Stock Options After a 409A: Form 3921, Withholding and the Books

What does the company file when it grants stock options?

Nothing goes to the IRS at grant when the option is priced at fair market value and has no readily determinable value, which is the usual case for a private startup (Publication 525). Filings start when someone exercises:

The spread is the share value on the exercise date minus the exercise price. What makes a case not simple: a grant dated before the board acted or priced on a stale valuation, ISOs that exceed the annual limit, an exercise more than three months after someone left, early exercise of unvested shares, or a sale back to the company. Each can change the form, the withholding or the deduction.

Gather: the option plan and stockholder approval, board approvals for each grant, every 409A report, the grant and exercise ledger, and prior Forms 3921, W-2 and 1099-NEC.

Why must the exercise price be at least the 409A value, and how long does a valuation hold?

An NSO priced below fair market value on the grant date is generally deferred compensation under section 409A, and an ISO priced below it is not an ISO unless the shortfall came from a good-faith attempt to value the stock (26 U.S.C. 422(c)(1)). An NSO stays outside 409A only if its price can never be less than the grant-date fair market value and the number of shares is fixed at grant (26 CFR 1.409A-1(b)(5)(i)). When a 409A failure is triggered, the holder includes the amount in income and owes an additional 20% tax plus interest (26 U.S.C. 409A(a)(1)(B); Form W-2 instructions, code Z).

For private stock, the regulation presumes a value reasonable when it comes from an independent appraisal dated no more than 12 months before the grant, or from a qualifying written report for an illiquid startup. A value is no longer reasonable, even inside 12 months, if it misses later information that may materially affect it; the regulation's examples are resolving material litigation or issuing a patent, and a new financing round may also qualify (26 CFR 1.409A-1(b)(5)(iv)(B)). The company engages its own appraiser; this page covers what follows.

The grant date is the day the corporate action granting the option is complete, with the shares and price fixed (26 CFR 1.421-1(c)). A grant letter dated before board approval does not move the grant date back, so price it against the value on the approval date.

ISO or NSO: which can we grant, and to whom?

Only employees can receive ISOs; contractors, advisors and outside directors receive NSOs. Section 422 sets the ISO conditions (26 U.S.C. 422):

An option that fails a test is taxed as an NSO, so payroll must withhold on its exercise. Track the annual limit by the year shares first become exercisable (the vesting year, or the grant year if early exercise is allowed), since one grant can be part ISO and part NSO. For the employee's side after leaving, see exercising options when you leave.

Form 3921 for an ISO exercise: what does the company file, and by when?

The corporation files one Form 3921 for each ISO exercise in the calendar year and gives the employee a copy. The form shows the grant date, exercise date, exercise price per share, fair market value per share on the exercise date, and number of shares (Form 3921 instructions). No Form 3921 is needed for a nonresident alien employee to whom the company was not required to give a Form W-2 for any year from the grant year through the exercise year.

A deadline on a weekend or holiday moves to the next business day. A company filing 10 or more information returns of all types combined must e-file (General Instructions for Certain Information Returns). A late or missing form can cost $60 to $340 per return, charged again for the employee copy. For forms missed in past years, see tax clean-up before due diligence.

The ISO exercise itself is not wages: no income tax withholding, Social Security, Medicare or federal unemployment tax (Publication 15-B). The spread can still matter for the employee's alternative minimum tax.

NSO exercise withholding: what must payroll withhold and report?

For an employee or former employee, the NSO spread is wages subject to income tax withholding, Social Security, Medicare and federal unemployment tax. It is reported on Form W-2 in box 1, box 3 up to the $184,500 wage base, box 5, and box 12 with code V (W-2 instructions; Publication 15-B).

• Income tax: the spread is supplemental wages (26 CFR 31.3402(g)-1). The company may withhold a flat 22% if it withheld from the employee's regular wages this year or last; supplemental wages above $1 million in a year must be withheld at 37% (Publication 15).
• Social Security and Medicare: 6.2% and 1.45% from each side, plus 0.9% Additional Medicare withholding once the employee's wages pass $200,000.
• Deposits and returns: include the tax in the regular deposit and on Form 941. A large exercise can trigger the next-day deposit rule at $100,000.

The spread is paid in shares, not cash, so arrange how the employee funds the withholding before the exercise is processed. The company owes income tax it should have withheld. If withheld taxes are not paid over and the company cannot pay, the IRS can charge the trust fund recovery penalty, the full unpaid withheld income tax and employee Social Security and Medicare tax, to each officer or employee responsible for collecting or paying them who acted willfully (Publication 15); see behind on payroll taxes. State income tax withholding may also apply and differs by state.

For a contractor, advisor or outside director, there is no payroll. Report the spread in box 1a of Form 1099-NEC when it and other service pay reach $2,000, due by January 31 (1099-NEC instructions; Publication 5992). The holder's own tax is covered in exercising startup stock options.

Early exercise of unvested options: what paperwork does the company keep?

Keep the exercise agreement with the company's repurchase right, the vesting schedule and a copy of any section 83(b) election. A person who makes an 83(b) election, due within 30 days after the shares are transferred, must also give the company a copy (26 CFR 1.83-2).

The 83(b) election decides when an early-exercised NSO is taxed. Without it, income arises as the shares vest, measured on the value at vesting (Publication 525), so an employee's vesting dates become payroll events with withholding and W-2 reporting. An early-exercised ISO goes on Form 3921 for the year of exercise, with the value on the exercise date, because the shares count as transferred even while unvested (26 CFR 1.421-1(g)). Whether the employee should file the election is covered in early exercise of startup stock options.

Stock-based compensation tax deduction: does the company get one?

For NSOs, yes: the corporation deducts the amount the holder includes in income, in its tax year that includes the end of the holder's tax year (26 U.S.C. 83(h)). When the shares are already vested at exercise, the deduction instead follows the company's accounting method, usually the year of exercise (26 CFR 1.83-6(a)(3)). The holder is treated as having included it when the company timely files the W-2 or 1099 (26 CFR 1.83-6(a)(2)). No deduction is allowed now for any part the company must capitalize, such as research costs it amortizes (26 CFR 1.83-6(a)(4)); see deducting software development costs.

For ISOs, generally no. The company gets no deduction when the employee meets the holding periods: two years from grant and one year from exercise (26 U.S.C. 421(a); 422(a)). If the employee sells sooner, a disqualifying disposition, the employee has ordinary income and the company deducts the same amount in the year of the sale (26 U.S.C. 421(b)). Report that income in W-2 box 1, with no withholding or Social Security and Medicare (Publication 15-B). The deduction requires the W-2 or W-2c to be furnished and filed by the time the company files the return claiming it (26 CFR 1.83-6(a)(2)). The company learns of the sale only if someone tells it, so ask employees to report early sales.

How do options show in the books, and why does the tax return differ?

The books and the tax return count option cost at different times and in different amounts. The financial statements record a stock compensation expense under the company's accounting framework, commonly spread over the vesting period. The tax deduction follows the rules above: NSO spread at exercise or vesting, ISO only on a disqualifying disposition.

The gap is reconciled on Form 1120 Schedule M-1 (not required when total receipts and year-end total assets are both under $250,000), or on Schedule M-3 when total assets reach $10,000,000, where line 9 of Part III compares stock option expense per the books with the deduction (Form 1120 instructions; Schedule M-3 instructions). The IRS audit guide for examiners, which is not binding guidance, has them reconcile the option deduction to the W-2 code V amounts (Publication 5992), so keep a report by holder of exercise dates, spread, withholding and form issued.

Tender offer or buyback from employees: what does the company withhold?

It depends on what is being sold:

• Options exercised to sell: an NSO exercise is wages for an employee, with the usual withholding and W-2 code V.
• ISO shares sold before the holding periods end: a disqualifying disposition; W-2 box 1 reporting, no withholding.
• A price above fair market value: any part paid for services rather than for the shares is pay, and for an employee that means wages. Whether a premium is pay depends on the facts; no rule is written for tender offers, so treat the point as unsettled.

The seller's side, including when a company buyback counts as a sale, is covered in selling startup shares in a tender offer. Buybacks above 5% of the company's stock can also cost stock it issues within a year before or after them its QSBS status (26 U.S.C. 1202(c)(3)); see QSBS for founders and early employees.

What should the option ledger keep?

The ledger should let anyone rebuild every form and deduction from one record:

• Holder, holder type (employee, former employee, contractor, director) and country of residence
• Board approval date, grant date, ISO or NSO, shares and exercise price
• The 409A report used and its valuation date
• Vesting schedule and the ISO annual-limit split by year
• Each exercise: date, shares, fair market value, spread, withholding and form issued
• Early exercises, repurchase rights and 83(b) copies
• Termination dates and post-termination exercise deadlines
• Reported early sales of ISO shares

Example

These scenarios are illustrative and use US dollars.

An employee exercises ISOs

An employee exercises ISOs over 10,000 shares at $1 when the 409A value is $4. The company files Form 3921 showing the grant date, exercise date, $1 price, $4 value and 10,000 shares. It withholds nothing and puts nothing on the W-2. The $30,000 spread may count toward the employee's alternative minimum tax. The company gets no deduction unless the employee later sells early.

An employee exercises NSOs

An employee's NSO exercise has a $50,000 spread. That is $50,000 of wages. If the company withheld from the employee's regular wages and uses the flat rate, it withholds $11,000 of federal income tax at 22%. Assuming the employee's wages for the year, including the spread, stay under the Social Security wage base and the Additional Medicare trigger, it also withholds $3,100 of Social Security and $725 of Medicare and pays its matching share. The W-2 shows $50,000 in box 12 with code V, and the company deducts $50,000.

An advisor exercises NSOs

An advisor who is not an employee exercises NSOs with a $20,000 spread. There is no payroll and no withholding. The company reports $20,000 in box 1a of Form 1099-NEC and deducts $20,000.

Different for you?

• Grants were dated before board approval or priced on an old valuation: a 409A or ISO problem may need correcting before the next round; get corporate tax help.
• Forms 3921 or W-2 code V amounts were missed in past years: see tax clean-up before investor due diligence and get corporate tax help.
• You are the employee exercising: see exercising startup stock options and AMT on incentive stock options.
• Staff live and work in Canada: Canadian rules apply; see stock options for employees in Canada.
• The company is running a tender offer or buyback: see selling startup shares in a tender offer and get corporate tax help.
• An option holder lives or works outside the US: withholding and forms can differ; see paying contractors abroad and hiring employees abroad.
• Founders are deciding their own pay: see founder salary in a venture-backed corporation.