Adam K. Desjean, Esq., associate, Vacovec, Mayotte & Singer LLP, Newton, with his thanks to his colleague Ken Vacovec for his helpful suggestions for this article.
In July, Massachusetts issued new regulations addressing the taxation of nonresidents of Massachusetts. Included in the regulations were new rules on the sourcing of nonresidents’ income from the exercise of stock options that are not qualified stock options (“NSOs”) under the Internal Revenue Code. In 2005, the Treasury Department similarly issued regulations addressing the sourcing of stock option gains of nonresidents of the United States. The “grant to exercise” sourcing rule Massachusetts announced in its regulations differs from the “grant to vest” sourcing rule that the federal government adopted in its 2005 regulations. As a result of these differing sourcing rules, a foreign person who is a nonresident of both Massachusetts and the United States will often recognize different NSO income amounts for Massachusetts and federal tax purposes when he or she exercises NSOs that were received in connection with Massachusetts employment.
Residency and Sourcing
The concept of residency differs for Massachusetts and federal tax purposes.[1] In general, for federal tax purposes, an individual is a resident of the United States if the taxpayer is a United States citizen or a green card holder, or if the individual is “substantially present” in the United States.[2] While the actual “substantial presence” test is more nuanced, many tax practitioners refer to the substantial presence test as the “183- day rule,” as most otherwise nonresident individuals who are present in the U.S. for 183 days or more are residents under the substantial presence test.[3]
For Massachusetts tax purposes, a taxpayer who is domiciled in Massachusetts is a resident.[4] In addition, Massachusetts has its own 183-day rule for determining residency. Under Massachusetts’ 183-day rule, a non-domiciliary who has a “permanent place of abode” in Massachusetts and who spends more than 183 days in the state during the taxable year is a resident of Massachusetts for state tax purposes.[5]
The consequences of residency/nonresidency are similar under both the federal and Massachusetts tax systems. For a taxpayer who is a resident of the United States, gross income includes income from all sources worldwide.[6] In contrast, nonresidents of the U.S. are federally taxable only on their U.S. source income.[7] As under the federal system, the gross income of a Massachusetts resident for Massachusetts tax purposes includes income from all sources worldwide.[8] Gross income of a nonresident of Massachusetts is analogous to gross income for a nonresident under the federal tax system in that it takes into account only gross income from sources within Massachusetts.[9]
Stock Options Rules
A nonqualified stock option is a stock option that fails to be a qualified stock option under § 422 or § 423 of the tax code.[10] Qualified stock options are treated favorably if certain holding period requirements are satisfied. The rules governing stock option qualification are quite detailed. Accordingly, only the broad outlines of the rules for qualification under §§ 422 and 423 are presented here.
Section 422 delineates the requirements for “incentive stock options” (“ISOs”). In order for an option to be an ISO, the option must be granted pursuant to a plan of an employer that permits an employee to purchase shares of the employer, or shares of a parent or subsidiary of the employer.[11] In addition, the plan itself must be approved by the granting company’s shareholders, the options must be granted within 10 years of the date of the plan’s adoption,[12] and options granted under the plan must be exercisable within 10 years of the grant date of the option.[13] Finally, an option will not be a qualified option under § 422 if the option exercise price is less than the fair market value of the stock at the time that the option is granted.[14]
Section 423 contains the rules relating to options granted pursuant to employee stock purchase plans (“ESPPs”). ESPP options, like ISO options, must be granted pursuant to shareholder-approved plans and the options granted must be for the purchase of stock of the employer or a parent or subsidiary of the employer.[15] Unlike ISOs, however, ESPP options can be granted with a built-in “spread” between the option exercise price and the fair market value of the stock at the time of the option grant. The spread amount is limited to the lesser of 15 percent of the fair market value of the stock at the date of the option grant or 15 percent of the fair market value of the stock at the time the option is exercised.[16]
Tax Consequences of Disqualifying Dispositions
As indicated above, options granted under both ISO and ESPP plans have holding period requirements for statutory treatment to obtain. In both instances, the employee must hold the stock for at least two years after the grant of the option, and the stock must also be held for at least one year after the option is exercised.[17] Dispositions of stock prior to the attainment of the holding period requirements are disqualifying dispositions.[18]
If the holding period and other requirements are met in the case of an ISO, then the employee recognizes no income on the grant or exercise of the option, unless the taxpayer becomes subject to the alternative minimum tax (“AMT”). The AMT income is generally the difference between the fair market value of the stock at the time of the exercise of the option and the amount paid for the stock plus any amount paid for the option.[19] If ISO stock is disposed of in a disqualifying disposition, then the gain on the sale of the stock obtained under the option is treated as compensation – that is, as ordinary income.[20]
For an ESPP option, if the holding period requirements are met, then the amount of the “spread” that will be treated as ordinary income will be the lesser of (1.) the difference between the fair market value of the shares when sold and the option exercise price for the shares or (2.) the difference between the option exercise price and the fair market value of the shares at the time of the grant of the option.[21] All of the option spread will be treated as ordinary income if ESPP stock is disposed of in a disqualifying disposition.[22]
Nonqualified Stock Options
If certain requirements are met, nonqualified stock options will be taxed as income upon grant,[23] but since these requirements are seldom met, option income is generally recognized with respect to NSOs only upon exercise of the option. The option income is the spread between the exercise price and fair market value of the stock at the time of the exercise of the option, and it is all ordinary income.[24] Subsequent sale of stock acquired through the exercise of an NSO results in capital gain, which is taxed at the applicable capital gains tax rates and sourced based on the sourcing rules for capital gains.
Federal Sourcing of NSO “Spread” Income
Prior to 2004, little explicit guidance existed on the appropriate sourcing for federal tax purposes of the spread income component that results from the exercise of NSO options.[25] The rule generally used[26] for the sourcing of compensation from the performance of personal services is time-basis apportionment, under which the personal services income is sourced to the U.S. by multiplying the personal services income by the ratio computed by dividing a taxpayer’s days worked in the U.S. over the total number of days worked.[27]
While prior to 2004 it was clear that the spread income resulting from the exercise of NSOs was compensation, the relevant period over which to apply time basis apportionment was not. Revenue Ruling 69-118 indicated that for ESPPs, disqualifying disposition gains were to be sourced based on where services were performed during the period from the option grant to the time of the exercise of the option.[28] Regulations issued under § 911, however, suggested that in the case of substantially nonvested property—which NSOs, as incentive compensation, invariably are—the appropriate period over which to apply the time basis of apportionment was the time between the grant of the NSO and the vesting of the NSO.[29] In practice, most grantors of NSOs sourced the NSO spread to the U.S. based on the place of performance of services during the grant to exercise period.[30]
In July 2005, the Treasury finalized temporary regulations that had been issued in 2004 addressing the proper sourcing of the NSO spread component. Under the new regulations, compensation from stock options will generally constitute a “multi-year compensation arrangement.”[31] The regulations state that for multi-year compensation arrangements, “[t]he determination of the period to which such compensation is attributable, for the purposes of determining its source, is based upon the facts and circumstances of the particular case.”[32] However, the new regulations further add that “[i]n the case of stock options, the facts and circumstances generally will be such that the applicable period to which the [option spread] is attributable is the period between the grant of an option and the date on which all employment-related conditions for its exercise have been satisfied (the vesting of the option).”[33]
Example of Sourcing Under New Federal Regulation:
NSO to purchase 100 shares at $1/share
Grant date: Jan. 1, 2004
Vest date: Dec. 31, 2005
U.S. resident: Jan. 1, 2004 – Dec. 31, 2005 (assume 240 U.S. workdays in each year)
Option exercise date: July 1, 2006, stock FMV of $3/share
Non-U.S. resident: Jan. 1, 2006 – exercise date (July 1, 2006) (assume 120 non-U.S. workdays)
NSO income: $200 ($300 FMV at exercise less $100 exercise price)
Sourcing: All U.S. source income, as all workdays during grant to vest sourcing period are U.S. workdays.
Massachusetts Sourcing of Stock Option Income
Prior to this year, Massachusetts sourced all of the “spread” from an NSO to Massachusetts if the NSO was granted in connection with Massachusetts employment, regardless of where services were performed between the time that the NSO was granted and the time that income was recognized with respect to the NSO.[34] For its new sourcing rule, Massachusetts adopts a time-basis method of apportionment, with sourcing based on the number of days worked in Massachusetts.[35] As under the old Massachusetts sourcing rule for NSOs, a nonresident of Massachusetts must recognize income derived from NSOs that are “connected” to Massachusetts employment or to the conduct of a trade or business in Massachusetts.[36] In a departure from the federal sourcing rule, for Massachusetts purposes, the period over which the time-basis apportionment is to be applied is the period from the date of the option grant to the exercise of the option.[37]
The Massachusetts sourcing of income can be illustrated using the facts assumed in the illustration of the federal sourcing rule above. For this example, it should be assumed that the option was granted in connection with Massachusetts employment and that all of the workdays spent in the U.S. in 2004 and 2005 were worked in Massachusetts.
Total NSO income: $200
Workdays during grant to exercise period (Jan. 1, 2004 – July 1, 2006)
Massachusetts: 480 days
Non-Massachusetts: 120 days
Total Days: 600 days
Massachusetts apportionment %: 80% (480/600)
Massachusetts source income: $160 ($200 x 80%)
While the new Massachusetts rule for sourcing the compensation component of NSO gains is more generous than the old rule, Massachusetts’ new sourcing rule is apt to engender much confusion among individuals who are taxable as nonresidents of both the United States and of Massachusetts. The inevitable result of Massachusetts’ adoption of a sourcing rule that differs from the new federal sourcing rule for the sourcing of the NSO spread will be that nonresidents (of both the U.S. and Massachusetts) whose only continuing source of U.S. income is from the exercise of nonqualified options will often have differing gross incomes for Massachusetts and federal tax purposes. Given that many taxpayers will likely be unaware of this difference in the starting point for the computation of tax, there seems to be the potential for significant, albeit unwitting, noncompliance with the new Massachusetts sourcing rule.
Apart from this potential for confusion, the distinction embodied in the new Massachusetts NSO sourcing rule would appear to suffer from a lack of raison d’etre. While the old Massachusetts NSO sourcing rule captured more income for Massachusetts than both the current and old federal sourcing rules, it is not at all clear that the new Massachusetts regulation will result in the sourcing of greater amounts of income to Massachusetts than would be sourced to the state if Massachusetts followed the federal rule contained in the 2005 federal regulations. Indeed, inasmuch as under the Massachusetts rule the option-holder has significant control over the sourcing of income – he or she, after all, decides when to exercise the option – it seems possible that the new Massachusetts rule will actually result in less tax revenue for the commonwealth than if the federal “grant to vest” rule had been adopted.
Conclusion
In conclusion, as a result of the new, differing state and federal sourcing rules, transnational taxpayers who have received NSOs in connection with Massachusetts employment will have to be particularly mindful of their respective gross income computations.
[1] Given the divergence in the federal and Massachusetts residency rules, it is possible that the Massachusetts and federal tax treatments of NSO gains would differ purely as a consequence of the fact that a taxpayer is a resident of the United States for federal tax purposes and a nonresident of Massachusetts for Massachusetts tax purposes, or vice versa.
[3] Under the Internal Revenue Code, an individual is substantially present in the United States during a tax year if the taxpayer is present in the U.S. for at least 31 days in the calendar year and, under a formula which treats a portion of prior years’ days of presence as days of presence in the current tax year, the taxpayer’s days of presence in the U.S. for the current tax year equals 183 or more days. See 26 U.S.C. § 7701(b)(3).
[4] Mass. Gen. Laws ch. 62, § 1(f).
[5] Mass. Gen. Laws ch. 62, § 1(f).
[7] 26 U.S.C. § 871(a)(1).
[8] See Mass. Gen. Laws ch. 62 § 2.
[9] Mass. Gen. Laws ch. 62 § 5A.
[10] 26 U.S.C. § 421. Section 421 does not refer to “qualified stock options” but to qualifying transfers, which transfers can occur only with the options described in §§ 422 and 423.
[12] 26 U.S.C. § 422(b)(2).
[13] 26 U.S.C. § 422(b)(3).
[14] 26 U.S.C. § 422(b)(4).
[15] 26 U.S.C. § 423(b)(1).
[16] 26 U.S.C. § 423(b)(6).
[17] See 26 U.S.C. §§ 422(a)(1), 423(a)(1).
[19] See 26 U.S.C. § 56(b)(3), § 83.
[20] 26 U.S.C. § 422(c)(2).
[22] See Treas. Reg. § 1.421-2(b)(1) and 26 U.S.C. § 83.
[23] See Treas. Reg. § 1.83-7 and 26 U.S.C § 83. The primary reason that few NSOs are taxed as income upon grant is because NSOs must have a “readily ascertainable fair market value” in order to be taxed upon grant. Treas. Reg. § 1.83-7(a).
[24] See Treas. Reg. § 1.83-7(a) and 26 U.S.C. § 83.
[25] Bissell, 907-2nd T.M., U.S. Income Taxation of Nonresident Alien Individuals, A-65.
[26] The regulations indicate that compensation should be sourced based on “the facts and circumstances of the particular case.” Treas. Reg. § 1.861-4(b)(2)(i). However, the regulations also indicate that in many instances apportionment on a time basis is acceptable. Treas. Reg. § 1.861-4(b)(2)(i).
[27] Treas. Reg. § 1.861-4(b)(2)(ii)(E).
[28] Rev. Rul. 69-17. Revenue Ruling 69-17 addressed sourcing for the purpose of Internal Revenue Code § 911, which permits U.S. taxpayers to exclude from gross income certain foreign earned income. See 26 U.S.C. § 911.
[29] See Treas. Reg. §§ 1.911-3(e)(4)(i) & (ii)(Example 3).
[30] See Bissell, supra note 25, at A-65.
[31] Treas. Reg. § 1.861-4(b)(2)(F).
[32] Treas. Reg. § 1.861-4(b)(2)(F).
[33] Treas. Reg. § 1.861-4(b)(2)(F).
[34] MA Dept. of Revenue Directive 03-12.
[35] See 830 CMR § 62.5A.1(3)(c)(2), § 62.5A.1(5).
[36] 830 CMR § 62.5A.1(3)(c)(2); MA Dept. of Revenue Directive 03-12.
[37] 830 CMR § 62.5A.1(3)(c)(2).