Some employees earn stock options as part of their compensation packages at work, giving them the right to purchase shares of stock at a fixed price in the future. If the stock gains in value over time, employees can exercise their stock options, sell the shares, and receive a gain.
Yet there are big implications for your taxes from exercising employee stock options, and it's important to understand all the intricacies involved. In particular, once you know which type of options you have, you can calculate your best strategy for exercising those options and reaping the rewards of your successful work.
Two types of stock options
Employees can receive one of two types of stock options. Incentive stock options, or ISOs for short, are available only to employees of a company. Nonqualified stock options, or NQSOs, can be given to anyone, including outside consultants and corporate board directors, as well as workers.
The biggest difference between ISOs and NQSOs is in how they're taxed. With incentive stock options, exercising the option doesn't create a taxable event for ordinary income tax purposes as long as you hold onto the shares that you receive upon exercise. Later on, you'll pay capital gains tax on any gain when you sell, but as long as you hold the shares for longer than a year after exercising the option, the gain will be eligible for lower long-term capital gains rates.
By contrast, NQSOs create two separate taxable events. First, when you exercise the option, you'll be treated as having received taxable compensation equal to the difference between the current market value of the shares you receive and the amount that you have to pay under the option contract. Later, when you sell the shares, any difference between the value of the shares when sold compared to the market value of the shares when you exercised the option is treated as a capital gain or loss.
A simple example
A basic example shows how this works in practice. Say you get stock options letting you buy 100 shares of stock at $5 per share. Several years later, the stock has climbed to $15. You exercise the options, and then a few years after that, the stock goes to $30. You then decide to sell.
With ISOs, there would be no taxable event upon exercise, and you'd pay long-term capital gains tax on the difference between the $5 you paid and the $30 you received. For 100 shares, that would amount to capital gains taxation on $2,500 in gains.
With NQSOs, you'd end up paying ordinary income tax rates on compensation for the difference between the $15 per share value at exercise and the $5 you paid, or $1,000 for the 100 shares. After that, the subsequent rise from $15 per share to $30 would get taxed at long-term capital gains rates, so you'd owe capital gains tax on $1,500. Because ordinary income tax rates are higher, the NQSO scenario is almost always less favorable than the ISO scenario.
Where things get more complicated
You can see from the example above that sometimes it can make more sense with NQSOs to exercise sooner rather than later. Any gain before exercise is subject to ordinary income tax, but gain after exercise gets taxed at potentially lower capital gains rates. But the downside from early exercise is that you have to pay the exercise price right away, rather than keeping it invested elsewhere.
That's where the calculator below can be helpful. By running through various scenarios with NQSOs, you can decide whether exercising early makes more sense than simply waiting until closer to the expiration date of the options to exercise.
Editor's note: The following language is provided by CalcXML, which built the calculator below.
Be very careful
Finally, keep in mind that the tax issues with stock options can be extremely complex. For example, with incentive stock options, there are implications that involve the alternative minimum tax. If you're subject to that tax, then ISOs can have tax impacts. Moreover, AMT treatment can have disastrous consequences if the stock goes through a cycle of big gains and subsequent declines in the share price.
Receiving stock options is a great employee benefit, but it also requires you to be thoughtful about what to do with them. By using the resources at your disposal, you can make a better decision with your stock options, and maximize their value while keeping taxes as low as possible.