A corporation is allowed to take a tax deduction for turning employees into owners of the company when following the rules for either granting shares of stock or awarding options to purchase stock. In both cases, employees are taxed on the value of stock received. A recipient of stock grants cannot sell the shares until the passage of time called the vesting period. Shares obtained by exercising stock options are eligible for resale at any time.
The value of shares received as a stock grant is taxed as ordinary compensation. This calculation typically occurs after the vesting period when the employee is no longer restricted from selling the stock. But an employee can elect to incur the tax impact when the restricted stock is initially granted. An employee with regular stock options is taxed upon exercising the right to buy shares. The stock value on the exercise date minus the amount paid to purchase the shares is added to compensation. This is the bargain element of stock options.
Basis is the term used to describe the amount invested in something for tax purposes. For both stock grants and stock options, an employee’s basis is the amount paid for the shares plus any value taxed as compensation. The beginning holding date for stock grants is normally the vesting date. But, if the employee elects to have the value taxed on the grant date, that is the holding period start. The holding period for shares acquired with stock options begins on the option exercise date.
Sale of shares acquired from stock grants or exercise of stock options results in a capital gain or loss calculated as the difference between sales proceeds minus the basis. A gain from selling more than one year after the holding period starts is taxed at a favorable long-term rate. Sale of shares one year or less after the holding period begins is a short-term capital gain. A capital loss occurs when sales proceeds are less than the basis. A maximum amount of $3,000 per year of capital loss is deductible against other income sources. Excess carries over to future years.
Incentive Stock Options
Incentive stock o(ISOs) are different than regular stock options. No amount is taxed as compensation when exercising ISOs. However, when shares acquired with ISOs are sold less than one year after exercise or less than two years after the option grant, the bargain element is taxed as compensation in the stock sale year. Selling more than one year after exercise and two years after the option grant results in more money taxed as long-term capital gains. The bargain element becomes part of the capital gain because it is not taxed as compensation.