Your employer may offer stock options as part of your compensation package, and if they do, it’s important to understand how the stock options affect your overall tax picture.
What is a stock option?
A stock option is the right (but not the obligation) to buy shares of the publicly traded company’s stock at a future date at a specific price.
Generally, employees cannot immediately sell the options; they must hold on to the options for a period of time before they can be exercised. (To “exercise” a stock option means to buy the stock.) When the date comes, the employee can choose to buy the stock at the price promised, and if the stock price has risen significantly, the employee stands to make a lot of money when selling the shares (potentially more than a salary alone would have generated).
Why would an employer give an employee stock options?
Stock options are typically used as part of a bonus program, a reward for performance or to attract new talent to a company. Companies want employees to become shareholders so they have a personal stake in the growth of the company, its share price and stock value.
How are stock options taxed?
How that works depends on which type of stock option your company offers:
Non-Qualified Stock Option
A non-qualified option (also called non-statutory) is the most common type of stock option. These are taxed when they are exercised. The difference between the price at which the stock is purchased and the price it’s worth on the stock market is the gain, and that gain is considered ordinary income that should be included in the stockholder’s W-2. It’s important to note that non-qualified stock options can be issued to anyone — not just employees.
- There are no special tax benefits.
- NQSO’s will generate ordinary income and a capital gain/loss.
- When granted, they are granted at a predetermined price. This allows the employee to exercise (“purchase”) at that price within a designated timeframe.
- When the option is exercised, the employee has ordinary income for the difference between the price they pay (grant price) and the fair market value on the date they purchased the stock (exercise price).
- The income recognized at exercise will be reported on Form W‐2.
- The company receives a corresponding tax deduction.
- When the employees sell the shares in the future, the gain or loss on the shares is taxed as a capital gain or loss.
Incentive Stock Options (Statutory Options)
When an incentive stock option is exercised, it does not result in immediate taxable income. This means the employee can continue to hold the stock without any tax liability. It also means that if they hold it long enough, any gain would become a long-term capital gain, which means it would be taxed at a lower rate.
- No income tax is due at grant or exercise (“purchase”). Instead, the tax is deferred until you sell the stock.
- Can have AMT
- Only employees can qualify for ISOs.
- Usually reserved for high-level employees who are more likely to have enough cash to buy the shares.
- No tax advantage to employers.
- The ISO must be exercised within 10 years of the date of grant.
Restricted Stock
Restricted stock transfers the stock to the employee on the date of grant subject to vesting (the process by which an asset is earned over time) restrictions. With restricted stock, the employee has the right to make a Section 83(b) election, the option to pay taxes on the total fair market value of restricted stock at the time of granting (rather than the fair market value when the stock vests).
Restricted Stock Units
Restricted Stock Units are awarded to an employee as a form of compensation.
- There is a specific vesting plan outlining when the employee will receive the stock.
- When the stock vests, the employee receives the units and the fair market value of the stock received on that date is considered income.
- Depending on the employer’s plan, you may elect to pay taxes on the income at the time the stock is awarded, at the time the stock vests, or at the vest date.
- The amount reported to you as income on Form W‐2 by your employer at the time the stock vests will then be your adjusted cost basis in these stock units.
- The Section 83(b) election is not allowed.
Employee Stock Purchase Plans
Employee stock purchase plans are formal plans created by publicly traded companies that allow employees to set aside money over a period of time (the offering period), usually out of payroll deductions, to purchase stock at the end of the offering period. Plans can be qualified or non‐qualified.
- The shares are usually bought at a specified discount from the market value.
- Employees are not taxed until they sell the stock.
- Same holding period as ISOs to receive special tax treatment (if a qualified plan)
- If not a qualified plan, there is no special tax advantage.
- Based on how long the employee holds the stock, the discount is considered ordinary income and included on Form W‐2 (non‐qualifying) or it is considered capital gain income and accounted for at the time of sale (qualifying).
Each type of stock option has its own complicated rules, so it’s essential to provide your CPA with the appropriate information about the type of stock options your employer provides. If you have questions about stock options and their tax implications, reach out to us at info@sbfcpa.com.