How Employee Mobility Affects Taxation of ISOs and ESPPs

A discussion on state-to-state mobility and Incentive Stock Options (ISOs) disqualifying dispositions on the discussion forum inspired me to revisit the issue of qualifying plans and mobility in this Blog.

Mobile employee compliance may be tricky enough on its own, but when an employee with an award from a tax-favorable plan is mobile, the taxation is even trickier because the favorable tax treatment of their awards is only applicable to one country (usually the origin country). Although the tax benefits are specific to each type of plan and country, in general, most qualifying stock plans are taxed when the underlying shares are sold. When an employee is granted a tax-qualifying award and then relocates to another country, typically the tax benefits are not recognized in the new location. Shares may need to be sold to cover taxes, which could lead to a tax event in the original country.

ISOs, ESPPs, and Section 6039 Filings

Let’s start with the timely topic that I get asked about every January. As you are aware, Forms 3921 and 3922 are informational filings that report the exercise of Incentive Stock Option (ISOs) and the transfer of shares under a Section 423 (ESPP) plan. These filings are “all or nothing.” The number of shares reported for mobile employees are not prorated for these filings.

Forms 3921 and 3922 are not required if:

1. The employee is a nonresident alien for the entire calendar year (i.e. resident outside the United States for the year and who is not a US citizen or green card holder),
   and
2. The company is not required to issue a W-2 for the individual from the date of grant to the date of exercise.

This exception is very narrow. In general, if the employee worked in the United States between the grant and exercise (or purchase), the company will be required to issue a 3921 or 3922 and the full number of shares must be included.

Background: US Taxation of Mobile Employees

The United States has adopted the Organization for Economic Cooperation and Development’s recommended income sourcing methodology for stock options. Under this method, compensation earned by nonresidents in connection with their options is taxed based on the number of days they worked in the United States during the vesting period of the options. For more information on sourcing, see “How to Source Equity Comp Income for Mobile Employees.”

For employees who hold tax-qualified awards and move during the period that these rights vest, this sourcing methodology applies to any ordinary income recognized upon disposition of the shares acquired under the arrangement.

In addition, the United States taxes citizens, green card holders, and residents on worldwide income. Accordingly, any ordinary income recognized by these individuals upon disposition of ISO or ESPP shares should be fully reported on Form W-2.

ISOs and Mobility

When an employee with an ISO grant transfers from the United States to another country, all else being equal, the ISO does not lose its tax qualifying status. The employee can still receive US tax favorable treatment; however, this treatment does not extend to the other country where they are now resident (unless the award also qualifies for tax favorable status in the other country). Many countries will tax ISOs at the time of exercise in the same manner as non-qualifying stock options.

If a non-US resident employee has a disqualifying disposition, for example, if the employee sells shares to cover non-US withholding on the ISO, then the amount reported on the W-2 should be prorated and only the US sourced income reported. Here are a couple examples of how the sourcing rules work in practice:

• If the employee moved out of the United States after 75% of the vesting period had elapsed (assuming a single vesting tranche) 75% of the ordinary income recognized upon disposition should be reported on Form W-2.
• If the employee moved out of the United States after the ISO had fully vested, any ordinary recognized upon disposition of the shares is fully reportable on Form W-2.

As noted above, for a US citizen, green card holder or resident, the entire disqualifying disposition amount should be reported on the W-2.

ESPP and Mobility

When an employee participating in an ESPP transfers to or from the United States, the taxation of the shares acquired under the ESPP will depend on whether the company offers the Section 423 plan globally or whether there is a nonqualifying plan for non-US participants. The rest of this section assumes that the Section 423 plan is offered globally.

A US taxpayer who participates in a Section 423 plan can still receive US tax favorable treatment even if they are now based outside the United States; however, similar to ISOs, this treatment does not typically extend to the other country where they are now resident. Many countries will tax ESPP purchases at the time of purchase on the difference between the stock price at purchase less the purchase price paid by the employee.

For US citizens and residents (including former residents), if the ESPP purchase price is discounted, W-2 reporting is required at sale regardless of whether the disposition is disqualifying (unless the shares are sold at an economic loss). In the case of a qualifying disposition, the sale could take place many years after the purchase occurred.

Employees Who Move Out of the United States

For non-US citizens, the company should allocate the income to be reported on the W-2 based on the employee’s work location between the start of the offering period and the purchase date.

Employees Who Move to the United States

Employees may also begin participating in a Section 423 ESPP while working outside the United States The employee may be overseas from the start of the offering period to the sale of shares. If they later relocate to the United States in the same year as the sale of the shares, this disposition should not be treated as W-2 income, even if it occurs in the same year as their relocation to the United States.

However, if they dispose of the shares after relocating to the United States, then the income should be fully reported on Form W-2.

If employees relocate to the United States during an offering period, they may be required to pay tax in their former country on a portion of their gain at the time of purchase, based on the length of time they worked in that country during the offering. In addition, if they subsequently dispose of the shares while based in the United States, any ordinary income resulting from their disposition is fully reportable on Form W-2.

State to State Mobility

In general, where there is taxable compensation to be reported the income should be reported in the states the employee worked or lived in during the life of the award. This is true of ISO disqualifying dispositions and ESPP. Companies should make sure they understand the sourcing rules for each relevant state so that the appropriate amounts are reported.

Note that withholding may apply for some states:

• Pennsylvania does not recognize the tax qualifying nature of ISOs and ESPPs; for Pennsylvania state purposes, the income is taxed at the time of exercise (or purchase). If the employee is mobile, a portion of the income should be subject to state (but not federal) payroll reporting and withholding.
• There is a common misconception that Ohio state taxation is similar to Pennsylvania; however, the requirements there are different. Ohio recognizes the tax qualifying nature of ISOs and ESPP; the Ohio requirement is withholding of state tax on disqualifying dispositions.