The abuse of stock options has made headlines lately, thanks to big-name companies such as Apple (Nasdaq: AAPL ) , KB Home (NYSE: KBH ) , and UnitedHealth (NYSE: UNH ) . However, despite abusive transactions such as options backdating, there are still many legitimate uses of stock options, and a large number of employees benefit from option grants. As the first part of this article discussed, using stock options can be positive both for employees and for the companies that employ them.
Taking advantage of stock options requires careful planning. When you receive options or decide to exercise them, the IRS may be looking over your shoulder, waiting to collect its share of any profits you make. In determining the best time to exercise stock options, you should take into account the way that various types of stock options are taxed.
Types of stock options
To know how your stock options will be taxed, you first need to find out what type of stock option plan your company has established. There are two main categories of stock option plans. Incentive stock options, or ISOs, are offered under stock option plans that meet several requirements under the tax laws, the most restrictive of which is that the option's strike price must be no less than the fair market value of the company's stock when the option is granted. If the stock option plan doesn't meet the IRS guidelines for ISOs, then the options issued under that plan are called non-qualified stock options, or NSOs.
The tax rules for each category are quite different. Both types of options offer employees the opportunity to treat some of the gains from their stock options as capital-gains income, which is currently taxed at lower rates than ordinary income, like your salary. In general, ISOs offer additional tax benefits, but the additional requirements sometimes make them difficult for some companies to use.
Incentive stock options and taxes
Incentive stock options give employees a wide degree of latitude to take advantage of some nice tax benefits. The best thing about ISOs is that they give you the ability to defer tax indefinitely and to transform what would usually be ordinary income into capital gains. When you first receive an ISO, there is no tax impact. Because the option must include a strike price no greater than the current fair market value, the option has no intrinsic value that could be taxed. Additionally, there is no tax effect when you exercise the option; you purchase the stock for the strike price, and any gain since you first received the option is reflected in the stock's tax basis. Finally, as long as you hold on to the stock for a given period after exercise, any profit you make when you sell the stock is treated as capital gains and taxed at lower rates.
Unfortunately, there's one wrinkle in the tax rules for ISOs. Although regular tax rules allow you to defer tax liability until you sell the stock you acquired by exercising your options, the alternative minimum tax operates differently. Under the AMT rules, you may be taxed on the difference between the price you pay for shares and the fair market value of those shares at the time you exercise your options. This can lead to some incredibly bad results. Specifically, if you exercise your options when the stock price is high, you may have a large AMT bill. Yet if the stock price falls back during the mandatory holding period, then you may end up paying tax on gains that you never actually received. This actually happened in the 1990s to many employees who exercised right at the top of the market.
Taxes and non-qualified stock options
The rules that apply to NSOs are quite different. In rare cases, you may have to pay taxes as early as when options are granted to you. More typically, however, there's no tax liability until you exercise the options. However, unlike with ISOs, exercising NSOs is a taxable event both for regular and AMT purposes. Even worse, the difference between the option exercise price and the market price when you exercise your options is treated as ordinary income and taxed at regular rates. If the stock you receive by exercising your options is subject to restrictions, such as a vesting period, then you may be able to defer the gain until those restrictions no longer apply. After you exercise your options, any further gain in the price of your stock is treated as capital gains.
As you can see, the taxation of stock options can be extremely complicated. Mistakes you make in deciding how and when to exercise your options can cause a great deal of damage. In the final part of this article, you'll learn how to maximize your potential profit from your stock options while you protect yourself from some of the risks involved with them.
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Fool contributor Dan Caplinger has never had the good fortune of getting stock options at work. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy doesn't backdate on you.