As more Americans take on international roles, stock options have become a key part of the expatriate executive’s compensation package, especially when working for foreign employers. These options offer exciting opportunities to benefit from a company’s growth, but they also come with complex U.S. tax implications that can catch the unwary off guard.
Imagine you’re an American executive at a tech startup in London, and your employer offers you stock options as a perk. It’s a chance to share in the company’s success, but what does it mean for your U.S. taxes? The rules differ from those for traditional wages, and missteps can lead to unexpected tax bills.
This article breaks down the U.S. tax treatment of non-statutory stock options. These are the most common type received from foreign employers as they are not granted under either an employee stock purchase plan or an incentive stock option plan.
Each stage of stock options given in connection with employment from grant, to exercise, and a later sale of purchased shares has tax implications. This article highlights the key U.S. tax considerations at every step and reviews a tax planning strategy that could save money.
1. Grant of the Stock Option: Usually No Tax, But Watch Out
When a foreign employer grants an individual non-statutory stock options, the individual typically does not owe U.S. tax because of the option grant. This assumes the options lack what is called a “readily ascertainable fair market value”, which is common with private companies since options on such stock are not publicly traded.
A potential pitfall lies in Section 409A of the U.S. Internal Revenue Code, which governs deferred compensation. If the options defer compensation in a way that triggers Section 409A, the individual could face taxes and penalties because of the option grant. Section 409A commonly applies when stock options have an exercise price below the stock’s fair market value at the time of grant or if they include features that allow deferral of income beyond standard vesting and exercise terms.
2. Exercising The Stock Option: The Main Tax Event
The significant tax event typically occurs when the individual exercises the options by purchasing the stock. The difference between the stock’s fair market value at exercise and the price the individual pays is treated as ordinary income. For example, if the individual pays $30 per share and the stock’s FMV is $100, the individual reports $70 per share as income.
For Americans living and working overseas, this income might qualify for the foreign earned income exclusion (up to $130,000 in 2025) if the work tied to the options was performed abroad. Determining how much of this income is foreign versus U.S-source, can become complex and depends on the individual’s specific circumstances. An examination of the individual’s services, and where and when they were carried out in relation to the options being granted is needed. This complexity makes expert advice essential.
3. Restricted Stock And Capital Gains
If the stock purchased by the employee upon exercise of the option is considered “substantially nonvested” then the employee will not be taxed at the time he exercises the option. In order for the stock to be considered “substantially nonvested” there are two requirements. The stock must be: (i) nontransferable and (ii) “restricted” so as to be “subject to a substantial risk of forfeiture” (e.g., the individual loses the stock if he leaves the company within a certain time period).
If both of these restrictions are met, the employee will not be taxed at the time he exercises the option. Taxation will occur at a later time when either one of the restrictions lapse. At that time, the individual is taxed on the difference between the FMV of the stock at time of lapse minus the option price he paid. Assuming the value of the stock has risen in the meantime, the employee will pay higher tax. This is so because he will have more compensation income and compensation income is treated and taxed as ‘ordinary income’ with a current maximum rate of 37%.
In contrast, when the employee reports income at the time he exercises the option (for example, because the stock he acquired by exercising the option was not “substantially nonvested”), he would acquire a basis in the stock equal to the FMV of the stock at that time. When the stock is later sold, any future appreciation after the option was exercised would generally be taxed as capital gain. If the gain is taxed as “long term” capital gain, it is taxed much more favorably (generally at top rates of 15% or 20%) in comparison to “ordinary income” rates.
Here is an example: Assume the individual exercises options when the stock is worth $100, paying $20, but restrictions prevent selling for two years, and the stock rises to $150 when the restrictions lift. The individual is taxed on $150 – $20 = $130 as ordinary income (with a top rate of 37%). If taxation had occurred at exercise, the individual would owe tax on $100 – $20 = $80 of ordinary income. Any later gain would be capital gain. The delay can result in a higher tax bill if the stock rises, so timing is significant.
4. Section 83(b) Election, Maybe A Strategic Move
If the stock is substantially nonvested, the individual can make an election under Code Section 83(b) to pay tax at exercise of the option instead of waiting for the restrictions to lapse. The individual would report the FMV at exercise minus the option price as ordinary income at that time. Future appreciation would be treated as capital gain. Using the earlier example, electing at exercise taxes the individual on $80 ($100 – $20) upfront. If the stock rises to $150 by the time restrictions lapse and the individual sells at $200, the $100 gain ($200 – $100) is capital gain.
The election is not free of risk. The individual pays tax upfront, even if the stock value declines or if the stock is forfeited later. If the value of the stock drops to $50, the individual would have paid tax on $80 that was never realized. It is a calculated risk and one that must be carefully evaluated.
5. Foreign Information Tax Reporting
When a U.S. person owns shares in foreign entities, special tax considerations come into play. These include foreign information return reporting, for example, on Form 8938. Such reporting gets confusing with the grant to an employee of options on foreign stock or restricted foreign stock itself. Reporting on Form 8938 may be required if the option or shares are treated as a “specified foreign financial asset.” Unvested shares and options generally may be disregarded for purposes of Form 8938 until the time of vesting, unless the individual makes a valid election to include the assets in income under Code Section 83(b).
6. Stock Options, Not Immune To Foreign Taxes
The foreign country where the taxpayer is living and working may also tax the stock option at grant, exercise, or sale, depending on local tax laws. Some countries tax options as employment income upon vesting or exercise, while others treat gains as capital gains upon sale. This can lead to double taxation if both the U.S. and the foreign country tax the same income.
To mitigate this, proper tax planning is essential to maximize the use of foreign tax credits, avoid timing mismatches, and ensure compliance with both U.S. and foreign tax rules. A tax professional familiar with cross-border taxation can help structure the reporting to minimize overall tax liability and take advantage of tax treaties where applicable.
Conclusion: Plan Ahead, Seek Expertise About Foreign Stock Options
Stock options can enhance an expatriate’s wealth, but the tax rules are intricate. From the timing of taxation to the interplay of U.S. and foreign tax laws—including the risk of double taxation mitigated by tax treaties—the stakes are high. Understanding the basics is a starting point, but personalized advice from a tax professional familiar with international rules is essential to maximize benefits and ensure compliance. The complexity should not overshadow the value of stock options.
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Reach me at vljeker@us-taxes.org
Visit my US tax blog www.us-tax.org It is an invaluable guide in all areas of U.S. international tax. Stay on top of legislative developments and tax reform, (including impact on foreign stock options) and keep ahead of U.S. tax changes impacting your life, family or business.
NO ATTORNEY-CLIENT RELATIONSHIP OR LEGAL ADVICE
This communication is for general informational purposes only. It is not intended to constitute tax advice or a recommended course of action. Professional tax advice should be sought as the information here is not intended to be, and should not be, relied upon by the reader in making a decision.
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