How Employee Stock Options Are Taxed

As an incentive and to help grow the organization’s market value, many companies will offer stock options to key employees. The options give the employee the right to buy a specified number of shares of the company’s stock at a future date at a specific price. Generally, options are not immediately vested and must be held for a specified period before they can be exercised. Once vested, and assuming the stock price has appreciated to a value higher than the option price of the stock, the employee can exercise the options (buy the shares), paying the lower option price for the stock rather than the current market price. This gives the employee the opportunity to participate in the growth of the company through gains from the sale of the stock without the risk of ownership.

There are two basic types of employee stock options for tax purposes, a non-statutory option and a statutory option (also referred to as the incentive stock option), and their tax treatment is significantly different.

Non-statutory Option

The taxability of a non-statutory option occurs at the time the option is exercised. The gain is considered ordinary income (compensation) and is included in the employee’s W-2 for the year of exercise.

The employee has the option to sell or hold the stock he or she has just purchased, regardless of what he or she does with the stock, the gain, or the difference between the option price and market price of the stock at the time of the exercise, is immediately taxable. Because of the immediate taxation and to generate the cash necessary for purchase, most employees who have been granted options will immediately sell their stock when exercising their option. Under that scenario, the W-2 wage income will reflect the profit on the sale. Since the difference between the option price and market price is included in wages, it is also subject to payroll taxes (FICA).

Form 8949 (the tax form used to report sales of stock and other capital assets) will need to be prepared to show the sale, essentially with no gain or loss, so that the gross proceeds of sale are properly reported on the return. Although the W-2 shows the profit, the brokerage will also report the gross proceeds on Form 1099B. If there was a sales cost, such as a broker’s commission, then the result would be a reportable loss, albeit usually a small amount.

If an employee chooses to hold the stock, he or she would have to pay the tax on the difference between the option price and exercise price, plus the FICA tax, from other funds. If the stock subsequently declines in value, the employee is still stuck with the gain reported when the option was exercised. Any loss on the subsequent sale of the stock would be limited to the overall capital loss limitation of $3,000 per year.

Statutory (Incentive) Options

In the taxation of a statutory options, no amount of gain is included as regular income when the option is exercised. Therefore, the employee can continue to hold the stock without any tax liability; and, if he or she holds it long enough, any gain would become a long-term capital gain taxed at a preferential rate. To achieve long-term status, the stock must be held for:

However, there is a dark side to statutory options. The difference between the option price and market price, termed the spread, is what is called a preference item for alternative minimum tax (AMT) purposes. If the spread is great enough, that might cause an additional tax liability due to the AMT. The rules surrounding AMT are complex which is why we recommend you seek the guidance of a tax advisor if you are granted incentive stock options.

Planning opportunities with options

With an increase in the value of stock options in 2020 and 2021, we’ve received a number of questions regarding the timing of exercising and/or selling options. While we cannot provide investment advice, we can model the tax and cash flow implications of certain actions at different stock valuations. Using a team that includes both your investment and tax advisors will ensure that you are maximizing the financial benefits of stock options.

If you are planning to exercise employee stock options and have questions or wish to do some tax planning contact us at Cray Kaiser so we can help to minimize the tax bite.

<< Back to all blogs

Could a Voluntary Disclosure Agreement Help Your Business?

What You Need to Know About Advance Child Tax Credit Payments for 2021

Important Information for S-Corp Shareholders and Partners of a Partnership