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Perquisites: Discovery, Taxation Issues, and Problems

Discovery, Taxation Issues, and Problems

By Barry S. Sziklay

Perquisites (“perks”) come in many forms and flavors and are designed to achieve specific goals such as compensating an executive or key person for past or desired future performance.

In essence, a perk is a privilege or benefit granted to an employee in addition to his or her regular salary or other compensation. The primary motivation from the employer’s standpoint for granting a perk to an employee is to convey something of value to the employee to either reward for past performance, incentivize the employee to remain in the employer’s employ, and/or incentivize desired future performance of the employee with respect to attaining certain business goals such as, for example, achieving a certain level of sales, revenue, collections, earnings, etc. The list of possible future performance goals is virtually endless. The overriding point, however, is that perks represent compensation to the employee in one form or another.

Perks can be immediately tax deductible to the employer and taxable to the employee, or the taxability of the perk can be deferred. In either case, there must be symmetry between the employer’s ability to deduct the perk and the employee’s requirement to report the perk as taxable income, which taxable income could be characterized as either capital gain or ordinary income or some combination of the two.

It is important to keep in mind that perquisites are “engineered” to accomplish goals set by the employer. Those goals are a function of such things as (1) the objective of maintaining the employer’s competitiveness with respect to other employers; (2) the stage of development of the employer, i.e., whether it is a start-up, established private company, or established publicly traded company; (3) goals that are specifically achievable by the employee to whom the perk is granted (for example, a sales goal), as opposed to department, division, or company-wide goals (for example, achieving a certain level of revenue; earnings before interest, tax, depreciation, and amortization (EBITDA); return on equity; stock price appreciation, etc.); and (4) short-term and long-term goals. The foregoing list is not exhaustive because each employer’s situation is unique.

This article covers perquisites in the form of employee stock options, Internal Revenue Code § 83, corporate insider-trading blackout periods, and what the family lawyer needs to know about all of these things. Retirement plan issues are covered elsewhere in this issue.

Employee Stock Options

Often, an employer will want to reward an employee with an equity interest in the employer—that is, an employee stock option. This type of perk can take many forms depending upon the circumstances of the employer. Start-up ventures, such as many of the high-tech companies you read about daily, will frequently give key employees stock options. A wonderful description of how these types of perks work may be found in an article that appeared in the February 27, 2016, issue of Forbes magazine, How Employee Stock Options Work in Startup Companies, which can be accessed at

Employee stock options are called options because they give employees the right to acquire a share of stock in the future at the option of the employee. The date on which the employee is given the right to acquire the stock is called the grant date. The employee stock option agreement may be a letter agreement between the employer and one or more employees or it might be memorialized in a stock option plan document, which you generally encounter in publicly traded companies. The stock option agreement will provide that the employee can exercise the right to purchase the stock beginning with the later of the date of grant or vesting date until the expiration date of the option. This is called the option term. All employee stock option grants have expiration dates. If the employee does not exercise the option before the expiration date, the right to exercise the option and acquire the employer’s stock generally expires with no tax effect on either the employer or the employee. Most employee stock option awards are subject to a vesting schedule.

An employee stock option gives the employee the right to purchase a share of an employer’s stock at a fixed price, which is called the strike price or exercise price. This requires the employee to pay cash or make some other form of payment to exercise the option and acquire the stock. The strike price at date of grant is generally no less than the fair market value of the stock on that date. What makes the option potentially valuable to the key employee is that the stock value may increase over time and can be greater than the strike or exercise price at the date of exercise—thus, the compensatory element of the stock option.

I.R.C. § 83 and Nonqualified Stock Options and Incentive Stock Options

Nonqualified Stock Options

Regardless of whether the stock options are issued by a start-up venture or a publicly traded corporation, there are two types of employee stock options: (1) nonstatutory or nonqualifed (NSOs) and (2) qualified or statutory incentive stock options (ISOs). The income tax treatment of nonqualified stock options is governed by I.R.C. § 83, “Property Transferred in Connection with Performance of Services.” If an NSO has a readily determinable fair market value on the date it is granted, the value of the stock, less any payment received from the service provider (i.e., the employee or holder of the option) as payment for the stock, is included in the income of the employee as compensation income, and the employer would get a corresponding deduction at the same time. If the NSO does not have a readily determinable fair market value at the grant date, it will be taxed to the employee as compensation at the date of exercise or as soon after exercise as the option property (i.e., the employer stock) is transferable or not subject to a substantial risk of forfeiture. The employer gets a compensation deduction at the same time the employee has to include in income the excess of the stock price over the strike price at the date of exercise. Unlike a statutory stock option (discussed below), a nonqualified stock option can be granted to both employees and independent contractors and to their beneficiaries.

There is, however, the following very important election that an employee can make pursuant to § 83(b), “Election to Include in Gross Income in Year of Transfer”:

An employee or independent contractor can elect to have the excess of the fair market value of the restricted property over his cost taxed to him in the year it is received, even though the property remains substantially non-vested (Code Sec. 83(b)). The election must be made no later than 30 days after the property is transferred (Reg. §1.83-2(b)). The election is made by filing two copies of a written statement with the IRS Service Center where the taxpayer files his return—one at the time of the election and one with the tax return for the tax year in which the property was transferred. In addition to stating that the election is being made under Code Sec. 83(b), the statement must include a series of items set forth in the Code. (Reg. §1.83-2(e)).

When it comes to nonqualified options (NQOs), the § 83 election is critical because the difference in value between the stock option strike price and the fair market value at the date of grant is generally zero or close to zero. That means that employees will not recognize compensation income (i.e., ordinary income) at the date of exercise because they recognized it in the taxable year in which they made the § 83(b) election and can qualify for capital gains tax treatment when the stock is subsequently sold after the date of exercise. The capital gain would be equal to the difference between the stock price at the date of sale and the exercise price of the stock option. The § 83(b) election could be a critical election for a key employee of a start-up enterprise that could potentially experience an explosion in the value of the stock between the date of grant and the date of exercise, the latter of which could coincide with an IPO or other sale of the employer. The tax difference between ordinary income and capital gains could be quite substantial.

Incentive Stock Options

Incentive stock options are subject to many, many more tax rules and regulations than NQOs. See I.R.C. § 422. With ISOs, “no income shall result at the time of the transfer of such share to the individual upon his exercise of the option with respect to such share . . . .” § 421(a). The employee is first taxed when he or she sells or otherwise disposes of the option stock. He or she then has capital gain equal to the sales proceeds minus the option price.

Stock acquired under an incentive stock option qualifies for favorable tax treatment only if it is not disposed of before the later of two years from the date of the grant of the option or one year from the date of the exercise of the option. If this holding period is not satisfied, the portion of the gain equal to the difference between the fair market value of the stock at the time of exercise and the option price is taxed as compensation [§ 421(b) and Treas. Reg. § 1.421-2(b)] . . . . Dispositions for this purpose include sales, exchanges, gifts or transfers of title. They do not include transfers by reason of bequest or inheritance, transfers as part of a tax-free reorganization or exchange of stock of the same corporation, pledges, conversions to common stock, transfers into or out of joint tenancy, transfers to an agent without change in legal title, or transfers between spouses or incident to divorce.

See CCH Tax Research Consultant, COMPEN: 24,150, Holding Period Requirement for Stock Acquired by ISO Exercise.

For alternative minimum tax (AMT) purposes, the difference between the fair market value on the earlier of the date of option exercise or the date the stock is transferable or no longer subject to a substantial risk of forfeiture and the option price is subject to AMT. I.R.C. § 56(b)(3). The employer generally does not receive a tax deduction for the issuance of ISOs. ISOs cannot be granted to independent contractors.

Blackout Periods

Stock owned or acquired by corporate insiders, whether via exercise of NQOs or ISOs, a grant such as a restricted stock grant, restricted stock unit grant settled by transfer of corporate stock to the key employee, or otherwise, is frequently subject to trading restrictions during so-called blackout periods. Publicly traded companies have to adopt an insider trading policy. In Insider Trades During Pension Fund Blackout Periods, SEC Release No. 34-47225, 17 C.F.R. parts 240, 245, and 249, the Securities and Exchange Commission adopted a final rule related to § 306(a) of the Sarbanes-Oxley Act of 2002 (SOX).

. . . Section 306 (a) prohibits any director or executive offer of an issuer of any equity security from, directly or indirectly, purchasing, selling or otherwise acquiring or transferring any equity security of the issuer during a pension plan blackout period that temporarily prevents plan participants or beneficiaries from engaging in equity securities transactions through their plan accounts, if the director or executive officer acquired the equity security in connection with his or her service or employment as a director or executive officer. In addition, the rules specify the content and timing of the notice that issuers must provide to their directors and executive officers and to the Commission about a blackout period. The rules are designed to facilitate compliance with the will of Congress as reflected in Section 306(a), and to eliminate the inequities that may result when pension plan participants and beneficiaries are temporarily prevented from engaging in equity securities transactions through their plan accounts.

See In general, a blackout period is at least three consecutive business days but not more than sixty days during which the majority of employees at a particular company are not allowed to make alterations to their retirement or investment plans. Most publicly traded companies have extended blackout periods to cover trading by their senior executives and directors. Such periods generally correspond with expected earnings announcements and expected public dissemination of what would otherwise be characterized as material, nonpublic information that would only be known to corporate insiders.

In order for corporate executives to makes trades in their own company’s stock, they generally have to obtain clearance from in-house securities counsel and potentially file SEC Form 3, 4, or 5 with the agency. Form 3 is filed when a person becomes an insider to disclose his or her stock ownership and must be filed within ten days of becoming an insider. Form 4 is filed when an insider buys or sells his or her employer’s securities; it must be filed within two days of the transaction date. This also covers transactions in derivative securities such as option, stock purchase warrants, and convertible securities. Form 5 must be filed within forty-five days after the company’s fiscal year end to report at least one transaction a corporate insider failed to report.

What the Family Lawyer Needs to Know


During this phase of litigation, the family lawyer needs to obtain the following information, generally through a formal notice to produce or by request for answers to interrogatories. Production notices and interrogatories may have to be supplemented by deposition of the employee-litigant. The information in the Discovery Checklist on the facing page should be requested in all cases regardless of which means of discovery are employed.

Allocation and Valuation Issues

For grants during the period of coverture, it will be important to establish whether such equity-based compensation was awarded for past or future services or for some combination of the two. The required allocation of the awards between the spouses will be a function of state law. How the allocation can be effectuated will be a function of the plan terms and the company’s policies. Determining the value of the awards when future services are required and equity values may change is beyond the scope of this article; however, you should determine with the help of experts how the employer itself values the equity awards. This will give you some guidance as to how such awards may be valued. The company’s valuation, however, will most probably be for financial reporting purposes, not for marital dissolution purposes, so another valuation may be required for the latter purpose.

New I.R.C. § 83(i) Qualified Equity Grants

Pursuant to the Tax Cuts and Jobs Act of 2017, signed by President Trump on December 22, 2017, a new I.R.C. § 83(i) was enacted for stock attributable to options exercised or restricted stock units (RSUs) settled after December 31, 2017, which allows employees to elect to defer income from option or RSU stock for up to five years after vesting. The statute is complex, and regulations have not yet been issued to implement this new section of the law. Pursuant to this new section, a “qualified employee,” which is a defined term, I.R.C. § 83(i)(3), that specifically excludes a one-percent owner, the CEO, and the CFO, can make an election similar to an I.R.C. § 83(b) election with respect to “qualified stock,” another defined term, to, among other things, defer the recognition of taxable income or loss to “the date that is 5 years after the first date the rights of the employee in such stock are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier . . . .” I.R.C. § 83(i)(1)(B)(iv). Qualified stock is essentially stock received in connection with the exercise of an employee stock option or in connection with the settlement of RSUs. This change in law introduces still another uncertainty from an allocation and valuation standpoint because it can push out the tax effects five years beyond what previously could occur.

Stock Options: A Discovery Checklist

  • Latest and/or last plan participant statement showing details of what the employee owns.
  • Plan participant statement as of the date of separation, date of filing the complaint, or such other date or dates as may be relevant in your particular circumstances;
  • Complete plan documents. If the plan is sponsored by a publicly traded corporation, you should also obtain the latest proxy statement, which, in general, will cover the company equity award and retirement plans.
  • For each grant of stock options, restricted stock, restricted units, performance units or shares, stock appreciation rights, and any other form of equity-based compensation, you should obtain a copy of each grant award statement or agreement.
  • For each equity-based compensation award, you should obtain the complete plan document.
  • You should, independent of the litigant, confirm the tax aspects of each plan in which the employee participates. You need to determine the date or dates the employee becomes taxable; whether the income will be characterized in whole or in part as ordinary income (remuneration) or capital gain; whether the employer is required to withhold taxes on such remuneration or capital gain; whether the employer is required to withhold Social Security, Medicare, federal and state unemployment taxes, etc.; and how tax withholdings can be paid, either in cash or by sale of securities.
  • I.R.C. § 83(b) elections. This is a very important discovery issue, particularly for start-up companies in which one or both of the spouses may have acquired equity interests. You should request a copy of the IRS election filing. This is an absolute “must-obtain” document. If the employer is a private company, you should request any valuation that was prepared in connection with the issuance of the equity award. Most private companies will have a valuation prepared to establish the fair market value of its stock at the date of grant. You should obtain a complete copy of that valuation report.
  • You should ascertain if there have been any offers to purchase the company, plans to take the company public via an IPO, or capital raises since the date of grant. You should request complete details of any of the foregoing events in terms of documents produced by the company or prepared for its use by third parties in order to ascertain the potential increase in value of the equity grants.

Barry S. Sziklay, CPA, ABV, CFF, PFS, is a partner at Friedman LLP, a New York City-based accounting firm that offers a broad range of consulting services. He is a nationally recognized valuation and litigation support practitioner with over forty years of experience in a broad range of CPA firms, as well as within the investment banking industry. He is the Partner-In-Charge of the firm’s Forensic Accounting, Litigation Support and Valuation Services practice. He was a founding and managing member of a major New York-area financial services firm serving individuals, domestic and international businesses, and their attorneys.

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