If you have employee stock options, one of the most important things to understand is your potential tax consequences. Managing your taxes effectively can be the difference between reaching your financial goals and falling short.
First, you need to know what kind of stock options you were granted. They are either incentive stock options (ISOs) or non-qualified stock options (NQSOs). You can find this information in your option grant.
We’re going to walk through the various stages of option ownership and the taxes that are triggered at each event.
First, I want to define an important term that I’ll use throughout: bargain element. The bargain element is the difference between your exercise price and the fair market value (FMV) of the stock at the time of exercise.
Bargain Element = FMV at Exercise – Exercise Price
For public companies, the FMV of the stock will be the stock price at the time of exercise. For private companies, you will use the latest private valuation of the stock, which you can ask your company for.
For example, if you decide to exercise your options and your exercise price is $2/share while the FMV of the stock is $10/share, then your bargain element is $8/share.
Grant and vesting
No taxes are due for either ISOs or NQSOs at grant or vesting.
NQSOs are taxed at exercise, whether you decide to immediately sell the stock or hold on to it. The bargain element is considered W-2 compensation and gets taxed as ordinary income. That means there will be federal income taxes, state income taxes (if applicable), social security tax, and medicare tax withheld.
Taxes will be withheld automatically, but it’s important to note that federal income taxes are typically withheld at the supplemental rate of 22%. If your federal tax bracket is above the 22% bracket, you may not be withholding enough and it could make sense to increase your paycheck withholding, make estimated tax payments, or set aside money to pay the extra taxes when you file your tax return.
ISOs are not taxed at exercise, BUT there’s a big caveat. Exercising ISOs and holding the shares beyond the calendar year could trigger the alternative minimum tax (AMT). The AMT is a parallel federal tax calculation that is calculated along with the regular federal tax calculation. Both calculations are run and you pay whichever results in the higher tax bill.
This is important for ISO holders because the bargain element of any ISOs exercised but not sold over the calendar year gets added to your income for the purposes of the AMT calculation. This makes it much more likely to trigger an AMT tax bill, which can be significantly higher than your regular tax bill.
There are different strategies you can take to avoid or minimize AMT, but that post is for another day.
The sale of shares is a taxable event for NQSOs. The gain (or loss) is treated as a capital gain (or capital loss). Since the bargain element on your NQSOs have already been taxed at exercise, the gain or loss is calculated from the FMV at the time of exercise.
If you held the shares less than 1 year from the exercise date, the gains are treated as short-term and taxed as ordinary income. If you held the shares greater than 1 year from the exercise date, the gains are treated as long-term and taxed at the more favorable long-term capital gains rates.
For example, if you exercised 1,000 NQSOs on 9/1/21 with an exercise price of $2/share and a FMV at exercise of $10/share, then sold those shares 1 month later for $11/share, you’d have a short-term capital gain of $1/share.
The sale of shares from an ISO exercise also creates a taxable event, but the holding period requirements are more complicated. There are two requirements to get more favorable tax treatment. The sale of shares must be at least:
- 2 years from the grant date AND
- 1 year from the exercise date
If you meet BOTH requirements then it’s known as a qualifying disposition and the difference between the exercise price and sales price is treated as a long-term capital gain for regular federal income tax purposes.
If you don’t meet both requirements, the sale is called a disqualifying disposition and the gain will be taxed at your ordinary income tax rates.
There is an additional complication with the cost basis for your ISOs. If you hold the shares across the calendar year, which makes the bargain element reportable under the AMT calculation, then you will have a different cost basis on the shares for AMT and for regular federal income tax.
How to navigate
As you can see, the taxation of employee stock options is complicated. There are several strategies you can take to minimize your taxes, but any strategy needs a healthy dose of risk control as well. Talk to a qualified professional to come up with a custom strategy that fits your financial goals.