Before getting down to how your employee stock options may impact your taxes and how you can plan to minimize tax impact, let us look at the basics.
What is a Stock Option?
An employee stock option is the right your employer gives you to buy a certain number of shares of company stock at a pre-set price over a certain period of time.
- When you buy the stock, you are said to be exercising your stock option.
- The pre-determined price at which you are allowed to buy the stock is called the grant price. Strike price and exercise price are other names that mean the same thing.
- The time period for which your option remains open is called the exercise period.
Incentive Stock Options and Nonqualified Stock Options
A company may offer you, their employee, one of two types: Incentive Stock Options (ISO) that come as part of a plan and Nonqualified Stock Options (NQSOs or NSOs) with no such plan.
ISOs are meant only for US employees and only corporations can issue them. NSOs may be offered to any service provider, such as domestic or foreign employees, consultants, directors and advisors. Corporations, LLCs and partnerships can issue NSOs.
In addition to their other differences, ISOs and NSOs have different tax implications. Let us consider each in greater detail.
Stock Option Agreement (aka Option Grant)
Your employer grants stock options to you using a stock option agreement or option grant. The stock options may be mentioned in your offer letter, but you have to separately sign the option grant to be eligible for the stock options.
The option agreement and its terms are important. It will specify:
- Thetype of stock optionsand the number of shares you will be getting;
- Strike priceat which you exercise your option;
- Vesting scheduleof when you become eligible to buy the shares and the numbers of shares you may buy;
- Expiration dateof the stock options. Usually, ISOs expire ten years from the date of grant, or when you leave the company. There may be a time within which you can exercise your options. Any options you do not exercise within that time period expire.
Grant Date
Often there is a gap between the time you join a company and the option agreement making its way to you. This is because it requires Board approval. The date the stock options are granted to you—when the Board approval is given—is important for tax purposes.
Accepting the option agreement does not obligate you to buy the shares and you are free to let the options expire at no cost to you. But, unless you sign the stock option agreement, you are not eligible to exercise your options.
Vesting
Vesting is when you become eligible to use your stock options. Often companies will start their vesting schedule after you complete one year of employment. This prevents people from joining just to get stock options and leaving shortly afterwards. At vesting, you will get part of the stock options you are eligible for. From then on, every year, or as per the agreement, more and more shares become vested.
Prices of Stock Options
Strike price, grant price and exercise price are all the same.This is the price at which you can exercise your option to buy the eligible shares.
Fair market value (FMV)
The value of a stock is called the fair market value (FMV). For a listed stock, the FMV is the price at which stocks were trading on that day. For unlisted shares, FMV is typically determined by an independent valuation and is considered the accepted current value of a share of the (private) company’s common stock.
At the time you decide to buy—exercise your options—the company shares of your employer may have a market value that is above, below or the same as your strike price.
- Stock option in-the-money.If the stock fair market value is above your strike price, it is called in-the-money. As with common parlance, you are in the money then, that is, able to make a profit.
- At-the-money stock optionshave a FMV that is the same as your strike price. You make neither a profit nor a loss with the transaction.
- Underwater stock optionsare when the FMV of stocks have dipped below the strike price. If you haven’t exercised your options and the expiry date draws near, and the stocks are under water, you can forget about them.
Important Times for Stock Options
There are two points that are important for taxes: the point at which you exercise your stock options and when you sell them. There are usually no tax implications at the point of granting stock options.
There are also two types of taxes in play: ordinary income tax and capital gains tax.
Taxes at Options Exercise
Exercising options is a taxable event. And the taxes you are liable to pay depend on the type of options you hold.
Tax on NSOs:For tax purposes, the spread or the difference between the current fair market value of the stock and your strike price is treated as ordinary income.
Tax on ISOs:If you have ISOs, exercise of options is not subject to regular tax. However, the spread is subject to alternative minimum tax (AMT).
If the options are at-the-money, you will not be liable for tax as there is no difference between FMV and the strike price. You are exercising your stock option at the FMV. But if you exercise your options at a lower price than the FMV, you will have to pay taxes on the difference, just as you would pay on your salary or regular income.
The image below is a visualization fromCarta.com. Carta helps companies and investors manage their cap tables, valuations, investments, and equity plans. If you are a visual learner they have some helpful charts that you may want to look at.
An Exercise Plan for Stock Options
To make the best of your stock options, it is important to have an exercise plan. You must also to keep track of their expiration dates. For tax planning purposes, your goal should be to exercise your stock options in such a way to fall into a lower tax bracket. This can be achieved in a number of ways.
Taxes at Sale
After exercising your options, the next point at which you face tax implications is when you sell the stock. Once you exercise the options, what do you plan to do with the shares? If you are hanging on to them, that is not a problem. But if you want to sell them off, this may affect your tax position. The timing of the sale, the length of time you hold the shares, and the length of period from grant to sale all matter to your taxes.
For ISOs, the taxes applicable at sale are the sales price less the exercise price is the gain considered a capital gains tax. Basically, the difference between when you bought the asset and when you sell the asset is the capital gain for you. AMT makes things more complicated and if AMT was paid at exercise generally a credit is returned when the stock is sold.
Eligibility for Long Term Capital Gains Tax Rate
If you have ISOs:
You need to fulfill two conditions to be eligible for long-term capital gains rate for federal income tax purposes:
- Hold the stock for more than one year after exercise of stock options and;
- Hold the stock for more than two years after the grant of stock options.
Then you are eligible for the long-term capital gains tax rate.
Warning: Your company may label your options as ISO but if the statutory requirements are not meet and kept under the tax law to qualify for ISO treatment they will be taxed as NSO.
If you have NSOs:
The applicable capital gain is calculated on sale price minus the FMV of the stock at the exercise date. To be eligible for the long-term capital gains tax rate, NSOs must be held for more than one year after exercising of the options.
Making an 83(b) Election
The 83(b) election is a provision under the Internal Revenue Code that enables a startup founder or an employee the option to pay taxes upfront at time of granting options, on the total FMV of a restricted stock.
By filing the election, you are giving notice to the IRS that you wish to be taxed on your stock options (or other equity) at the point it was granted to you instead of when it is vested. By making this election you may be able to save on taxes later.
The Section 83(b) election changes how the IRS treats your gains from the options. The usual method is to treat your gains as ordinary income at exercise. Section 83(b) election changes that to be based on the long-term capital gain instead. The US tax code rewards people who hold their investments for longer than one year with a discounted tax rate. This election allows for the possibility to convert more of your gain to the lower capital gains tax rate vs. ordinary income taxes.
For example, for the 2020 tax year, the highest rate applicable to long term capital gains is 20%, applicable for those with an income over $441,451. Those making up to $40,000 have a zero rate while those making between $40,001 and $441,450 pay at 15%.
In contrast, short-term capital gains are taxed as ordinary income and the federal income tax brackets apply. These are at present much higher than the highest rate of 20%.
When you make the section 83(b) election, you effectively end up paying tax on the value of the shares at the time of grant. As a result, all your future gains that occur between the grant date and date you sell your shares will be treated as a capital gain. Normally, you pay tax on options at time of vesting, not when they are granted to you. And gains between the grant and vesting or exercise date are taxed at ordinary income rates. The section 83(b) election effectively begins the clock on long-term capital gains rate immediately, instead of waiting for the vesting date.
There is a downside to the Section 83(b) election. People who receive large amounts of restricted stock grants will have to pay a large tax bill upfront and have to do so without selling any of those same shares to help cover it.
There is also the risk of the employer company failing or experiencing a drop in stock value before the options are fully vested or exercised. And this means you would have paid taxes — due to §83(b) election — without getting anything in return. Still, if you have some confidence in your employer’s long-term prospects, you may want to consider this election. It may be worth paying some taxes up front and locking in the lower capital gains rates for potential future gains.
A Section 83(b) election must be filed within 30 days of your being granted the stock by your employer. You can treat the grant date as the date the Board of Directors of your employer approves your option grant.
Your employee stock options can help you build wealth, especially if you make use of them in a planned manner, knowing all the tax implications and understanding the time-frame constraints. Consider talking to a tax professional and a financial planner before taking big decisions on your employee stock options. They will help you optimize your wealth and avoid a large tax bill.
Want Guidance on Your Stock Options and Timing?
At Proseer we guide individuals and businesses on how best they can optimize their tax position. If you have questions about your employee stock options, timing of exercise or want to discuss tax implications, go ahead and submit a request to contact us.
