Dividend Equivalents for Stock Options

Corporations may choose to offer incentives to all employees or restrict them to executives. Stock options, restricted shares, bonuses and various other devices help executives maintain the lifestyle worthy of their corporate rank. Corporations frequently justify executive incentives -- often called “golden handcuffs” -- as a way to keep valuable talent from taking jobs with competitors. Depending on the nature of the incentive, the IRS will tax it when it is granted, vested or sold.

Stock options allow you to purchase a specified number of company shares for a specified price -- the exercise price. When the corporation grants you a stock option, you have the opportunity -- but not the obligation -- to exercise it once it vests. Vesting periods might extend several years after you first receive the option, but in some plans the options vest immediately. Stock options classified as “statutory” may qualify for a tax deferment. With statutory options, you don’t create taxable income until you sell the underlying stock. You owe no tax when you receive or exercise the options.

Dividend equivalents are not dividends. They are payments of cash or additional shares that you would have received had you already exercised your stock options. Because they are not dividends, these payments do not qualify for the special tax rate on qualified dividends. When you agree to accept dividend equivalents, you may have the choice to receive them at the same time that shareholders receive their dividends. Alternatively, you may be granted the dividend equivalents but not receive the money until you exercise your stock options.

If you defer your dividend equivalents until you exercise your stock options, you may create a hornet’s nest of problems. Section 409A of the Internal Revenue Code governs the rules for nonstatutory deferred compensation plans. If you can receive your dividend equivalents only by exercising your stock options, you might trigger back-taxes and penalties on those options when you exercise them. Section 409A is notorious for its complexity, and you might do well to seek professional guidance before deciding when to accept your dividend equivalents.