If you receive stock options as part of your employee compensation package, your company may have provided you with some general tax advice. However, most people require more extensive guidance in order to avoid the tax pitfalls, and seize the tax advantages, that stock options can offer. Stock options can affect you in the current tax year, and far into the future, so it’s important to understand how the taxation of stock options works.
To begin with, there are two types of stock options:
- Statutory stock options are those granted under an incentive stock option plan (ISO) or an employee stock purchase plan. As a general rule, they receive the most favorable tax treatment. Only employees are eligible.
- Nonstatutory (also called nonqualified) stock options, are those that are granted neither under an employee purchase plan nor an ISO, such as stock options granted to executives. Both employees and independent contractors, including non-employee directors, are eligible.
There are advantages and disadvantages to both types of stock option; understanding the tax treatment of the type of option you have (and you may have both types) will help you extract the maximum benefit.
Are My Stock Options Taxable Upon Receipt?
If you have been granted a statutory stock option, the good news is that you generally need not include any amount in your gross income upon receipt or exercise of the option. The bad news comes in the form of exposure to the Alternative Minimum Tax (AMT), which may be payable upon exercise of ISOs. Because the exercise of an ISO does not itself generate cash as the sale of stock would, you may need to use other funds or sell some stock in order to pay the AMT.
For instance, in 2015, your company might grant you ISOs allowing you to buy 1000 shares of stock at the current market price of five dollars per share. A few years later, you choose to exercise the options when the shares have reached fifteen dollars apiece. The difference between the exercise price of five dollars and the actual fifteen dollars—ten dollars, multiplied by a thousand shares, is subject to AMT. If you later sell the stock and realize a profit, you may be able to recoup some of what you paid via an AMT credit. However, if you lose money on the stock, you may end up paying tax on income you never really received.
With nonstatutory, or nonqualified, stock options, you may have income upon receipt of the option. However, unlike ISOs, nonstatutory stock options are not subject to the AMT. How much income to include in your gross income, and when to include it, will depend on whether the fair market value (FMV) of the stock option is readily determinable. If a stock can be actively traded on an established market, the FMV can be readily determined.
Otherwise, the FMV can be readily determined only if all of the following conditions are met: you can transfer the option; you can exercise the option immediately in full; the option (or the stock subject to it) is not subject to any condition or restriction that has a significant effect on the FMV of the option (other than a condition to secure payment of the purchase price).
What Happens When I Sell the Stock?
When you sell a stock from the exercise of an ISO, you will pay tax. If you plan carefully, this will be long-term capital gains tax. You may be familiar with the usual capital gains holding period of one year, but stock from the exercise of an ISO is different. In order to qualify for long-term capital gains taxation, you must hold the shares for more than one year after you exercise the option, and sell the shares no earlier than two years after the grant of your ISOs. Failure to observe both parts of this requirement means income from the sale will be some mix of ordinary income and long-term or short-term capital gain, depending on the timing of exercise and sale and other factors.
When you sell stock from the exercise of a nonstatutory stock option, you will have either taxable income or deductible loss. Any income will be seen as either long-term or short-term capital gain; how it is characterized will depend on how long you held the stock after exercising the option.
Stock options and their tax implications are complicated. Unfortunately, this article only begins to discuss the taxation of stock options. If stock options are part of your compensation package, you should have knowledgeable guidance regarding their exercise, and the sale of stock from them.
The attorneys of Ortiz & Gosalia, PLLC have post-JD degrees in tax law and can help you to understand your stock options and how to get the most from them while minimizing taxes. With offices in Redmond, Bellevue and Kirkland, we offer services throughout the Seattle area and Washington State. If you would like to learn more about stock options and taxes, we invite you to contact us.