STOCK OPTIONS
WHAT ARE EMPLOYEE STOCK OPTIONS?
An employee stock option is the right or privilege granted by
a corporation to an employee to purchase the corporation’s
stock at a specified price during a specifi ed period.
Those stock option plans that meet the requirements of
Sections 421 through 424 of the Internal Revenue Code (IRC)
are referred to as statutory stock options; those that do not are
referred to as nonstatutory or nonqualified stock options (NSO).
The determination whether a stock option plan meets the
requirements of the IRC are made by the Internal Revenue
Service (IRS).
California’s employment tax treatment of stock
options conforms to the federal tax treatment, which
has evolved through court decisions, IRS rulings and
notices, and amendments to the IRC.
In addition to statutory and nonstatutory stock options
defined in the IRC, there is also a California Qualified
Stock Option, which must meet the requirements of Section
17502 of the Revenue and Taxation Code (R&TC).
The following discussion defines the various types of stock
options and provides a detailed explanation of California’s
employment tax treatment of income derived from stock options.
The attached one-page summary table is provided for quick
reference.
STATUTORY STOCK OPTIONS
There are two types of statutory stock options:
• Incentive Stock Options (ISO), which must meet the
requirements of Section 422 of the IRC and are usually
intended for “key” employees as defined by the IRC.
The gain from the exercise of an ISO is based on the
spread income (the difference between the fair market
value of the stock when the option is exercised, less the
cost to the employee).
• Employee Stock Purchase Plans (ESPP), which must
meet the requirements of Section 423 of the IRC and
are usually intended for “rank and fi le” employees. The
gain from the exercise of an ESPP is based on both the
spread income and the discount portion of the stock
(ESPPs may be granted with an option price below the
full fair market value of the stock as of the date granted,
but this discount may not exceed 15 percent).
The employment tax treatment of a statutory stock option
depends, in part, upon when the employee disposes of
(sells, exchanges, gifts, or transfers) the stock acquired
through the exercise of the option. Stock that is disposed
after a required minimum holding period is said to have
a “qualifying disposition.” Stock not held for this period is
said to have a “disqualifying disposition.” Stock disposed to
comply with conflict-of-interest requirements is an exception
to the minimum holding period.
Employment Tax Treatment of Statutory Stock Options
California’s employment tax treatment of the income realized
from a statutory stock option is the same as the federal
treatment: no income results from the grant or exercise of
the stock option. Any gain from the sale of stock is a capital
gain, not wages, and it is not subject to employment taxes:
Unemployment Insurance (UI), Employment Training Tax
(ETT), State Disability Insurance* (SDI), and Personal Income
Tax (PIT) withholding.
Note: Although no employment taxes are required, in cases
where there has been a disqualifying disposition of a statutory
stock option, the gain from the spread income (and the
discount portion of stock acquired by the exercise of an ESPP)
must be reported as PIT wages on the Quarterly Contribution
Return and Report of Wages (Continuation) (DE 9C).
NONSTATUTORY STOCK OPTIONS
As stated above, an NSO is an employee stock option that
does not meet the requirements of Sections 421 through
424 of the IRC. Consequently, it does not enjoy the same
favorable tax treatment as a statutory stock option.
Employment Tax Treatment of Nonstatutory Stock Options
When an NSO is subject to tax depends on whether, at
the time the option is granted, the stock has a “readily
ascertainable” fair market value. This is determined by
Section 83 of the IRC and corresponding federal regulations.
• Income resulting from an NSO that has a fair market
value at the time it is granted is considered wages for
California employment tax purposes and is subject to
UI, ETT, SDI, and PIT withholding and reportable as PIT
wages at the time the option is granted.
• Income resulting from an NSO that did not have a readily
ascertainable fair market value at the time it was granted
is wages for California employment tax purposes and is
subject to UI, ETT, SDI, and PIT withholding and reportable
as PIT wages at the time the option is exercised.
Note: Most NSOs do not have a readily ascertainable fair
market value at the time they are granted.
CALIFORNIA QUALIFIED STOCK OPTIONS (CQSO)
Section 17502 of the R&TC provides that a stock option
specifically designated as a CQSO will receive the
favorable tax treatment provided by Section 421 of the IRC
if all the following conditions are met:
1. The option was issued on or after January 1, 1997, and
before January 1, 2002.
2. The earned income of the employee to whom the option
is issued does not exceed $40,000 in the tax year in
which the option is exercised.
* Includes Paid Family Leave (PFL).
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3. The number of shares of stock granted in the option does
not exceed 1,000 and the combined fair market value of the
shares is less than $100,000 at the time the option is granted.
4. The employee must be employed by the company at the
time the option is exercised (or within three months of that
date), or within one year if permanently and totally disabled.
Employment Tax Treatment of CQSOs
For federal purposes, CQSOs are subject to federal
employment taxes in the same manner as an NSO (see above).
For California employment tax purposes, a qualifi ed CQSO
receives the favorable tax treatment of a statutory stock
option (see above). However, there is no minimum holding
period for a CQSO, so there can be no disqualifying
disposition. As a result, PIT wages are never reportable
upon the disposition of stock obtained through a CQSO.
STOCK OPTIONS TRANSFERRED IN A
COMMUNITY PROPERTY SETTLEMENT
In California, a stock option granted during the period of a
marriage (or, effective January 1, 2005, during a registered
domestic partnership) is community property. Any stock
option transferred in a community property settlement is
an NSO, either because it did not qualify as a statutory
stock option initially or by virtue of the transfer. If a statutory
stock option is transferred due to a divorce or pursuant to
a domestic relations order, the option no longer qualifies
as a statutory stock option as of the day of the transfer.
Thereafter the option is treated as an NSO.
When an NSO is transferred to the nonemployee spouse/
partner as part of a community property settlement, there is
no income to either party until the nonemployee exercises the
option. When the option is exercised, the income is subject
wages for UI, ETT, SDI, and PIT withholding purposes.
However, the income is not reportable as PIT wages.
The employee’s ex-spouse (or former registered domestic
partner) realizes income based on the employee’s services.
The employer should report the income as follows, based
on the requirements established by the IRS in Revenue
Rulings 2002-22 and 2004-60:
• Employee: The income is reportable on behalf of the
employee for California UI, ETT, and SDI purposes
since it resulted from the employee’s prior services.
However, the income is not subject to PIT withholding
and is not reportable as PIT wages for the employee.
• Ex-spouse or former registered domestic partner: The
income is reportable as nonemployee compensation on
federal Form 1099-MISC. California PIT withholding is
required, but the income is not reportable as PIT wages.
MULTISTATE JURISDICTIONAL ISSUES
Stock options, as explained above, may not immediately
become “wages” subject to taxation. An employee may
be granted an option in one state, exercise the option in
a second state, and dispose of the stock in a third state.
For UI, ETT, and SDI purposes, wages derived from the
exercise of a stock option are subject to the jurisdiction of
the state in which services are otherwise subject at the time
the “wages” are paid (when the option becomes taxable).
For California PIT purposes, wages derived from stock
options are allocated between the states in which the
employee performs services for the employer that grants
the option. This allocation begins when the option is granted
and ends when the income derived becomes taxable.
For California Residents, all taxable wages resulting
from stock option transactions are to be reported to the
Employment Development Department (EDD) as PIT wages
regardless of where the services that generated the wages
were performed. If the same wages are taxed in another
state, then the California PIT withholding required is reduced
by the amount of state income tax withheld and paid to the
other state. If the employee is not a resident of California,
then only the wage allocated to California must be reported
to the EDD and are subject to California PIT withholding.
Example - California Resident
On March 1, 2009, your company grants nonstatutory stock
options to an employee who is a resident of Michigan. On
June 1, 2011, the employee is transferred to your California
location and takes up permanent residency in California. On
August 1, 2011, the employee exercises the options.
Because the employee is a California resident, the wages
resulting when the nonstatutory stock options are exercised
(difference between the fair market value of the shares on
August 1, 2011, and the option price) must be reported to
the EDD and are subject to California PIT withholding. If
the wages are also subject to state income tax withholding
by Michigan, then the amount of California PIT withholding
required is reduced by the amount of state income tax
withheld and paid to Michigan.
Example - Nonresident
An employee is granted an NSO (without a readily
ascertainable fair market value) for services performed in
California employment. The employee retires and moves to
Nevada, where he exercises his option.
In this case, the spread income is subject to UI, ETT, and
SDI in California because the services that resulted in the
stock option were localized in California. Similarly, for PIT
withholding and wage reporting purposes, because all the
employee’s services were performed in California, the income
(and tax thereon) is allocated exclusively to California.
ADDITIONAL INFORMATION
For further assistance, please contact the Taxpayer
Assistance Center at 888-745-3886 or visit the nearest
Employment Tax Office listed in the California Employer’s
Guide (DE 44) and on the EDD website at
www.edd.ca.gov/Office_Locator/.
The EDD is an equal opportunity employer/program.
Auxiliary aids and services are available upon request to
individuals with disabilities. Requests for services, aids, and/
or alternate formats need to be made by calling
800-745-3886 (voice), or TTY 800-547-9565.
This information sheet is provided as a public service and is intended to provide nontechnical assistance. Every attempt has been made
to provide information that is consistent with the appropriate statutes, rules, and administrative and court decisions. Any information that
is inconsistent with the law, regulations, and administrative and court decisions is not binding on either the Employment Development
Department or the taxpayer. Any information provided is not intended to be legal, accounting, tax, investment, or other professional advice.
DE 231SK Rev. 5 (10-12) (INTERNET) Page 2 of 3
Employment Tax Treatment of Stock Options
Federal Employment Tax Treatment California Employment Tax Treatment
Type of Stock Option FUTA FICA
Federal Income
Tax Withholding UI/ETT/SDI
PIT
Withholding PIT Wages
Statutory Stock Option
Includes Incentive Stock Option (ISO) and
Employee Stock Purchase Plan (ESPP)
Qualifying Disposition
Not subject
1
Not subject
2
Not subject
3
Not subject Not subject Not reportable
Disqualifying Disposition
Not subject
1
Not subject
2
Not subject
,5 4
Not subject
Not subject
Reportable when
disposed
Nonstatutory Stock Option (NSO)
With Readily Ascertainable Fair Market
Value When Granted
Subject when
granted
,7 6
Subject when
granted
,7 6
Subject when
granted
,7 6
Subject when
granted
Subject when
granted
Reportable when
granted
Without Readily Ascertainable Fair
Market V
alue When Granted
Subject when
exercised
,8 7
Subject when
exercised
,8 7
Subject when
exercised
,8 7
Subject when
exercised
Subject when
exercised
Reportable when
exercised
California Qualifi ed Stock Option (CQSO)
Must meet all the requirements of R&TC,
Section 17502 of the R&TC. If the requirements
are not met, the CQSO will receive NSO
treatment for California employment tax
purposes. See NSO above.
See NSO above See NSO above See NSO above Not subject Not subject Not reportable
1
IRC, Section 3306(b)(1)
2
IRC, Section 3121(a)(22)
3
IRC, Section 421(a)
4
IRC. Section 421(b)
5
IRC. Section 423(c)
6
IRC, Section 83(a)
7
Code of Federal Regulations, Title 26, Section 1.83-7(a)
8
IRC, Section 83(e)(3)
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