withholdings.
COMMENT: If I know Steve, he is retiring when the checks clear.
How about the employer?
Steve’s employer has a tax deduction equal to the income included on Steve’s W-2.
The employer also has employer payroll taxes, such as:
Let’s be honest, the employer payroll taxes are a drop in the bucket compared to Steve’s income from exercising the option.
Why would Steve’s employer do this?
There are two reasons. One is obvious; the second perhaps not as much.
One reason is that the employer wants to hold onto Steve. The stock option serves as a handcuff. There is enough there to entice Steve to stay, at least for a few years.
The second is that the employer manufactured a tax deduction almost out of thin air.
How many shares did Steve exercise?
What was the bargain element in the option exercise?
$110 - $10 = $100. Times 50,000 shares is $5,000,000 to Steve.
How much cash did the employer part with to pay Steve?
Whatever the employer FICA, federal and state unemployment taxes are – undoubtedly a lot less than $5,000,000.
Tax loophole! How Congress allow this? Unfair! Canadian football!
To my way of thinking, Steve is paying taxes on $5,000,000, so it is only fair that his employer gets to deduct the same $5,000,000. To argue otherwise is to wander into the-sound-of-one-hand-clapping territory.
But, but … the employer did not actually pay $5,000,000.
I admit: so would I. I would frame the check. After I cashed it. It would also be my Christmas card every year.
You are starting to understand why Silicon Valley start-up companies like nonqualified stock options. Their cost right now is nada, but it can be a very nice tax deduction down the road when the company hits it big.
I suspect that Soupman, Inc did something like the above.