Stock Option Income-Double Taxed Income

Posted: 3 Feb 2003

Abstract

Taxpayers who have been compensated with employee stock options and their counsel should pay mind to the risks of double taxation from the overlapping jurisdictional claims to the gains derived from that compensation. Some observers may predict this concern will diminish with declining Internet start-ups, which frequently paid employees in such options, and the faltering bull market, which triggered the exercise of such options. Nevertheless, as audits progress for tax returns for 1999, 2000, and 2001, clients and practitioners who dislike taxes, especially paying the same tax twice, need to be aware of the potential for issues to arise during these audits.

To conceptualize these issues, imagine a corporation grants 10,000 nonstatutory stock options to an employee on December 1, 2001. Assume, the corporation is based in State A and the employee resides in State B. On December 1, 2004, three years later, the employee retires from the corporation and moves to State C. While a resident of State C, the former employee exercises all 10,000 options. Unhappy with the retirement community in State C, the former employee relocates to State D on January 1, 2005 and sells the stock to a third party.

Analysis of potential jurisdictions that may tax the gain on the options requires considering: State A, the state where the employee performed services; State B, the state in which the employee resided when the corporation granted the stock option; State C, the state in which the employee resided when the stock options were exercised; and State D, the state in which the employee resides when the stock is ultimately sold. Advanced planning and record keeping will be critical elements in mitigating and possibly eliminating these concerns. This Article serves as a first step for practitioners to become aware of the issues they may face and to provide guidance on how to avoid these issues.

Part II of this Article provides an overview of the different types of stock options provided to employees and the general federal and state and local rules concerning the taxation of such options. It is important to note that this Article limits its scope to the personal income tax consequences of stock options to employees, but employers are affected as well due to states' withholding tax rules. Employers may have to withhold employment taxes for multiple states and localities, which proves difficult because they may be unaware of the individuals change in residence after retirement or otherwise.

Part III of this Article highlights the pitfalls of employee stock options with two examples of how taxpayers may be affected by the dueling state and local tax regimes of New York and California, and then Illinois and Connecticut. This Article concludes with Part IV recommending how practitioners can avoid double taxation and how federal and state officials could remove the possibility altogether.

Suggested Citation

Silverman, Debra L., Stock Option Income-Double Taxed Income. Available at SSRN: https://ssrn.com/abstract=337541

Debra L. Silverman (Contact Author)

Roberts & Holland LLP ( email )

Worldwide Plaza, 825 Eighth Avenue
New York, NY 10019-7416
United States

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