A stock option is a contract between you and a company. Essentially, it gives you the right to buy a fixed number of shares of the company’s stock at a fixed price (also known as the exercise price). However, you typically must wait for a period of time until you can purchase the shares. This process is called vesting.
Also, when you receive an option grant, there is no tax to pay.
Example of a Stock Option
You get hired by XYZ Corp. and the company grants you an option to purchase (or exercise) 10,000 shares at a price of $20. The vesting is for a five year period, which means you can buy 2,000 shares per year. And this is cumulative. That is, after year two, you can purchase 4,000 shares if you did not make any purchases after year one and so on.
Ok, suppose a year goes by and you sell 2,000 shares. The stock is now at $30, which means you have a gain:
$60,000 ($30 current stock price X 2,000 shares)
$40,000 ($20 exercise price X 2,000 shares)
= $20,000 gain
Now suppose that — at the time of the exercise — the stock price is instead at $10. In this case, there will be no value for the option:
$20,000 ($10 current stock price X 2,000 shares)
-$40,000 ($20 exercise price X 2,000 shares)
= – $20,000
In other words, if the stock value is below the exercise price, there is no reason to exercise the option.
Ok, then what is the tax if there is a gain on the exercise? It depends on the type of option you have, whether it’s an incentive stock option or a nonqualified option.
Incentive Stock Option (ISO)
If you exercise a stock option and hold onto the shares for more than a year, then you will not owe any federal income tax. Yet there is an important wrinkle — that is, you will probably need to pay the Alternative Minimum Tax (AMT). This is a separate tax system and requires the filing of Form 6251. In fact, the effective tax rate can be as high as 35% because of the phaseout or exclusion of various deductions and exemptions.
The good news is that — over time — you should be able to recover some or all of the AMT amount, which is done with a tax credit. But you will need to make sure you file Form 8801 for each year, until you use up the credit.
When you sell the stock, the gain or loss will be equal to the proceeds from the sale minus the cost basis. The cost basis will be the amount you paid to exercise the option plus the income recognized — from the payment of AMT — when you exercised the option. If you sell the shares more than one year from the exercise, the gain will be long-term and the preferential tax rates will apply. Otherwise, you will be taxed at your ordinary rates.
Now, let’s suppose that you exercise the ISO but sell the shares within a year or less. In this case, you will have a disqualifying disposition. This means you will need to recognize compensation income for the difference between the value of the shares and the purchase amount. This will be taxed at your ordinary rates (the same as your wages). Also, there will be no alternative minimum tax (AMT) due.
What’s more, your employer will not withhold any taxes, though. So if you want to avoid paying IRS penalties and interest, you might need to do quarterly estimated payments.
As for the sale of the shares, you will either have a capital gain or loss. This is calculated as the proceeds from the sale minus the amount paid for the shares plus the compensation income recognized. The last element is often missed, which can mean paying much more taxes.
Also, if you sell your stock more than a year after the exercise of the option, then you will be eligible for preferential long-term capital gains rates (the maximum is 20%).
For the sale, you will get a 1099-B from your brokerage firm, which will provide details of the transaction. You will then report this on Form 8949 and Schedule D, which will be a part of your 1040.
When you exercise a nonqualified option, you will pay ordinary taxes on the compensation income, which is the value of the shares at the time of the exercise minus the amount paid for the shares.
So let’s take an example: Suppose you exercise an option — which has an exercise price of $10 — for 1,000 shares. At the time, the value of the stock is $20. In this case, you will have the following compensation income:
$20,000 (1,000 shares X $20 current stock price)
-$10,000 (1,000 shares X $10 exercise price)
= $10,000 compensation income
So, if you are in the 28% tax bracket, the federal tax will be $2,800.
Your employer will actually withhold federal and state taxes as well as the amounts for Social Security and Medicare. This will be reported on your W-2.
But this is not the end. You may also owe taxes when you sell the shares. Again, with our example, let’s say the stock price goes $25 and you sell 1,000 shares. To calculate the gain, there will be a wrinkle:
$25,000 (1,000 shares X $25 current stock price)
– $10,000 compensation income recognized
– $10,000 (1,000 shares X $10 exercise price)
= $5,000 gain
As you see, the IRS allows you to use the compensation income as part of the cost of the shares (or the “cost basis”). The reason is that you have already paid taxes on this.
Yet many people do not realize this — and, as a result, overpay their taxes!
Next, the taxes owed on the $5,000 depends on your holding period, which is the time of the exercise of the option and the sale of the shares. If this is over one year, then you will pay the long-term capital gains rates, which is at a maximum of 20%. If not, you will instead be required to pay the short-term capital gains rates, which is at the ordinary rates.
When you sell the shares, your brokerage firm will include these on Form 1099-B. With this, you will be able to fill out Form 8949 and Schedule D for your 1040 return.