Module Overview

Wages and salary represent direct monetary compensation for personal services and are consistently included in gross income and subject to tax unless specifically exempted by law. Stock-based compensation and fringe benefits are normally included as part of compensation package in addition to wage and salary, and differ significantly in their form, tax treatment, and the timing of income recognition. Stock-based compensation involves equity awards that have distinct tax implications tied to the type of option and the timing of certain events (grant, exercise, or sale). Fringe benefits are a form of pay provided for the performance of services, but they are generally non-cash benefits. Any fringe benefit provided is taxable and must be included in the recipient’s pay unless specifically excluded by law. The value of a taxable fringe benefit is typically its fair market value (FMV), or in some cases, specific valuation rules (like the cents-per-mile, commuting, or lease value rules for vehicles) apply.

Stock-based Compensation

Equity compensation involves receiving company stock or the option to purchase company stock as part of an employee’s compensation package. The tax treatment of different forms of equity compensation can vary significantly based on the type of award and specific holding periods.

Full Value Equity Compensation

Employees can receive actual shares or the promise of shares with restrictions in exchange for their service.

Restricted Stock Units (RSUs):

RSUs, also generally governed by § 83, are a promise to deliver shares of company stock or their cash equivalent at a future date, usually upon vesting. When RSUs vest and shares are delivered, the FMV of the shares at the time of vesting is taxed as ordinary income to the employee (§ 83(a)) and is considered wages subject to payroll taxes. Similar to RSAs without an 83(b) election, the holding period for capital gains purposes begins on the date the shares are delivered upon vesting. Any gain or loss upon a later sale is then treated as a capital gain (short-term or long-term).

Restricted Stock Awards (RSAs):

With RSAs, governed by § 83, shares of company stock are granted to the employee but are subject to certain restrictions, typically vesting based on continued employment over a period. When the restrictions lapse (vesting occurs), the FMV of the shares at that time is taxed as ordinary income to the employee (§ 83(a)) and is considered wages subject to payroll taxes. The employee can make an 83(b) election (§ 83(b)) within 30 days of the grant date to be taxed on the FMV of the shares at the time of the grant, even before vesting. This can be advantageous if the stock is expected to appreciate significantly, potentially converting future ordinary income into capital gains. Any subsequent gain or loss upon the sale of the vested shares is treated as a capital gain (short-term or long-term) based on the holding period from the vesting date (or grant date if an 83(b) election was made).

Stock options

A stock option is a type of compensation that provides employee with an option to buy stock in exchange for the services. A key feature of stock option is that no income is generally recognized at the time the option is granted or when it is exercised for regular income tax purposes. Instead, for regular tax, the income (gain or loss) is typically recognized upon the sale or other disposition of the stock acquired through the option.

Incentive Stock Options – ISOs:

ISOs, governed by § 421 and § 422, offer potentially more favorable tax treatment, but they have stricter requirements. Generally, there is no regular income tax at the time of exercise. However, the difference between the FMV at exercise and the grant price is considered a preference item for the Alternative Minimum Tax (AMT) (§ 56(b)(3)). If the employee holds the shares for at least two years from the grant date and one year from the date of exercise (a qualifying disposition under § 422(a)(1)), any gain upon sale is taxed as long-term capital gain (§ 1222(3)). If these holding period requirements are not met (a disqualifying disposition under § 422(c)), the difference between the FMV at exercise and the grant price is taxed as ordinary income (§ 61), and any additional gain is taxed as a short-term or long-term capital gain depending on the holding period after exercise.

Non-Qualified Stock Options – NQSOs:

When an employee exercises an NQSO, the difference between the fair market value (FMV) of the stock at the time of exercise and the option’s grant price is taxed as ordinary income to the employee (§ 61) and is considered wages subject to payroll taxes under § 3101 (Social Security), § 3111 (Employer Social Security), § 3121(a) (Definition of Wages), § 3301 (FUTA), and § 3402 (Income Tax Withholding). When the employee later sells the shares, any gain or loss is treated as a capital gain (§ 1221) (short-term if held for one year or less from the exercise date (§ 1222(1)), long-term if held for more than one year (§ 1222(3))).

Stock Appreciation Rights (SARs)

Unlike stock options, SARs typically do not require the employee to purchase the underlying stock. Upon exercise, the employee receives the appreciation in value, either in cash or in shares of stock. The taxation of SARs is primarily governed by Internal Revenue Code (IRC) § 83, Property Transferred in Connection with Performance of Services. When an employee exercises SARs, the fair market value of the cash or stock received is taxable as ordinary income in the year of exercise, as it is considered compensation for services rendered. This income is subject to ordinary income tax rates and is also subject to payroll taxes, such as Social Security and Medicare taxes, as well as income tax withholding at the time of payment.

Employee Stock Purchase Plans (ESPPs):

ESPPs, governed by § 421 and § 423, allow employees to purchase company stock at a discounted price through payroll deductions. If the shares are held for at least two years from the grant date of the offering and one year from the date of purchase (a qualifying disposition under § 423(a)(1)), the discount (generally the lesser of the discount from grant date or purchase date) is taxed as ordinary income (§ 423(c)), and any additional gain upon sale is taxed as long-term capital gain (§ 1222(3)). If the shares are sold before meeting these holding period requirements (a disqualifying disposition under § 423(c)), the discount at the time of purchase is taxed as ordinary income (§ 83), and any further gain or loss is treated as a short-term or long-term capital gain based on the holding period after purchase.

Form 3922, Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423(c), is used by corporations to report ESPP stock transfers to both the IRS and employees. The form provides details such as the grant date, purchase date, fair market value on those dates, and the number of shares transferred. Employees use this information to properly calculate the amount of ordinary income and any capital gain or loss when they sell the stock. See a video for step-by-step walkthrough.

Fringe Benefits

Fringe benefits received in connection with the performance of taxpayer’s services are included in gross income as compensation unless taxpayers pay FMV for them or they’re specifically excluded by law. Employer must include all taxable fringe benefits in Form W-2, box 1, as wages, tips, and other compensation, and, if applicable, in boxes 3 and 5 as social security and Medicare wages. Although not required, the employer may include the total value of fringe benefits in box 14 (or on a separate statement).

A crucial consideration for certain fringe benefits, particularly those intended to be excluded from an employee’s taxable income, is compliance with nondiscrimination rules. These rules, found primarily in Internal Revenue Code (IRC) Section 132 (for benefits like no-additional-cost services, qualified employee discounts, and on-premises eating facilities, though not on-premises athletic facilities), Section 125 (for cafeteria plans), Section 105(h) (for self-funded health plans), and Section 129(d) (for dependent care assistance programs), prevent employers from disproportionately favoring highly compensated employees (HCEs) or key employees with tax-advantaged benefits. If a benefit plan fails these nondiscrimination tests, the tax exclusion is typically lost only for the highly compensated or key employees who received the discriminatory benefit, meaning they must include the value of the benefit in their gross income and pay taxes on it, while non-HCEs can still enjoy the tax-free benefit.

Here are the major categories of fringe benefits organized by their primary purpose:

Health and Well-being Benefits

Health and well-being benefits are primarily intended to support the physical and mental health of employees and their families. Generally, the value of coverage provided by the employer under an accident or health plan is not included in gross income. This exclusion typically applies to employer contributions to Archer MSAs, Health Flexible Spending Arrangements (Health FSAs), Health Reimbursement Arrangements (HRAs), and Health Savings Accounts (HSAs).  Employer contributions for long-term care coverage are also generally excludable, unless they are made through a flexible spending or similar arrangement, in which case they are included in wages. Furthermore, the value of free or low-cost use of an employer-operated gym or athletic club on employer premises is not included in gross income, provided it is primarily used by employees, their spouses, and dependent. However, if employer pays for an off-site fitness program, its value is included in employee’s compensation.

Financial Planning Benefits

Financial and Retirement Planning Benefits are designed to help employees save for retirement and manage long-term financial planning, often providing tax advantages. The cost of up to $50,000 of employer-provided group-term life insurance coverage is generally not included in gross income, but any cost exceeding this limit is taxable. Contributions made by your employer to qualified retirement plans like 401(k), 403(b), the Federal Government’s Thrift Savings Plan (TSP), Salary Reduction Simplified Employee Pension (SARSEP) plans, Savings Incentive Match Plan for Employees (SIMPLE plans), and Section 457 plans are generally not included in income at the time contributed, with the notable exception of Roth contributions. Furthermore, qualified retirement planning services provided by an employer that maintains a qualified retirement plan are not included in an employee’s gross income. This exclusion is found in Internal Revenue Code § 132(m). The provision specifically limits the exclusion to retirement planning services, which include counseling and educational sessions about the employer’s plan

Work-Related Convenience and Support Benefits

Work-related convenience and support benefits are non-cash perks provided by employers to help employees perform their jobs, commute, or enjoy added convenience. Many can be excluded from taxable income if certain conditions are met. These include working condition benefits, such as employer-provided items that would be deductible if purchased personally; meals and job-required lodging provided on business premises for the employer’s benefit; and qualified transportation benefits such as transit passes or parking, which are tax-free up to specific limits. Also excluded are no-additional-cost services, such as free airline seats or hotel rooms, if they involve excess capacity at no extra cost to the employer, and employee discounts on goods or services offered in the ordinary course of business. These are subject to specific limits and not applicable to real or investment property.

Professional development and family support benefits

Professional development and family support benefits help employees pursue education, advance professionally, and manage family responsibilities, with several types of assistance eligible for income exclusion. Up to $5,250 of employer-provided educational assistance can be excluded from income, and qualified tuition reductions from educational institutions may also be excluded for employees, certain family members, and graduate students engaged in teaching or research. Dependent care benefits provided under a qualified plan can be excluded up to specific limits (e.g., $5,000 or $2,500 if married filing separately), and adoption assistance for qualified expenses may also be excluded from income, although it is still subject to Social Security and Medicare taxes.

Employers can generally deduct the cost of many fringe benefits provided to employees, though specific rules and limits apply to different types of benefits, and some benefits are explicitly non-deductible.

Tax Planning Considerations

Stock-based Compensation

Stock-based compensation presents unique tax planning issues because the timing of income recognition and the type of tax treatment can vary depending on the form of compensation received.

For nonqualified stock options (NQSOs), taxable income is generally recognized at the time of exercise. The amount included in income is the “bargain element,” which is the difference between the fair market value of the stock on the exercise date and the exercise price. This income is taxed as ordinary income. While delaying exercise can postpone the tax liability, it also exposes the taxpayer to the risk of stock price declines.

For incentive stock options (ISOs), exercising the option does not normally create a regular income tax liability. However, the bargain element must be included in alternative minimum taxable income (AMTI), which can trigger the alternative minimum tax (AMT). As a result, the timing of ISO exercises requires careful planning.

For restricted stock awards (RSAs) and restricted stock units (RSUs), income is recognized when the restrictions lapse and the stock vests. At that time, the fair market value of the stock is included in ordinary income. Employees may make an 83(b) election for RSAs, which allows the value of the stock to be recognized as income on the grant date rather than the vesting date. This election can be advantageous if the stock is expected to appreciate, since future increases in value may be taxed as capital gains instead of ordinary income.

The sale of shares acquired through equity compensation also presents planning opportunities. The length of time the shares are held after exercise or vesting determines whether any subsequent gain or loss is classified as short-term or long-term. Long-term capital gains generally receive more favorable tax treatment. Thus, holding shares for at least one year following exercise or vesting is a common tax minimization strategy.

Fringe benefits

Fringe benefits provided by employers can offer significant tax savings opportunities. Tax planning in this area involves prioritizing benefits that are excluded from income.

Employees should seek to maximize non-taxable benefits when offered a choice, such as under a cafeteria plan. A tax-free benefit provides a greater net value than a taxable benefit of the same amount because it avoids income and payroll taxes.

Flexible Spending Accounts (FSAs) for healthcare and dependent care expenses allow employees to set aside pre-tax dollars to pay for qualifying personal expenses. These contributions reduce taxable income, but employees must be mindful of the “use-it-or-lose-it” rule, which generally requires that contributions be spent within the plan year. Some plans, however, provide a short grace period or a limited carryover provision.