Employee stock option sourcing rules govern the US tax classification of income generated by stock options as US-source income or foreign-source income. In this article, I will provide a general overview of the employee stock option sourcing rules.
Employee Stock Option Sourcing Rules: Importance of Income Sourcing Rules
Income sourcing rules are very important in US international tax law for two reasons. First, for US taxpayers, these rules will determine the ability to utilize their foreign tax credit. Second, for foreign taxpayers, the issue is whether they will be taxed in the United States. For example, if a non-resident alien received stock options the income from which is sourced to a foreign country, then he may completely escape US taxation of this income.
Employee Stock Option Sourcing Rules: Qualified vs. Non-Qualified Options
There are two types of stock options relevant to the employee stock option sourcing rules – qualified options (also called Incentive Stock Options) and non-qualified options. Let’s discuss both types in more detail.
A stock option is a qualified option if it is issued pursuant to rules set forth in the Internal Revenue Code. In the vast majority of cases, if an employee exercises a qualified stock option, he will not receive income at that time. Moreover, as long as he meets the statutory holding requirements, once the employee sells the stock, he will realize a capital gain. So, when we are talking about income sourcing for qualified stock options, we really need to concentrate on the sourcing of long-term capital gain.
Non-qualified options are the options that do not qualify for the preferential tax treatment under the Internal Revenue Code. Obviously, they are taxed in a different manner than qualified stock options. Generally, the employee does not recognize any income when he receives a non-qualified stock option. Rather, he will recognize ordinary income upon the exercise of the option; this ordinary income will equal to the difference between the value of the stock received and what he paid to exercise the option. This is the income that is relevant to our discussion of the employee stock option sourcing rules.
Now that we understand both types of options and what type of income they usually generate, we are ready to apply the employee stock option sourcing rules to this income.
Employee Stock Option Sourcing Rules Concerning Qualified Options
As we have already established, an employee usually generates a long-term capital gain as a result of a disposition of stock from a qualified option. The sourcing rules in this case require that the source of income is determined in the same manner as any other gain from a security disposition. In other words, the income must be sourced to the employee’s residence.
For example, let’s suppose that Pierre, a citizen of France, worked for a few years as a business analyst in New York for a multinational corporation. On the third year of his employment, the employer rewarded Pierre with qualified stock options. Then, the employer moved Pierre back to France. In France, he exercised his options; two years later (while still in France), Pierre sold the stocks. In this scenario, Pierre’s long-term capital gain would be treated as French-source income since he resided in France when the gain was realized.
Employee Stock Option Sourcing Rules & Non-Qualified Options: General Rule
The analysis with respect to non-qualified options is a lot more complex. Our starting point is the fact which we already established – income generated from non-qualified option is treated as compensation.
Second, the IRS does not list non-qualified options as a fringe benefit. Hence, we can assume that the IRS does not wish to apply the fringe benefit sourcing rules to compensation. Rather, most likely, the general salary-sourcing rules should apply.
As I pointed out in another article, the main rule here is that the location where the employee renders his services determines whether this is US-source income or foreign-source income. If an employee works in the United States, then his salary would be considered US-source income; if he works in a foreign country, his salary would be sourced to that country. See §§861(a)(3) and 862(a)(3).
Employee Stock Option Sourcing Rules & Non-Qualified Options: Allocation
In the context of non-qualified stock options, the general rule means that we have to determine where the employee was when he earned the options. If the employee worked only in the United States or only in a foreign country, this is a very easy case.
What happens, however, if we are dealing with a cross-border employee who is paid, in part, with non-qualified options? In this case, we have to engage in the process of allocating time between the United States and a foreign country (or even various foreign countries). As I pointed out in another article, time allocation is the default method in this case, but other options are available.
Let’s use an example to illustrate the time allocation rule with respect to non-qualified options: a US corporation hired Charles to work for its UK subsidiary in 2016. As part of his compensation, the employer granted non-qualified options exercisable in 2019. The work involved working not just in London, but also in New York. In 2019, Charles exercised the options. At the same time, he determined that out of the total 1,200 days he worked during the past three years, he was in the United States for 200 days and 1,000 days in the United Kingdom. This means that one-sixth (200/1,200) of income from non-qualified options will be US-source income.
Employee Stock Option Sourcing Rules & Non-Qualified Options: Foreign Tax Credit
The real complexity comes in, however, when we include the foreign tax credit (“FTC”) considerations into our analysis. Other countries may treat non-qualified options differently from the United States and recognize the income earlier. This means that, potentially, an employee can receive bills from multiple countries at different times. The FTC calculations here will become quite complex.
Contact Sherayzen Law Office for Professional Help with Employee Stock Option Sourcing Rules
If you work in two or more countries and receive stock options from your employer, you will need to engage in complex tax calculations to correctly determine your US tax liability. This is why you need to contact Sherayzen Law Office for professional help. We have helped hundreds of US taxpayers around the world with their international tax issues, and We Can Help You!