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Updated May 26, 2016

If you’ve been granted stock options as part of your overall compensation package, congratulations. For many executives, stock options represent a significant financial asset.

Unfortunately, they are accompanied by a complex and often changing set of tax rules that both employer and executive must follow. You’ll likely seek the advice of a tax professional — but it still pays to have a grasp of the basics.

Tax Implications of Stock Options

Stock options have the potential to provide a sizeable financial benefit in times of increasing stock prices, but they often come with an equally sizeable tax impact. And if the stock price is falling, depending on your individual situation, options can have potentially devastating consequences.*

Take Jonah, for example. As a result of declining share prices, he faced a potential tax liability of $3,000,000 on stock then worth only $100,000. Fortunately, because he sought great advice early and could therefore take necessary actions before the end of the calendar year, he reduced his tax liability to only $35,000.

By January 31, your employer must provide you with a written statement that details any statutory stock options you exercised during the previous year — but by then it may be too late to take the actions necessary to minimize the tax impact. And these are not the only option transactions that have potential tax consequences.

The federal tax rules for stock options can be quite complex and they give rise to a range of planning opportunities that can help you maximize the financial benefit from your options, while minimizing the tax consequences.

A grasp of the basics will help you to make sound and informed decisions.

Statutory and Nonstatutory Options

From an income tax standpoint, there are two kinds of options: statutory and nonstatutory.

  Statutory stock options are those that meet the requirements for options as specified in the Internal Revenue Code—and are therefore subject to numerous qualification requirements. Incentive stock options (ISOs) are statutory options.

  Nonstatutory stock options (NSOs), or nonqualified options (NQs), do not meet the requirements in the Internal Revenue Code for statutory options.

Federal Tax Rules for Statutory and Nonstatutory Options

The federal income tax treatment for each can vary considerably, as described below.

Statutory Options (ISOs) Nonstatutory Options (NSOs, NQs)
Federal Income Tax Treatment at Option Grant
Not taxed at option grant. Taxed at option grant only if the options have a “readily ascertainable” fair market value, which is seldom the case.
If the options have a fair market value at option grant, you have taxable compensation income.
Deferred compensation rules to establish taxable income do not apply. Deferred compensation rules can apply unless the exercise price can never be less than the underlying stock’s fair market value as of option grant.
Federal Income Tax Treatment at Option Exercise
Not taxed at option exercise. However, there may be alternative minimum tax (AMT) consequences.*
The employer must provide a statement containing important information about the stock you received. This information helps to determine the subsequent tax treatmentfor example, the holding period required for long-term capital gains rates.
Assuming the options were not taxed when granted, they are taxed at option exercise as ordinary compensation income, subject to payroll taxes and withholding.
The amount of the income is based on the value of the stock less the combined amount you paid for the stock and for the option, if any.Exception: if the stock is nontransferable or is subject to a substantial risk of forfeiture, you are not taxed until those conditions no longer exist. However, you can choose to pay the tax at this time anyway, so that all future appreciation is considered a capital gain. The downside risk is that you may forfeit the stock, and therefore will have paid tax for stock you don’t own.
Federal Income Tax Treatment at Sale of Stock
Taxed as capital gain based on the amount realized on the sale less the price paid for the stock.

Exception: if the stock is sold within two years of the option grant or one year of the option exercise, the bargain element of the sale is considered ordinary compensation income and the remainder is capital gain.

Taxed as capital gain if you were taxed at either option grant, option exercise, or when restrictions lapsed. Otherwise, taxed as ordinary compensation income.

 

SEE ALSO Got Incentive Stock Options? Timing is Everything

SEE ALSO Exercising ISOs? How to Minimize the Investment and Tax Risks in Selling the Stock

SEE ALSO Receive Stock Options or RSUs from an Employer? You May be Able to Defer Taxable Income With an 83(i) Election

 

 

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SCOTT F. USHER
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