Employee stock options are a great incentive that can be embedded within many compensation packages. Often, employees are able to buy the company stock at a discount, providing a great opportunity to accumulate wealth if the stock performs well.
But the other piece of the puzzle is trying to grasp how taxes for employee stock options work. It could easily become a nightmare if you've never dealt with stock options before. Here are a few insights to take the confusion away so you can maximize the potential of this incredible work benefit.
How stock options work
There are two main types of stock options that you could receive as part of your compensation gift: incentive stock options and nonqualified stock options. The main difference between these two is how they are treated for tax purposes when you exercise the options.
Incentive stock options (ISOs), also known as statutory stock options, are granted under a stock purchase plan. However, nonqualified stock options (NSOs) are granted without a specific type of plan and are often referred to as nonstatutory stock options. As we'll see below, NSOs don't qualify for the same tax benefits that ISOs receive.
When you have employee stock options, there are three special occasions you need to be aware of: the date your company granted you the options, when you exercised them, and how long you hold the shares you receive on exercise before you sell them. These moments play an important role in your tax calculation.
Most of the time, there is a vesting schedule tied to your employee stock options. Simply put, you cannot tap into your stock option benefits until you've been at your company for a certain period of time. After you are vested, then you can exercise the options at any time before they expire.
Incentive stock options
Incentive stock options are simpler than nonqualified stock options from a tax perspective. Employees who have ISOs don't have to worry about taxes when they receive a stock option grant or exercise the options.
The order of operations works like this: You receive a stock option grant and then you exercise the options when you are eligible and ready to do so. After you exercise your options, then you'll have to make the ultimate decision: When do I sell my stock?
Let's say you were granted 2,000 shares of stock at an exercise price of $10. On the date that you decide to exercise your shares, the stock is actually worth $30 per share. If you sell immediately, you are paying $20,000 for something that is worth $60,000, but you'll have to pay ordinary income tax rates to lock in those gains now.
Your other option: exercise your options in one period and sell your stocks later. You may be able to unlock favorable long-term capital gains tax rates (a top rate of 20%) if you hold ISOs for at least two years from the date the options are granted and longer than one year from the exercise date before you sell; otherwise, you give up the right to exclusive tax benefits and risk being stuck with ordinary income taxes that could be as high as 37%.
The double tax for nonqualified stock options
It's important to have a tax strategy when exercising NSOs because you'll be hit with a tax twice, and it can get a bit complicated.
First, you'll typically have to pay ordinary income taxes when you exercise the options. You must pay the difference between what you paid for the stock (the exercise price) and the fair value of the shares when you exercised them. The IRS considers this as compensation income even though you haven't actually made any money.
Then, you'll pay capital gains tax if you sell the shares at a profit. If the sale results in a loss, you'll report a capital loss for the difference between your tax basis and what you received. You'll either pay short-term or long-term capital gains taxes depending on how long you've held the stock. When you hold your investment for over a year, you'll qualify for the preferential long-term capital gains rates of 0%, 15%, or 20%, based on your income range for the year.
More taxes to consider
Although ISOs are typically seen as a tax savior in comparison to NSOs, you'll have to consider the alternative minimum tax (AMT) if you are a high earner. There is also a $100,000 limit that restricts the total value of ISOs that can be exercised in a given year if you want to enjoy the incredible tax benefits.