Stock Options - When Are You Taxed?
What are Stock Options?
A stock option is when a company grants employees, officers, directors, contractors, or consultants the right to purchase a specified number of shares of their stock at a fixed price. Typically, a certain period of time needs to pass (the vesting period) until those options can be exercised, however the vesting period can also be based on certain goals either for the company or the individual. The “grant date” is when the options are initially offered by the company and the “exercise date” is when the shares are actually purchased by the individual.
Types of Stock Options
There are two types of stock options, and both are taxed very differently. The more common type is the nonqualified stock option (NQSO) and the other is the incentive stock option (ISO). NQSOs do not have any special tax treatment under the Internal Revenue Code. ISOs do have special tax treatment under the Internal Revenue Code since they are not subject to Social Security, Medicare, or withholding taxes. However, they must meet strict criteria to qualify. ISOs can only be granted only to employees (not to consultants or contractors) and there is a $100,000 limit on the aggregate grant value of ISOs that can vest in any calendar year. Also, the ISOs must be exercised within three months after the date of employment termination for an employee to retain the special ISO tax benefits after leaving the company.
When you exercise NQSOs, the difference between the market price of the stock and the option price (called the spread) is counted as ordinary income, even if you exercise your options and continue to hold the stock. This income will be subject to Social Security, Medicare and ordinary income tax rates. This amount will be withheld by the company and reported on the W-2 form. When the stock is ultimately sold, the difference between the sales price and the market price when the shares were acquired will be taxed as capital gains/(losses).
When ISOs are exercised, they will not be subject to payroll tax but may still be considered compensation on your W-2. This will happen when the shares are sold within one year of the exercise date, or within two years of the grant date. These scenarios are considered “disqualified sales” and spread is considered compensation. If the employer does not report the amounts on the W-2, it is up to the taxpayer to add them on the return. If the stock is exercised and held for over one year from the exercise date and over two years from the grant date, then the tax treatment is much more favorable. None of the spread would be considered compensation and any gains are fully captured at long-term capital gains rates.
We Can Help
Stock options can be a great benefit to increase compensation as an employee. However, there are also complex tax rules associated with them. If you receive stock options or need help with tax planning, contact our tax professionals at The Innovative CPA Group at 203-489-0612. Or contact us online.