Employee stock options are grants from your company that give you the right to buy shares for a guaranteed sum called the exercise price. If your company’s stock does well, you can cash in, or exercise, the options, meaning that you use them to buy shares at the exercise price and sell them at a higher market price.
But how are options taxed? You probably understand how to cash out a stock. But the tax consequences of exercising stock options are a different matter. Generally, the tax consequences of cashing out stock options depend on Internal Revenue Service rules for the kind of stock options you have.
Read More: Who Must File Income Taxes?
Nonqualified Stock Options
Nonqualified stock options are the most common kind of employee stock options. There are no tax consequences when you are granted nonqualified options until you use them by paying your company the exercise price to buy the stock. When you do, the difference between the exercise price and the market price of the stock on the date you exercise them is called your bargain element.
Suppose your nonqualified options have an exercise price of $50 per share and the stock is selling for $75 the day you exercise the options. In that scenario, the $25 per share difference is your bargain element.
The bargain element is considered part of your compensation along with your salary. The bargain element is added to your other pay on your W-2, and you have to pay income taxes, Social Security tax and Medicare tax on the money. The taxes are due for the year in which you exercise your nonqualified options.
Read More: W-2 Forms: What It Is, Who Gets One & How It Works
Holding Your Shares
After you exercise nonqualified options, you can sell the shares immediately and take the cash. Alternatively, you can hang onto the stock. If you decide to keep it for a while, your investment for tax purposes is called your cost basis and is the market price on the day you exercised the options. When you sell the shares at a future time, you will have a capital gain if the stock has gone up.
Suppose the cost basis is $75 per share and you eventually sell the shares at $85. That means you have a capital gain of $10.
If you waited more than a year after the exercise date to sell the shares, it’s a long-term capital gain, and the maximum tax rate on the $10-per-share capital gain is 20 percent. But if you waited one year or less, it’s a short-term gain and is taxed at the same rate as ordinary income. If the stock goes down instead of up after you buy the shares, you’ll have a capital loss that you can take as a tax deduction.
Incentive Stock Options
The second kind of employee stock options you might receive are called incentive stock options. These stock options give you a tax break if you follow special IRS rules. You must wait one year or longer after you are granted incentive stock options to exercise them. Then you must wait at least one more year to sell the shares you purchased with the options.
If you meet these requirements, all of your profits, including the bargain element, are taxed as long-term capital gains at a maximum rate of 20 percent.
Suppose you exercise incentive stock options and pay an exercise price of $50 per share when the market price is $75, giving you a bargain element of $25 per share. You wait a year and sell the stock when the price has gone up another $10 to $85 per share. In that case, your total profit of $35 per share is taxed as a long-term capital gain.
Incentive Stock Option Considerations
When you exercise incentive stock options, usually no taxes are due. You have a tax liability only when you sell the shares. There are two things to keep in mind.
If you are subject to the alternative minimum tax, you’ll have to pay income taxes on the bargain element for the year in which you exercise the options. You’re still entitled to the tax break, but you have to get the money by taking tax credits in future years.
Finally, if you exercise incentive stock options in less than one year after you get them or sell the shares less than a year after exercise, you lose the tax break. The IRS treats the options as if they were nonqualified stock options.
- IRS.Gov: Topic No. 427 Stock Options
- Corporate Finance Institute: Exercise Price
- IRS.Gov: Topic No. 703 Basis of Assets
- IRS.Gov: Topic No. 409 Capital Gains and Losses
- Corporate Finance Institute: Incentive Stock Option (ISO)
- IRS.Gov: Topic No. 556 Alternative Minimum Tax
- IRS.Gov: Publication 525 (2020), Taxable and Nontaxable Income
Based in Atlanta, Georgia, W D Adkins has been writing professionally since 2008. He writes about business, personal finance and careers. Adkins holds master's degrees in history and sociology from Georgia State University. He became a member of the Society of Professional Journalists in 2009.