Taxation of Stock Options

Stock options are a part of compensation packages that allow employees to purchase stock from their employer at a discount from its market price. While highly coveted, stock options carry more complex tax implications than a salary. Taxation of stock options is based on four major factors: The grant date, the type of option offered, when the option is exercised, and how long the stocks are held before being sold.

Stock Option Agreement

A stock option agreement allows employees to purchase shares of their company's stock at a predetermined price (known as the grant price) within a specific time frame. During that period, you can purchase stock at the grant price, even if the market price of the stock continues to rise. The agreement often includes a vesting schedule which outlines the number of shares that can be purchased each year over a set number of years. The date an employee receives their stock option agreement is known as the grant date, and is important to remember for tax planning purposes.

Types of Stock Options

There are two basic types of stock options: non-qualified stock options (NSOs) and incentive stock options (ISOs). The main difference between the two types is how they are taxed at the time they are exercised.

With NSOs, any difference between the grant price at which a stock is purchased and its market value is considered a "compensation element." This means it will be reported to the IRS by your employer and taxed like any other income. For example, if a stock is purchased at a grant price of $10 while the market value is $15, the $5 difference per share will be counted as compensation. If 100 shares are purchased, that would equal $500, all of which will be subject to income, Medicare, and Social Security taxes.

ISOs are not subject to taxation at the time they are exercised. Any difference between the grant price and market price does not get reported as income, and therefore is not taxed. This makes ISOs a more attractive offering, but is also why they are less common and generally reserved for executives or other high-ranking positions. Exercising an ISO does produce an adjustment for the purposes of the alternative minimum tax, something high-income earners will want to consider. There is a $100,000 cap on the total value of ISOs that are eligible for tax benefits in a given year.

Selling Stock Options

When stock options are sold, they become subject to capital gains taxes like any other security. Stocks sold more than one year after being exercised and two years after the grant date are subject to more favorable long-term capital gains taxes (maximum 20%). If stocks are sold sooner than one year from the exercise date or two years from the grant date, they will be taxed as short-term capital gains (maximum 37%).

The information provided is for informational purposes only. It is not intended to be used, and should not be used, as the sole basis for legal and/or tax advice. Individuals should seek and rely upon the guidance and advice of their own legal and tax counsel before making any decisions regarding any planning, investment, tax concepts or strategies discussed herein. Individual circumstances may vary and results discussed are no guarantees of applicability or future performance.

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