Stock options can be a highly profitable part of your portfolio. As long as you stay with your employer and the company performs well, you may be able to secure a significant profit within a few years of being granted stock options. The tax implications of stock options can be daunting, but that shouldn’t scare you away from exercising the options you’ve been given. Here’s an overview of what you need to know about stock options and taxes.
1. Your tax obligation doesn’t begin until you exercise your stock options.
When your employer grants you stock options, you’re only being given a promise: That you’ll be able to buy company stock, for a predetermined price at a predetermined point in the future. Assuming the company does well and the stock’s market price is higher than your grant price when you eventually sell your stock, you may be able to make a quick profit. Or, if the company isn’t doing well when your stock vests (the date they’re available to exercise or buy), your stock options may be worthless.
Because you’re not able to do anything with your stock options until they vest, you’re not generating any income for the IRS to tax. Don’t worry too much about your tax obligations when your company first offers you stock options, but do discuss it with your CPA as part of your tax planning.
2. Different types of stock options are taxed differently.
Stock options generally fall into one of two categories: Non-qualified stock options (NSOs) and incentive stock options (ISOs). Employees may receive either NSOs or ISOs from their employers. The major difference between these two types of stock options is the way they’re taxed, so it’s important to know what kind of stock options you have; refer to your grant agreement if you’re not sure.
For a demonstration of how NSOs and ISOs are taxed differently, let’s say you decide to exercise 1000 shares of stock with a grant price of $10 and a market price of $30. You’re able to buy those shares for $10,000, though they’re worth $30,000 if you decide to sell.
With non-qualified stock options, the IRS considers the $20,000 difference between the grant price and the market price to be compensation. Your employer will report this as income and you’ll pay ordinary income tax on that $20,000—even if you haven’t sold your stock yet. When you do sell, you’ll have to pay taxes again on any gains.
With incentive stock options, you may get a tax break. You only have to pay taxes when you sell the stock. Exercising your options doesn’t automatically trigger tax the way it does with NSOs. You still have to pay taxes when you sell the stock, but holding onto it for at least a year may let you avoid paying the income tax rate in favor of the lower capital gains tax rate—more on that next.
However, you do have to consider any exercised ISOs when calculating any alternative minimum tax you may owe; this is something to discuss with your tax advisor.
3. Exercising stock options may trigger the capital gains tax.
Sometimes, holding stocks long-term can yield a greater return than buying and selling quickly. The capital gains tax kicks in when you keep stocks for a holding period of at least one year after exercising your options, and at least two years after being granted the options. Both ISOs and NSOs are subject to capital gains taxes. (Or, if you have to sell stock at a loss, you may be able to claim a capital loss.)
Because high-income investors will have a lower capital gains tax rate than income tax rate, waiting to sell stock until the holding period is over could significantly lower your tax bill. Of course, fluctuating market prices mean that there’s some risk with holding onto stock long-term, so you’ll want to carefully consider your options before selling.
4. A lot of variables affect how much tax you’ll owe.
Tax rules around stock options are notoriously complicated. On your own, it can be difficult to predict how much tax you’ll have to pay when exercising and/or selling stocks. Your specific situation will affect how much you’ll owe. For example, what’s your filing status? Are you going to have to pay any alternative minimum tax? What else is going on with your overall tax strategy for the year?
Reporting stock option compensation correctly can also be difficult. There may be some complex calculations required, and you may need to file multiple forms to properly report all the moves you’ve made around stock options during the year. Most people won’t want to attempt doing this alone, as it’s easy to make mistakes.
Despite the potentially daunting tax implications, being granted stock options can be a very profitable opportunity. Advance tax planning lets you maximize your earnings, minimize your tax obligations and make filing as easy as possible.
At Sachetta Callahan, we understand the tax rules around stock options so you don’t have to. We’re here to help you take maximum advantage of this opportunity. I welcome your questions about stock options and taxes. Contact me today!
Michael J Callahan, CPA, CFP®, MST, Partner, Director- Wealth Management is a Certified Financial Planner™ practitioner, Certified Public Accountant, and holds a Master’s Degree in Taxation from Bentley University. Mike has been involved in personal financial planning, as well as both business and individual taxation for more than 15 years.