Offering employee stock options has long been one of the most effective ways for startups and high-growth companies to attract and retain top talent. With the rise of remote and distributed work, those options are still viable, but they become more legally complex, especially when it comes to international tax compliance.
We made this short guide on incentive stock options so you can reward your most committed international employees with equity while remaining compliant.
What is equity compensation?
Equity compensation or stock options for employees are a way for companies to reward their people for long-term commitment and investment in the company through an ownership stake. Most equity compensation plans are made in such a way that vesting is only possible gradually over a few years of employment, thus ensuring the employee's loyalty.
When employees are remote, their equity plan's tax treatment becomes more complex depending on their location, whether they live outside of the US, and whether they moved during the vesting of their stock options.
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Stock option basics
There are several basic terms everyone needs to understand when it comes to employee stock options.
- Grant date
A company grants stock options to an employee on a specific date called the grant date. On the grant date, the value of the shares is typically the fair market value price on that day.
- Vesting period
An amount of time an employee needs to wait to exercise their employee stock options.
- Vesting date
When the vesting period expires, the stocks become ready for exercising - this is called the vesting date.
- Exercising date
Finally, the day when the employee exercises their stock is the exercise date.
Types of stock option plans
Let's break down the different types of stock options for employees:
- Incentive stock options (ISOs) are the benefit that allows employees to buy the company shares at a discounted price. Additionally, ISO owners may get a tax break on the profit from the shares. ISOs are usually taxed at the capital gains rate, which is lower than the ordinary-income rate.
- Non-qualified stock options (NSOs) are the type of company shares that is not eligible for favorable tax treatment. When you own NSOs, you have to pay taxes both when you exercise your options and when you sell your shares.
- Restricted stock units (RSUs) are stock-based compensation for employees that are issued through a vesting plan and after completing agreed milestones, usually related to performance. When they vest, RSUs are assigned a fair market value.
- Employee stock purchase plans (ESPPs) are company plans where employees can buy shares at a discounted price by contributing with payroll deductions.
The most common ones are ISOs and NSOs, and their tax implications are slightly different.
Tax differences between ISOs and NSOs
The tax laws vary slightly for different types of stock options. First of all, ISOs can only be issued to employees and are not available for independent contractors. They are the preferred stock option of employees since the tax obligations are simpler - ISOs are only subject to capital gains tax when the stock is sold. Startups often prefer ISOs since their value can increase dramatically.
On the other hand, NSOs are more favorable for the employer who is issuing them, as they are eligible for a tax deduction when the employee exercises the stock. Employees bear more burden with NSOs, as they are taxed twice for them - when they exercise the stock and sell it - and they are taxed as ordinary income. NSOs are also more flexible in terms of who can get them, as they are available to both employees and independent contractors. Both of these stock options can be granted to foreign individuals and employees of a foreign subsidiary.
Stock options for non-residents
When it comes to non-US employees, companies can either grant options to employees of their own foreign subsidiary or to people they hired through a third party, like an employer of record (EOR). Awarding options through a subsidiary may have tax implications for the US parent company.
The tax treatment also differs for non-residents depending on whether they ever worked for the company inside the US or not. If the non-resident never worked in the US, exercising their stock option will not be subject to US income tax. However, if they did work in the US for a period of time, the matters get more complicated.
In this case, the employee can be due for income tax on all or part of what is called a spread. Spread is the difference between the market price of the stock on the exercise date and the exercise price. The calculation of whether the spread is US-sourced or foreign-sourced will be made based on the number of workdays the employee was in the US during the vesting period. If the foreign employee was granted NSOs, the US-sourced portion of the spread is taxable and subject to wage withholding.
International tax laws
Whether the stock options for a foreign employee are subject to US taxes or not will surely be taxed in the employee's home country. Both the employer and the employee need to understand these tax laws well and structure their agreement accordingly.
For example, some countries don't impose any taxes on awarded stock options before their vesting or exercising. Others treat the granting of stock options as an employee benefit and have tax withholding requirements from the grant date onwards. In some of these countries, exercising the options and selling them is taxed again as taxable income. Needless to say, the local tax rates for all these scenarios vary by country and even by region, so it's wise to consult local legal help or a CPA to make sure nothing is missed.
When employees are granted options in the US, they can choose between unfavorable and favorable tax treatment. That may not be the case in many foreign countries, but there could be similar local laws that apply. Identifying any tax treaties between the US and the foreign country can be beneficial for the tax treatment of both the company and the employee.
Another issue to check is whether the specific country your employee lives in has any restrictions or exemptions related to granting stock options. Securities laws regulate this area, and while some countries have no restrictions, others impose significant ones.
Your foreign employees may have foreign exchange control laws requiring them to report ownerships of shares in foreign companies. Option grants may be exempt from this rule in some locations, but it's always best to check and keep compliant on both sides.
Finally, companies should check the labor laws of their employees' home countries. In the US, it is generally considered that unvested stock options expire on the resignation or termination date. Still, some countries consider the options to be part of the severance package of the worker.