How are stock options taxed?

If you have stock options or equity-based compensation as a large part of your income, the tax treatment of your stock options is especially important. How stock options are taxed depends on the type of options you have (incentive or non-qualified) and your sale and exercise strategy. Not sure if you have ISOs or NQSOs? Here’s more on incentive vs non-qualified stock options.

How incentive stock options (ISOs) are taxed

Generally, there are no tax consequences at grant, vesting, or exercise of incentive stock options. In another words, these aren’t usually taxable events. There is one caveat though, the alternative minimum tax or AMT which we’ll address in a moment.

Your employer will not withhold taxes at exercise (because there aren’t any to withhold). But it’s important to note that employers don’t have to withhold taxes when you sell the stock either. You will want to coordinate your plans with your financial advisor and CPA prior to selling your stock options.

The alternative minimum tax

Exercising incentive stock options could have indirect tax implications if the stock isn’t sold before the end of the calendar year and triggers the alternative minimum tax (AMT). The AMT is a parallel tax calculation and when triggered, adds back or disallows certain tax deductions so the taxpayer pays more in tax than they would under the traditional system. Again, you’ll want to work with your accountant in advance to run the numbers.

A handful of states, including California, also have their own alternative minimum tax you should be aware of.

Taxation of ISOs at sale

When you sell incentive stock options, it’s considered either a qualifying or disqualifying distribution depending on how long you held the stock. A qualifying disposition carries tax benefits and a disqualifying disposition does not.

To meet the criteria for a qualifying disposition, you must hold your stock for at least 2 years from the grant date and at least 1 year after exercise. Everything else is a disqualifying disposition.

In addition to federal income tax and/or capital gains tax (discussed below), you may also need to pay tax at the state level.

Tax benefits for incentive stock options

If you meet the standards for a qualifying disposition of ISOs, then you will generally only pay long-term capital gains tax on the gain. For tax purposes, the gain is typically the sale price minus the strike price multiplied by the number of shares sold. Given that long-term capital gains rates are the most favorable, this can save considerably on your tax due.

But there’s also the risk that the stock declines in value and you’re left with less or perhaps even a loss. Holding onto stock long enough to qualify for favorable tax treatment can mean paying less in tax. Declines in the value of the stock can also yield tax savings too, and fewer proceeds along with it. Don’t let the tax-tail wag the dog when developing a strategy for the sale of your stock options!

How a disqualifying disposition is taxed

If you don’t meet the holding period requirements for a qualifying disposition, when you sell your stock it will be taxed as a disqualifying disposition. If you exercise and hold the shares for a period of time the disqualifying disposition is typically taxed as ordinary income and capital gains (assuming there is a gain). The difference between the fair market value of the stock when you exercised and your strike price is considered regular income, though not subject to payroll taxes.

Short-term capital gains apply if you hold the stock for less than a year before selling. If so, the gain (the difference between the price you sold the stock for and the value at exercise) is taxed as a short-term capital gain. Currently, short-term capital gains rates are the same as regular income. If you keep the stock for more than a year, it’s a long-term capital gain. But if you exercise and sell the stock right away, you shouldn’t have a capital gain to report.

This infographic includes a visual on how ISOs are taxed.

Other factors

There are other caveats to be aware of which often require coordination with your CPA and financial advisor. For example, there’s an annual vesting limit of $100,000 per year for incentive stock option tax treatment, based on the market value of the ISOs at the time of grant. Also, the taxation of stock options can change depending on how stock options are treated during a merger or acquisition.

Keep in mind, while incentive stock options have tax benefits if you satisfy the holding period requirements, it still may not be beneficial to do so on a risk-adjusted basis. Learn more about tax planning for ISOs.

How non-qualified stock options (NQSOs) are taxed

Although NQSOs don’t offer any tax benefits, the tax treatment is more straightforward. Unlike ISOs, your employer will withhold some funds for federal income tax purposes. However, this doesn’t mean flat withholding will be enough. Automatic withholding is based on a flat rate which may not apply to your tax situation.

Tax at exercise

Like ISOs, there are generally no tax consequences at grant or vesting. But exercising non-qualified stock options is a taxable event. At exercise, the amount that is typically included in ordinary income is the current market price less your strike price, multiplied by the number of shares you’re exercising. This is called the compensation element.

Your employer should deduct a flat amount for federal tax withholding taxes at exercise. If you live in a state with an income tax, verify the withholding with your employer. Another difference between the tax treatment of ISOs and NQSOs: payroll tax. The compensation element, which is taxed as regular income, is subject to payroll tax withholding with non-qualified stock options.

Again, you will want to coordinate your plans with your financial advisor and CPA prior to exercising or selling stock options.

Taxation of non-qualified stock options at sale

When you sell NQSOs, assuming for a gain, it’ll be taxed as short or long-term capital gains depending on your holding period. But if you exercise and sell the stock right away, you shouldn’t have a capital gain to report too.

If you’ve kept the stock for less than 1 year, it’s a short-term capital gain for tax purposes. The tax rates on short-term capital gains are the same as ordinary income. If you keep the stock for more than 1 year, long-term capital gains rates will apply.

At a high level, the capital gain is based on your sale price, less your cost basis. For simplicity, you can estimate your cost basis as the market price when you exercised. Again, it’s important to work with a CPA to do the real math for you!

This infographic has more on how non-qualified stock options are taxed.

Maximizing your gains doesn’t always mean paying the least amount of tax

Deciding when to sell your stock options isn’t a no-brainer. You’ll need to weigh several complex factors:

  • What’s your current tax situation? Do you expect your tax situation to change next year, aside from the stock options? For example, are you getting married, divorcing, moving to another state, getting a raise, selling a home or rental property, expecting an inheritance, etc.?
  • What are your expectations for the company? What’s the risk (or opportunity) for a merger or acquisition, IPO, bankruptcy, or other significant decline in the stock price or valuation?
  • How much company stock do you already own? Diversification is so important. Taking some risk off of the table by selling shares can help you avoid the worst outcome, even if it means paying more tax in the short run.

Developing a financial plan to diversify a concentrated stock position and limit your downside risk while managing taxes is advisable for individuals who have a large part of their wealth tied up in stock options and employer stock. To learn more about comprehensive wealth management for investors with stock options, contact a wealth advisor today.

How Stock Options Work

A Guide for Executives with Incentive and Non-Qualified Stock Options

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