Written by: David Bryant, CPA and Joe Bellante, CPA
If you’ve been awarded stock options from your employer, it’s essential to understand the tax implications of exercising them. In this post, we’ll break down the tax implications of stock options so you know what to expect.
Two Types of Stock Options
The tax treatment of stock options depends on whether it’s an incentive stock option or a nonqualified stock option.
Incentive Stock Option
An incentive stock option (ISO) gives employees—usually company executives—the opportunity to buy company stock at a discounted price. Employees do not owe federal income taxes when the option is granted or when they exercise the option. Instead, they pay taxes when they sell the stock. However, exercising an ISO produces an adjustment for purposes of the alternative minimum tax unless the stock is sold in the same year that the option is exercised. The adjustment is the difference between the fair market value of the stock and the amount paid for the stock. If the stock is held until the latter of two years from the grant date or one year from the exercise date, the sale will qualify for long-term capital gain treatment.
Otherwise, compensation income is reported for any amount received above the amount you paid up to the FMV on the date of exercise. Any amount over FMV would be capital gain, and a loss on the sale would be a capital loss.
Nonqualified Stock Option
Most of the time, when our clients receive stock options, they are nonqualified stock options (NSOs). These can be granted to employees, independent contractors, directors, and other service providers not on the company payroll. Employers often prefer NSOs because they can take a tax deduction when the employee exercises the options.
Typically, NSOs are taxable to the recipient when exercised. When the recipient exercises the option, the difference between the FMV and the amount paid for the stock is included in their taxable compensation. Withholding and employment taxes may be due unless the recipient is not an employee.
Then, when they later sell the stock, it’s treated like any other investment property. If they hold the shares for more than one year, any gain is taxed at long-term capital gains rates. If they hold the shares for less than one year, the gain is taxed at ordinary income tax rates, which are usually higher than the rate available on long-term capital gains. The holding period begins on the date of exercise, not the date the option was granted. The recipient’s basis in the sale is the amount they paid for the stock plus any amount included in their taxable income upon exercising the option.
If you’re unsure what type of stock options you have or need other details, check your stock option agreement. This contract should cover the number of shares you have the right to buy, the exercise price, the conditions to exercise, and when your options expire.
Nonqualified Stock Option Example
Since NSOs are the most common form of stock options, let’s look at an example to illustrate how a recipient pays taxes on the transaction.
ABC Company grants Employee A 10,000 shares of NSOs with a strike price of $1 per share.
Employee A decides to exercise the option when the stock price is $4 per share and pays ABC Company $10,000 ($1 for each option exercised). The $3 difference between the exercise price and the stock price is included in the employee’s taxable compensation on their W-2.
If Employee A sells the shares immediately, they shouldn’t owe any additional taxes on the sale. They can sell them for $4 per share, which is also their basis.
However, say Employee A holds onto the stock for two years and sells it for $5 per share. In that case, they would have a long-term capital gain of $10,000 — their $50,000 sales price less their $40,000 basis.
Common Tax Issues When Exercising Stock Options
One of the problems we often see with stock options is employees who receive a 1099 from a brokerage house after selling shares, but the 1099 says their basis is zero. If your 1099 shows no basis in shares you obtained from exercising stock options, it’s incorrect. In most cases, you can find your basis by getting a supplemental statement from the brokerage house.
Another common issue we see is under-withholding. When you exercise nonqualified stock options, your employer will most likely withhold a flat 22% for federal income taxes. However, you might be under-withheld if you’re in the 32%, 35%, or 37% tax bracket.
Stock options can be advantageous but can also create unexpected tax consequences. If you’re considering exercising stock options, reach out to our team of knowledgeable tax professionals. We can help you navigate this process and plan for (and minimize) any potential tax liabilities.