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Session #3: Equity Compensation — Tax Reporting, Exercise Considerations & Termination Events

Equity Compensation Master Class

Session #3 focused on the mechanics of tax reporting, common cost-basis errors, and how life events, job changes, mobility, and corporate transactions impact equity compensation taxation. The core message: most equity mistakes are not strategy errors — they are reporting and timing errors.

I. Tax Reporting Framework: Forms That Drive Everything

Aric Jacobson began by mapping the core IRS forms tied to equity compensation:

W-2 (Compensation Income)

• RSUs: Full FMV at vesting = ordinary income on W-2.
• NQSOs: Bargain element (FMV – strike) at exercise = W-2 income.
• Subject to federal, state, Social Security, and Medicare withholding.

IRS W-2 instructions:
https://www.irs.gov/instructions/iw2w3

1099-B (Broker Sales Reporting)

• Reports proceeds from stock sales.
• Frequently misreports cost basis, especially after:
  • Broker transfers
  • Long holding periods
  • ESPPs and RSUs
• Incorrect basis can cause double taxation.

IRS 1099-B guidance:
https://www.irs.gov/forms-pubs/about-form-1099-b

Form 8949 (Correcting Cost Basis)

Used to reconcile incorrect 1099-B basis and feed into Schedule D.

IRS Form 8949:
https://www.irs.gov/forms-pubs/about-form-8949

Aric emphasized this is one of the most common planning saves — correcting zero basis on RSUs can prevent tens of thousands in unnecessary tax.

ISO & ESPP Forms

• Form 3921 – ISO exercise reporting
  https://www.irs.gov/forms-pubs/about-form-3921
• Form 3922 – ESPP purchase reporting
  https://www.irs.gov/forms-pubs/about-form-3922

These forms do not create tax liability by themselves but are critical for AMT tracking and qualifying disposition analysis.

AMT Forms

• Form 6251 – AMT calculation
  https://www.irs.gov/forms-pubs/about-form-6251
• Form 8801 – AMT credit tracking
  https://www.irs.gov/forms-pubs/about-form-8801

AMT from ISO exercises creates a credit that must be tracked annually. Switching CPAs without transferring Form 8801 history can cause credit loss.

II. Award-Type Tax Treatment

RSUs

• Ordinary income at vesting.
• One-year holding period from vesting for LTCG.
• Cashless sales still generate:
  • W-2 compensation
  • 1099-B sale
• FICA timing nuance: if retirement-eligible, FICA can trigger before share delivery.

Nonqualified Stock Options (NQSOs)

• Ordinary income at exercise.
• Cashless exercise = two events:
  1. Compensation income (W-2)
  2. Sale transaction (1099-B)
• FMV at exercise becomes cost basis.

Incentive Stock Options (ISOs)

Preferential Treatment Requires:

• Exercise within 3 months of termination (generally)
• 2 years from grant
• 1 year from exercise

Internal Revenue Code §422:
https://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section422

If exercised after 3 months post-termination → becomes NQO for tax purposes (withholding and FICA apply).

ESPPs (Section 423)

Internal Revenue Code §423:
https://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section423

• Qualifying disposition: more capital gain.
• Disqualifying disposition: more W-2 income.
• Nonqualified ESPPs taxed like NQSOs.

III. Termination Events

Standard Termination

• Options: typically 90-day exercise window.
• ISOs retain status only if exercised within 3 months.
• RSUs: unvested typically forfeited.
• Negotiating extended exercise windows (especially in private companies) is critical.

Disability

• ISO window may extend up to 12 months.
• Definitions vary by plan — review documents carefully.

Death

• ISOs: no statutory exercise limit (subject to plan term).
• AMT credit cannot be transferred to heirs; final return usage must be evaluated.

IRS Publication 559 (Decedents):
https://www.irs.gov/publications/p559

Divorce

• ISOs transferred incident to divorce become NQSOs.
• RSUs taxed to recipient spouse at vesting.
• Complex reporting rules; 1099-MISC may apply in certain structures.

IV. State Mobility & Nexus Risk

A major focus of this session was state taxation risk.

Aric highlighted:

• California aggressively taxes equity tied to work performed in CA, even if exercised after moving.
• New York can tax remote employees if nexus is established.
• Multi-state day-count allocation may apply.

California Franchise Tax Board guidance:
https://www.ftb.ca.gov

New York Department of Taxation guidance:
https://www.tax.ny.gov

Remote work and equity compensation often create unexpected multi-state tax exposure.

V. Change of Control (M&A) Events

Treatment depends entirely on:

• Equity plan document
• Merger agreement
• Employment agreement

Common outcomes:

1. Forfeiture
2. Replacement awards
3. Acceleration

Double Trigger Trend

Acceleration requires:

• Change of control
• Termination within 12–24 months

Cash vs. Stock Treatment

• Cash payout = ordinary income.
• Stock-for-stock exchange may qualify as tax-free reorganization.

IRS corporate reorganization overview:
https://www.irs.gov/businesses/corporations/reorganizations

VI. Section 280G (Golden Parachute)

Applies to disqualified individuals if change-of-control payments exceed 3× base amount.

• Excess above 1× base amount subject to:
  • 20% excise tax
  • Regular income tax

Internal Revenue Code §280G:
https://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section280G

Internal Revenue Code §4999 (excise tax):
https://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section4999

Gross-ups are less common today but may still exist in legacy agreements.

VII. Wash Sales & Frequent Vesting

RSU vesting is treated as a purchase for wash sale purposes.

IRS wash sale rule:
https://www.irs.gov/publications/p550

Monthly or quarterly vesting can repeatedly create wash-sale windows if shares are sold at a loss.

Loss is deferred into basis — not permanently lost.

VIII. Planning Strategies Highlighted

• Spread exercises across years to manage brackets.
• Structure ISO exercises to straddle tax years.
• Exercise before deal close to avoid FICA.
• Negotiate extended windows at hire.
• Review plan amendments before retirement.
• Track cost basis independently of broker.

IX. Important Clarification

The transcript referenced the SALT deduction cap increasing to $40,000. This is subject to enacted tax law for the specific year and should be verified against current federal law before relying on that number.

Background explainer:
https://bipartisanpolicy.org/explainer/the-salt-deduction/

Core Takeaways

This session reinforced that equity compensation planning is:

• A documentation discipline.
• A tax-form discipline.
• A timing discipline.
• A mobility discipline.
• A plan-document discipline.

Most costly mistakes arise from:

• Incorrect basis reporting.
• Missing ISO deadlines.
• Poor termination timing.
• Ignoring state nexus.
• Failing to review change-of-control language.