Taxable Compensation for Former Employee turned Consultant
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A former employee who is now a consultant has exercised some options and received taxable compensation. This employee will be receiving a W-2 for his severance this year but receives a 1099 for all other services rendered. As part of his consulting agreement, options which would have cancelled upon his termination as an employee, continued to vest and remain exercisable during his consulting term. Will the taxable compensation recognized as a result of the exercise be included in the W-2 or on a 1099? This employee would also like to have tax withheld on an ISO exercise? Can we withhold tax and record it on the W-2? Please advise.
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First the disclaimer: I am not a tax advisor, so everything said here must be reviewed with your tax counsel.
There are a couple questions here.
1. Will the taxable compensation recognized as a result of the exercise be included in the W-2 or on a 1099?
Answer: This depends on when it is determined that the option were "earned". If the options were earned while the individual was an employee then you will use a W2. If the options were earned as a consultant you will use a 1099. Generally, options are considered "earned" on the vesting date, so the shares that were vested as of termination would generall be considered W2 reportable upon exercise.
2. This employee would also like to have tax withheld on an ISO exercise. Can we withhold tax and record it on the W-2?
Answer: The basic answer to your question is, No. You cannot withhold taxes on an ISO exercise. It may be that in the process of accelerating or continuing vesting as a condition of termination that the ISOs were in fact disqualified. If this is the case then withholding may actually be required.
ISO exercises are not W2 reportable. The Disqualifying Disposition of ISOs, while reportable on a W2 have no withholding requirement (therefore they have no statutory minimum withholding rate.) Because of these issues you should not be withholding tax on ISO exercises. If you need details citing IRS responses to these issues I think I can pull them for you.
Let's see if we can't some answers from our Tax Pro members on this one...