Get options, leave USA, exercise options. Tax?

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International Tax Lunch – Today

Today (June 12, 2015) at noon Pacific time our regular free 🙂 International Tax Lunch will be presented by yours truly. I will be talking about C corporations when they are used by nonresidents who buy U.S. real estate.

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Option exercise after leaving the USA

Today’s topic is one we have seen recently in a lot of expatriation cases. But it is not limited to expatriation only—this is a situation that applies to anyone who transitions from U.S. resident to nonresident.

You came to the United States in 2011 to work for a publicly traded U.S. company. As part of your compensation you are awarded stock options to purchase 1,000 shares of stock for $10 per share. The stock is trading at $10 when the options are awarded to you. These are nonqualified stock options. In 2014 you left the United States and returned to live in your home country. In 2015, you exercise the options when the stock is trading at $20 per share. You now own 1,000 shares of stock. Later in 2015, the stock is trading at $40 per share. You sell your 1,000 shares of stock.

What is taxed?

What can the United States tax you on?

• The receipt of the options?
• The exercise of the stock options?
• The sale of the stock?

No tax when you get the options

As a general principle, an employee is not taxed when receiving an award of nonqualified stock options. The rule says that if the option can not be valued with precision (the jargon is “the options have no readily ascertainable fair market value at grant”), then you are not taxed when your employer awards the option to you. I.R.C. §83(e)(3). In the example here, you are a U.S. taxpayer receiving options as part of your compensation, so we expect that general principle to apply. Options granted as part of a compensation package are not traded on a public market, so do not have a fair market value that is easy to determine.

Tax is due when you exercise the options

Remember that in our scenario you were awarded the stock options while you were a resident of the United States, but you exercise the options (you buy the stock that you are entitled to buy, at the price you are entitled to pay) while you are a nonresident of the United States. Our example says you were awarded options to buy 1,000 shares at $10 per share. You exercised the options when the stock was trading at $20 per share. You will pay tax to the United States when you exercise the options.

This is compensation income

When you exercise nonqualified stock options that are granted to you as part of your compensation package, you are buying 1,000 shares of stock for $10 each at a time when the shares are worth $20 per share. You plunk down your $10,000 and you magically own stock worth $20,000. The spread between what you paid ($10/share) and the value of what you bought ($20/share) is income to you. It is compensation income, taxed at ordinary rates.

Even though you are a nonresident . . .

The U.S. tax rules for nonresidents say that the United States can only tax income from U.S. sources if it is “fixed, determinable, annual, or periodic” income [I.R.C. §871(a)] or if it is income that is “effectively connected” with the conduct of a trade or business in the United States [I.R.C. §871(b)]. Working in the United States as an employee (or independent contractor, for that matter) is considered to be conducting a trade or business in the United States, and getting paid for that work is “effectively connected” to the work you do. But, you may object, when you exercised the option (and received compensation income) you were not in the United States, so even if this is compensation income, it is not U.S. source income because when you got paid you were outside the United States. Therefore, you should not be taxed on that compensation income that you made when you exercised the stock options. The Internal Revenue Code has that covered. Section 864(c)(6) specifically:

(6) Treatment of certain deferred payments, etc. For purposes of this title, in the case of any income or gain of a nonresident alien individual or a foreign corporation which—

(A) is taken into account for any taxable year, but (B) is attributable to a sale or exchange of property or the performance of services (or any other transaction) in any other taxable year,

the determination of whether such income or gain is taxable under section 871(b) or 882 (as the case may be) shall be made as if such income or gain were taken into account in such other taxable year and without regard to the requirement that the taxpayer be engaged in a trade or business within the United States during the taxable year referred to in subparagraph (A).

In plain language, if you get income in one year [I.R.C. §864(c)(6)(A)] but it is attributable to services performed in a different year [I.R.C. §864(c)(6)(B)], you pretend that the income was earned in the year that you performed the services, and then use that “pretend” to decide how the income is taxed in the year that you actually received it. For the stock options, you did the work to earn the options when you were a resident of the United States. Therefore the income will be taxable just like that, even though you are now a nonresident. You have $10,000 of gross income that is taxable in the United States in the year that you exercise the options, even though you are a nonresident. It is compensation income. And just so you know, your former employer will issue a Form W-2 to you with $10,000 of income showing on it.

No tax on later sale of the stock

Continuing with the example, you exercised the options and now own 1,000 shares of stock that you acquired when the stock was worth $20 per share. Several months pass by, and now the stock is worth $40 per share. You sell. Is the capital gain taxable in the United States? No. When a nonresident sells an investment in corporate stock (even in U.S. companies), the Internal Revenue Code does not impose tax. So when the value of the stock doubled, the capital gain (as the price went from $20/share to $40/share) stayed outside the reach of the IRS.

Disclaimer

This blog post is not tax advice. If you have stock options, you have sufficient complexity to hire a competent tax advisor to get the right answer. See you next week. Phil.