Employee stock options are a great incentive that can be embedded within many compensation packages. Often, employees are able to buy the company stock at a discount, providing a great opportunity to accumulate wealth if the stock performs well.
But the other piece of the puzzle is trying to grasp how taxes for employee stock options work. It could easily become a nightmare if you've never dealt with stock options before. Here are a few insights to take the confusion away so you can maximize the potential of this incredible work benefit.
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How stock options work
There are two main types of stock options that you could receive as part of your compensation gift: incentive stock options and nonqualified stock options. The main difference between these two is how they are treated for tax purposes when you exercise the options.
Incentive stock options (ISOs), also known as statutory stock options, are granted under a stock purchase plan. However, nonqualified stock options (NSOs) are granted without a specific type of plan and are often referred to as nonstatutory stock options. As we'll see below, NSOs don't qualify for the same tax benefits that ISOs receive.
When you have employee stock options, there are three special occasions you need to be aware of: the date your company granted you the options, when you exercised them, and how long you hold the shares you receive on exercise before you sell them. These moments play an important role in your tax calculation.
Most of the time, there is a vesting schedule tied to your employee stock options. Simply put, you cannot tap into your stock option benefits until you've been at your company for a certain period of time. After you are vested, then you can exercise the options at any time before they expire.
Incentive stock options
Incentive stock options are simpler than nonqualified stock options from a tax perspective. Employees who have ISOs don't have to worry about taxes when they receive a stock option grant or exercise the options.
The order of operations works like this: You receive a stock option grant and then you exercise the options when you are eligible and ready to do so. After you exercise your options, then you'll have to make the ultimate decision: When do I sell my stock?
Let's say you were granted 2,000 shares of stock at an exercise price of $10. On the date that you decide to exercise your shares, the stock is actually worth $30 per share. If you sell immediately, you are paying $20,000 for something that is worth $60,000, but you'll have to pay ordinary income tax rates to lock in those gains now.
Your other option: exercise your options in one period and sell your stocks later. You may be able to unlock favorable long-term capital gains tax rates (a top rate of 20%) if you hold ISOs for at least two years from the date the options are granted and longer than one year from the exercise date before you sell; otherwise, you give up the right to exclusive tax benefits and risk being stuck with ordinary income taxes that could be as high as 37%.
The double tax for nonqualified stock options
It's important to have a tax strategy when exercising NSOs because you'll be hit with a tax twice, and it can get a bit complicated.
First, you'll typically have to pay ordinary income taxes when you exercise the options. You must pay the difference between what you paid for the stock (the exercise price) and the fair value of the shares when you exercised them. The IRS considers this as compensation income even though you haven't actually made any money.
Then, you'll pay capital gains tax if you sell the shares at a profit. If the sale results in a loss, you'll report a capital loss for the difference between your tax basis and what you received. You'll either pay short-term or long-term capital gains taxes depending on how long you've held the stock. When you hold your investment for over a year, you'll qualify for the preferential long-term capital gains rates of 0%, 15%, or 20%, based on your income range for the year.
More taxes to consider
Although ISOs are typically seen as a tax savior in comparison to NSOs, you'll have to consider the alternative minimum tax (AMT) if you are a high earner. There is also a $100,000 limit that restricts the total value of ISOs that can be exercised in a given year if you want to enjoy the incredible tax benefits.
Taxes for employee stock options can be overwhelming. If you have no idea what you're doing when you file your taxes, seek out a professional to make the process less draining.
FAQs
You must pay the difference between what you paid for the stock (the exercise price) and the fair value of the shares when you exercised them. The IRS considers this as compensation income even though you haven't actually made any money. Then, you'll pay capital gains tax if you sell the shares at a profit.
How do employee stock options get taxed? ›
You have taxable income or deductible loss when you sell the stock you bought by exercising the option. You generally treat this amount as a capital gain or loss. However, if you don't meet special holding period requirements, you'll have to treat income from the sale as ordinary income.
How much tax is deducted from stock options? ›
In case of listed shares, long term capital gains arising from shares held for more than one year and exceeding Rs. 1 lakh would be subjected to tax @ 10% (without indexation) u/s 112A of the IT Act whereas short term capital gains would be subjected to tax @ 15% u/s 111A of the IT Act.
How is ESOP taxed? ›
ESOP distributions are taxed as ordinary income, but if you receive a lump-sum distribution in the form of stock, you'll generally pay ordinary income tax on the value of your employer's contributions to the plan, plus capital gains tax on the appreciation in stock value when the stock is sold.
What is the tax form for employee stock options? ›
Tax form for ESPPs. For ESPPs, information is reported to the employee in the year the options are exercised on Form 3922, Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423(c), but there is no income when the options are either granted or exercised.
How do I avoid double tax on ESPP? ›
They can only report the unadjusted basis — what the employee actually paid. To avoid double taxation, the employee must use Form 8949. The information needed to make this adjustment will probably be in supplemental materials that come with your 1099-B.
What are the disadvantages of stock options for employees? ›
Employees can't typically access the value of their options until after they're vested and exercised. This may not be an attractive benefit when staff members have lower salaries and need the funds now. In some cases, they may even encounter restrictions onhow they may sell the stock.
How to minimize tax on stock options? ›
TLDR
- Exercise early and File an 83(b) Election.
- Exercise and Hold for Long Term Capital Gains.
- Exercise Just Enough Options Each Year to Avoid AMT.
- Exercise ISOs In January to Maximize Your Float Before Paying AMT.
- Get Refund Credit for AMT Previously Paid on ISOs.
- Reduce the AMT on the ISOs by Exercising NSOs.
If you are trading in Futures and Options, you should get your accounts audited if your turnover is more than ₹10 crore. You can also apply a presumptive taxation scheme if your turnover does not exceed ₹2 crore and declare that your taxable income is at 6% of the total Futures and Options turnover.
Are RSUs taxed twice? ›
So how do RSUs get taxed? You'll owe taxes on your equity compensation twice, at vesting and when you sell. Vesting - On your vesting date, you automatically own shares of the company stock. The stock has a fair market value which is your cost basis.
*Note: ESOPs are allowed, but not required, to offer hardship distributions. In those cases, the IRS may waive the 10 percent excise tax if the distribution is taken to cover expenses that qualify as financial hardship, such as medical, funeral, or tuition expenses, and costs paid to avoid foreclosure.
What is the ESOP 25% rule? ›
ESOP rules set a limit of 25% of salary as the maximum amount that can be contributed to a participant's account annually, though most companies contribute between 6-10% of salary annually. The 25% is a combined limit that includes ESOPs, 401(k)s, profit sharing, and stock bonus plans offered by the company.
Can you cash out an ESOP after quitting? ›
Generally, it's only possible to redeem these shares if you terminate employment, retire, die, or become disabled. Some ESOPs may distribute dividend payments to employees who are still at the company. Other in-service distributions may be done by some plans as well.
How are employee stock options taxed? ›
Employee stock options
Generally, the gains from exercising non-qualified stock options are treated as ordinary income, whereas gains from an incentive stock option can be treated either as ordinary income or can be taxed at a preferential rate, if certain requirements are met.
How do I report an employee stock option? ›
You will receive a Form 1099-B in the year you sell the stock units. The form reports any capital gain or loss resulting from the transaction on your tax return. You should review your investment records to verify the cost basis amount on Form 1099-B.
How do you account for employee stock options? ›
When an employee exercises stock options, you'll credit Common Stock for the number of shares x par value, debit Cash for the number of shares x the exercise price, then debit Additional Paid-In Capital for the difference, representing the increase in value of the shares during the service period.
How are employee stock purchases taxed? ›
When you buy stock under an employee stock purchase plan (ESPP), the income isn't taxable at the time you buy it. You'll recognize the income and pay tax on it when you sell the stock. When you sell the stock, the income can be either ordinary or capital gain.
Do I have to pay tax on stocks if I sell and reinvest? ›
With some investments, you can reinvest proceeds to avoid capital gains, but for stock owned in regular taxable accounts, no such provision applies, and you'll pay capital gains taxes according to how long you held your investment.
