Stock options are when employees of a company are awarded the right to acquire shares in the company they work for. They are a non-traditional form of compensation aimed at retaining workers and incentivizing them to contribute to growing the company's value.
The options will be granted at a fixed price, the "grant price," which is set at less than the value of the shares is expected to be when the employee exercises the options. The employee is essentially given a discount on company shares.
Share options are usually vested; that is, the employee can only exercise their rights to the shares at a future time—sometimes at intervals over several years. In this way, they are used to retain employees who generally will forfeit their options if they leave the company.
There are two types of stock options that are taxed differently. Understanding how your options will be taxed can help you plan how to maximize your after-tax income.
Non-Qualified Stock Options (NQSOs)
Nonstatutory stock options, also known as non-qualified stock options (NQSOs), are generally given to the ordinary employees of the company. There is no tax effect when they are granted, but employees must pay tax when they exercise their options. The tax is calculated on the difference between the grant price paid by the employees and the fair market value (FMV) of the shares at the time the option was exercised.
For example, if you have a share option for 100 shares at $10 each and you exercise your option when the shares are worth $12, you will be taxed on $1200. You will have spent $1000 to buy the shares and immediately made a profit of $200. Your company records this profit as income, and it will be subject to all standard income taxes, plus Medicare and Social Security taxes.
When you subsequently sell the shares, you will be liable for tax again on any profit over the value of the shares when you exercised your option. In the example above, that would be anything over $12 per share. If the shares are sold within the same year they are exercised, they will be subject to income tax. If you wait at least a year, the profit will be taxed as a capital gain at a much lower rate. That’s generally a better idea assuming you are confident the share price will rise.
Incentive Stock Options (ISOs)
Incentive stock options (ISOs) are most commonly granted to executives and other higher-level staff. They are far more tax-friendly as you don’t have to pay tax when you exercise your option (unless you are subject to AMT, in which case see below.)
You will only pay tax when you sell the shares. Provided the sale is at least two years after you were granted the option and at least one year after you exercised it, the profits will be taxed as capital gains. If sold earlier, they will count as income.
ISOs and Alternative Minimum Tax (AMT)
If you are subject to the alternative minimum tax (AMT) and sell your shares in the same year you exercised your option, no AMT adjustment is necessary because the tax is the same for regular tax and AMT purposes.
However, if you don’t sell the stock the same year, then exercising an ISO creates an AMT adjustment under certain circumstances. It equates to the difference between the grant price you paid plus anything you may have paid for the ISO and the FMV of the shares when the option is exercised. The cost basis of the shares must be increased by the AMT adjustment to avoid future double taxation when they are eventually sold.
How the stock's market value is arrived at, whether your rights are transferable and whether they are subject to forfeiture can all impact whether or not an AMT adjustment is required.
Final Thoughts
From a tax perspective, it is usually most advantageous to exercise share options as early as possible and delay selling the shares for at least a year. That way, you minimize the payment of the higher income tax in favor of lower capital gains tax. However, the tax on share options can get complicated, so it's best to consult a financial advisor. A qualified advisor can look at your personal situation and advise you accordingly.
