State Income Taxation of Nonresident Equity-Based Compensation

The increase in people who work remotely means some planners may need to reassess clients’ income sources to avoid a tax surprise
By
Eric J. Coffill

Journal of Financial Planning: October 2022

 

Eric J. Coffill is a senior counsel with Eversheds-Sutherland (U.S.) LLP, resident in its Sacramento, California, office. He has been practicing state tax law for nearly 40 years, including 10 years on the California Franchise Tax Board Legal staff. His practice focuses on state tax controversies, including state court litigation; state and local tax aspects of business transactions; and tax matters involving high-wealth individuals. 

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Noncash, equity-based compensation is perpetually popular as companies look for ways to attract and retain top talent. A tax issue often arises in the context of a state attempting to tax such income of a nonresident. When an individual has lived and worked in a state, and then becomes a nonresident of that state and receives income from equity-based compensation, the issue becomes whether any of that income is nonresident source income taxable by the former state of residence. If one is changing residency to avoid state income tax, it is important to know what income will still be taxed by the former state of residence. Indeed, there is little point in changing residency for tax purposes only to find a high percentage of your income will continue to have a source, and thus be taxable, in the state of former residence. This sourcing issue is not only of concern to the taxpayer-employee, but also to the employer, who is typically required under state law to withhold tax from compensation income earned in the state to approximate the employee’s in-state personal income tax liability.

Individual taxpayers are entitled to the same federal constitutional protections as corporate taxpayers, including fair apportionment of income.1 But within those broad constitutional parameters, states have significant leeway in creating their individual tax systems. There are two basic rules for when and how states may tax the income of an individual. First, states with a personal income tax generally impose it upon their residents on all their income, regardless of where that income was earned, subject to a credit (albeit often an incomplete one) for taxes paid to other states on that income. The issue of state tax residency/domicile is beyond the scope of this discussion, but the devil is truly in the details when changing residency for state tax purposes.2 Be aware that a claimed change of residence/domicile, followed shortly by a large income realization event (such as income from equity-based compensation) is essentially an invitation for a state audit. Second, regarding nonresident taxation, under federal constitutional principles, states can only tax nonresidents upon their income with a source in that state,3 which includes compensation for personal services earned in that state.

Often stock and other property are transferred as compensation for personal services, which creates issues when a resident receives nonqualified (i.e., nonstatutory) stock options, incentive (i.e., qualified) stock options, restricted stock units (RSUs), profit interests, etc. and then changes their tax status from resident to nonresident before selling them. The crux of the issue is determining what portion of a nonresident’s total income from equity-based compensation is attributable to personal services performed in a taxing state. Be advised there are few rules with broad application to all states, and the law of the individual state must be consulted for a definitive answer in a given case. Also, bear in mind that cities and other forms of local government also may have rules for taxing stock options.4 However, below are the two basic state tax rules, using California and New York to illustrate them.

Statutory Stock Options

Statutory stock options are those whose plans meet the requirements of Internal Revenue Code (IRC) Sections 421–424. Such incentive stock options are typically treated differently from nonqualified stock options, so long as the incentive stock option remains a qualified stock option. Under the California approach, an individual does not include any amount in income when an incentive stock option is granted to the individual or when they exercise the option. Rather, the individual recognizes income when they sell the stock. If an individual exercises an incentive stock option while either a resident or nonresident and later sells the stock in a qualifying disposition while a nonresident, the income is typically characterized as the sale of intangible personal property and is sourced solely to the state of residence at the time the stock was sold. This is true even when the services that gave rise to the grant may have been performed in California.5

A different approach, such as that in New York, typically uses an allocation method for a nonresident, based on the period of time from the date the option was granted to the date the option vested (i.e., the point at which all service-related conditions necessary for the exercise of the option have been met).6 However, if elected by the individual, the allocation period is from the date of the grant to the earliest of the date the option is exercised, the date the individual’s services terminate, or the date the compensation is recognized for federal income tax purposes.7 The New York allocation workday formula is a fraction with a numerator of the number of days worked for the grantor within New York during the allocation period and a denominator of the total number of days worked everywhere for the grantor during the allocation period.8

Nonstatutory Stock Options

As a starting point, most states incorporate into their income base IRC Section 83, which governs nonstatutory stock options (and also restricted stock). In general, and absent a Section 83(b) election (discussed below), gross income includes the gain on the property in the first tax year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture,9 whichever occurs earlier.10 Section 83(b) elections are frequently made, which are essentially a letter to the IRS informing the agency that the individual elects to be taxed immediately on their equity—on the date the equity was granted—instead of when the equity vests (i.e., the treatment when there is no election). In either case, the income is taxed at the ordinary income tax rate. When the stock is later sold, it will be taxed at the lower federal long-term capital gains rate (assuming it is held for a year after the election or vesting). States may or may not have a separate, lower capital gains rate (e.g., California does not). The theory behind making the election is to accelerate the individual’s ordinary income tax obligation and have as much of the gain as possible taxed at the capital gains rate.

The grant of a nonstatutory stock option is not itself a taxable event. If an individual exercises their options while a resident of a state, the state typically will tax the difference between the fair market value of the shares on the exercise date and the option (grant) price. This is simply the application of the principle that a state typically taxes all of the income of its residents. However, if the individual exercises their nonstatutory options while a nonresident, the character of the stock option income recognized is compensation for services rendered. Thus, a state will tax the individual’s income received to the extent the individual performed services in their former state. States will typically take the approach that if an individual performed services for the employer both within and outside the state, there must be an allocation to the taxing state of the portion of total compensation attributable to the services performed in the state.

One approach is to allocate based on the number of working days between the grant date and the exercise date. This is the approach used by California. Assume a resident of California is granted a nonqualified stock option while they are employed and living in California. Later they move to Nevada and become a nonresident of California. Under the formula above, the California Franchise Tax Board (FTB) will calculate an allocation ratio based on the number of workdays in California out of the total workdays from the date of grant to the date of exercise. Thus, if there are 500 workdays in California and 1,000 total work days, the 500 / 1000 allocation ratio of 50 percent is then multiplied by the total stock option income to calculate the taxpayer’s taxable California source income.11

New York also sources income of nonresidents from stock options, stock appreciation rights, or restricted stock by multiplying the compensation by the New York workday fraction for the applicable allocation period.12 In the case of nonstatutory stock options that do not have a readily ascertainable fair market value at the time of the grant, the allocation is done in the same manner as in the case of statutory stock options, i.e., over the grant-to-vest period discussed previously.13 If the nonstatutory stock options have a readily ascertainable fair market value at the time of grant, the amount of compensation is the difference between the fair market value of the option on the date that the option is granted and the amount paid for the option by the individual.14 The allocation period for these nonstatutory stock options is the same period of time that applies to regular, non-stock-based remuneration from the grantor during the taxable year the option was granted.15 If a nonstatutory stock option does not have a readily ascertainable fair market value at the time of grant, the general rule is the compensation is determined in the same manner as for statutory stock options.16

Restricted Stock Units

A restricted stock unit (RSU) plan awards an employee company shares as a form of compensation, and the rights of the recipient are restricted until the shares vest. RSUs allow an employee to receive an amount based on the full value of a share upon vesting, rather than only an amount equal to the increase in value from the date of grant through the vest date. The taxation of restricted stock by a state is often through conformity of that state’s law to IRC Section 83(a). IRC Section 83(a) provides that a taxpayer does not recognize any gain when restricted stock is granted. Instead, a taxpayer recognizes taxable compensation to the extent the fair market value of the stock exceeds the option price when the restricted stock is vested. Fair market value of the stock is measured at “the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier . . . .”17 If the individual paid tax on the fair market value of the shares at the time they vest, that portion of the stock will not be taxed again when they sell the shares.

States typically treat RSUs as comparable to restricted stock if they have a clear grant date, a period of vesting, and their value is not recognizable on the grant date. Accordingly, when an employee performs services in a state during the grant-to-vest period of the restricted stock and during that period becomes a nonresident, a portion of the compensation from the vesting of the restricted stock is source income from and taxable by that state.

The problem with such a mechanical approach for allocating to a state a portion of equity-based compensation of a nonresident is classically demonstrated in Appeal of Prince.18 The taxpayer was a California resident who began working in California for Facebook in 2007. He then moved to Singapore and became a nonresident in 2010 while still working for Facebook. His compensation from Facebook included six grants of RSUs, all of which required him to continue to work for Facebook in order to receive the stock. The RSUs were granted on six dates between 2007 and 2010 and they all vested in 2012, when the taxpayer was a nonresident. The position taken by the FTB, and affirmed by the Office of Tax Appeals (OTA), was that for each grant, a simple day-count ratio was used between grant and vesting date. For example, there was a December 18, 2007, RSU grant date with an October 25, 2012, vesting date. Of the 1,219 total workdays between those two dates, 648 of them were California workdays. Thus, 53.16 percent of the compensation had a California source. That percentage was applied to the total taxable income from the grant of $1,624,700, which resulted in California taxable source income of $863,691 for the nonresident taxpayer.

The above result and methodology are not surprising, but it is a classic example of a common, and often very serious, problem where the stock is fluctuating in value. While this approach may appear to give, and often gives, “rough justice” in terms of an allocation of relative compensation inside and outside the taxing state, it can often become a trap for the unwary based on the facts and circumstances of the situation. If one assumes the value of the stock rose progressively and at a constant rate over the period between the grant and vest date, and also assumes the value of the services performed remained constant over that period, there is a certain beauty to the simplicity of this approach. Unfortunately for Prince, that was not the case, and it is often not the case. The value of the stock owned by Prince had skyrocketed from $7.27 per share at the time he left California in 2010 to $28 per share when the RSUs vested. Thus, it is certainly arguable that under a simple day-count method, the California workdays disproportionately sucked back into his nonresident California source income gain that occurred at a time he was no longer a resident. Sensing this problem, Prince proposed two alternative allocation methods: a calculation based on the RSU share price on the date he left California and became a nonresident, and an annual appreciation method. Both were rejected by the FTB and the OTA. However, such alternative methods cannot be categorically rejected in all cases. They were rejected here under the facts and circumstances of this case. The opinion concedes the working day approach “is in no way a mandatory formula to apply in every instance,” but there was no indication of any link shown between the performance of services and the accelerated increase in value of the stock after the move date. This language recognizing there is no mandatory approach makes it clear there are facts and circumstances where other allocation methodologies could be acceptable.

Turning to New York, if the Section 83(b) election is made (which is usually the case for the reasons discussed previously), the amount of compensation is the difference between the fair market value of the stock on the date the stock was received and the amount paid for the stock by the individual.19 The allocation period is the same period that applies to regular, non-stock-based remuneration from the grantor during the taxable year that the restricted stock was received.20 The New York source portion of restricted stock compensation when the Section 83(b) election is made is computed by multiplying the compensation attributable to the restricted stock by the New York workday fraction computed for the allocation period. Dividends received on restricted stock when the Section 83(b) election has been made are investment income that is not includable in New York source income.21

Concluding Thoughts

What are the key issues? First, what is the date of the change of residence/domicile? That date is crucial to all the allocation methods used for compensation income on a source basis. Second, what is the standard allocation method used by the taxing state where there is equity-based compensation received by a nonresident who was formerly a resident? Third, what alternative allocation methods can be considered? The two allocation approaches discussed in this article—California and New York—are the ones used by a majority of the states that tax equity-based compensation. The mechanism is typically a relative workday count methodology, but the problems with such an approach are illustrated previously in Prince. Thus, the strategy is often to seek an alternative method under the state’s law. In California, for example, the legal standard is whether the method is “reasonable,” and there is certainly more than a single reasonable method. Note the standard is not the “most” reasonable. In New York, for example, there is an alternative allocation provision under which if the standard methods of allocation and apportionment under the personal income tax regulations do not result in a fair and equitable allocation, a taxpayer may submit (or the department may require) an alternative allocation method.22 Careful attention to the facts of the particular case, and the particular law of the taxing state, can offer opportunities in taxing equity-based compensation of nonresidents.  

Endnotes

  1. Comptroller of the Treasury of Maryland v. Wynne (2015) 575 U.S. 542, 553-554.
  2. See Coffill, Eric. 2021. “Five Common Challenges When Changing State Tax Residency/Domicile.” Journal of Financial Planning 34 (10): 36–48.
  3. Shaffer v. Carter (1920) 252 U.S. 37.
  4. See, e.g., Willacy v. Cleveland Bd. of Income Tax Review, 165 Ohio St. 3d 103 (2021), where the Ohio Supreme Court agreed the City of Cleveland under its municipal law could tax stock options granted by an employer to an employee who worked in Cleveland at the time of the grant, even though the employee had moved to Florida before exercising the option.
  5. FTB Pub. 1004, “Equity-Based Compensation Guidelines” (2015).
  6. N.Y. Comp. Codes R. and Regs., tit. 20, sec. 132.24 (a), (c)(3)(i)(a).
  7. N.Y. Comp. Codes R. and Regs., tit. 20, sec. 132.24(c)(3)(i)(b).
  8. N.Y. Comp. Codes R. and Regs., tit. 20, sec. 132.24(c)(2).
  9. A substantial risk of forfeiture exists when the rights of a person in property are conditioned, directly or indirectly, upon the future performance of substantial services by any individual. IRC §83(c)(1).
  10. IRC §83(a)(1).
  11. FTB Pub.1004, “Equity-Based Compensation Guidelines” (2015).
  12. N.Y. Comp. Codes R. and Regs., tit. 20, sec. 132.24(b).
  13. N.Y. Comp. Codes R. and Regs., tit. 20, sec. 132.24(c)(3)(i).
  14. New York State Department of Taxation and Finance TSB-M-07(7)I.
  15. N.Y. Comp. Codes R. and Regs., tit. 20, sec. 132.24(c)(3)(ii); New York State Department of Taxation and Finance TSB-M-07(7)I. 
  16. New York State Department of Taxation and Finance TSB-M-07(7)I.
  17. 26 U.S.C. § 83(a).
  18. Appeal of Prince, 2021-OTA-088, Jan. 5, 2021 (nonprecedential). Although Prince is technically a non-citable, non-precedential decision, it is nevertheless a wonderful illustration of the pitfalls of using a simple day-count allocation method when there is significant appreciation during the allocation period. 
  19. New York State Department of Taxation and Finance TSB-M-07(7)I.
  20. Ibid.
  21. New York State Department of Taxation and Finance TSB-M-07(7)I. 
  22. N.Y. Comp. Codes R. and Regs., tit. 20, sec. 132.15(d)(3).
Topic
Tax Planning
Professional role
Tax Planner

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