Stock options are taxed when the stock option holder sells the shares acquired through exercising their stock option, resulting in either a taxable gain or deductible loss based on the transaction outcome.
Maybe you’re a prospective employee considering a job offer, or maybe you’re a startup founder bent on offering the most competitive equity compensation package under the sun. In any case, you’ll want to familiarize yourself with employee stock options. We’ve addressed the ins and outs of stock options in several other Pulley guides already, but there’s one subtopic that’s confounding enough to warrant its own guide. Yes, we’re talking about stock options and taxes.
When one chooses whether or when to exercise stock options, tax implications can play a crucial role. And to make matters even more confusing, the IRS doesn’t lump all stock options together into one big bucket of equity. Different types of stock options are taxed differently, so you’ll want to know what type you have and what impact this has on how your stock options will be taxed.
We’ll get to all of that in this guide. But first, let’s review some key equity terms related to employee stock options taxation.
- Key terms for employee stock options taxation
- Ordinary income tax vs. capital gains tax: What’s the difference?
- Defining two types of stock options
- How are incentive stock options (ISOs) taxed?
- When should I exercise my stock options?
- Ready for the next step in your equity journey?
Key terms for employee stock options taxation
Employee stock options are a type of equity compensation that gives an employee the right, but not the obligation, to buy a number of shares of company stock at a specific price. The name “option” comes from the fact that it’s really the employee’s choice—he or she may purchase the shares, but is by no means obligated to. If the employee chooses to not purchase the stock, the options would simply expire and that would be that.
So, now we know what employee stock options are. Before we dive any deeper, let’s take a look at five key terms that will come into play when we discuss how stock options are taxed:
- Option grant date: This is the date on which the employee stock option award is officially granted to the recipient. Typically, the stock price (or the value of the shares) on the grant date determines the recipient’s exercise price. This date also starts the clock for any vesting schedule outlined in the option grant agreement.
- Exercise price: Also known as the strike price, this is the price at which a share of company stock can be bought by the option holder. So, even if the current market value of the stock is higher when you exercise your options, your exercise price is the price you’ll pay.
- Exercising: When you exercise your stock options, you buy shares of company stock at your agreed-upon exercise price. If the value of those shares increases from the grant date to the exercise date, you are buying those shares at a price below the fair market value.
- Fair market value (FMV): The fair market value of a company’s stock is how much one share of that stock would be worth on the open market. This may be determined differently, depending on whether the company is public or private.
- Vesting schedule: Options often vest on a specified schedule, which outlines what needs to happen before you earn the right to exercise your options. Some plans allow for early exercise, which means options can be exercised prior to vesting. (This may allow for certain tax benefits; more on that later.)
Now that we’ve got the basics out of the way, let’s look at some other key tax terms to understand. We’ll start with the two types of taxes you should familiarize yourself with before you decide to exercise options.
Ordinary income tax vs. capital gains tax: What’s the difference?
Generally speaking, stock options are only taxed after they’re exercised. The specific tax rates you’ll pay after exercising your options, however, may differ depending on the type of option.
When exercising stock options, you’ll likely pay either ordinary income tax or capital gains tax (or both).
Ordinary income tax rates are generally quite a bit higher than long-term capital gains tax rates. In a typical case, the difference between your exercise price and the stock price at the time of exercise will be taxed as ordinary income. Here’s an example:
- Your company offers you stock options at an exercise price of $10.
- You decide to exercise your options when the stock price is $15, or $5 more than your exercise price. In this case, you stand to gain $5 per share.
- That $5 profit per share will be taxed as ordinary income when you exercise. Since this profit was earned as part of your employment compensation, the IRS treats it the same as it does your regular salary and income.
Capital gains tax rates apply to profits you make on assets you already own. So, you’ll typically pay capital gains tax on the difference between the stock price at the time of exercise and the stock price at the time you sell it for a profit. Here’s an example of when capital gains tax might apply:
- After exercising your stock options when the stock price is $15, the stock price rises to $20.
- You sell all of your shares for $20 a share.
- The $5 difference between the stock price when you exercised ($15) and the stock price when you sold ($20) will be taxed as capital gains.
Short-term capital gains tax vs. long-term capital gains tax
One other distinction applies here, and it’s an important one. There are two types of capital gains tax: short-term capital gains and long-term capital gains.
Generally speaking, short-term capital gains apply to profits you earn from selling assets you’ve held for a year or less. These are typically taxed at the ordinary or regular income tax rate, so they don’t confer any benefits.
Long-term capital gains apply to—you guessed it—profits you earn from selling assets you’ve held for longer than a year. Long-term capital gains tax rates are usually quite a bit lower than ordinary income and short-term gains rates, so it pays to optimize your exercise strategy to favor long-term capital gains rates, if possible.
Now that we’ve clarified the difference between these tax rates, let’s look at the two main types of stock options in the U.S. The major benefits you get from the first type—incentive stock options, or ISOs—have to do with their tax treatment.
Defining two types of stock options
The two major types of stock options you should know about are incentive stock options (ISOs) and non-qualified stock options (NSOs). For taxation purposes, the IRS distinguishes between the options granted in an ISO plan vs. an NSO plan, calling the former “statutory stock options” and the latter “nonstatutory stock options.”
What are incentive stock options (ISOs)?
Incentive stock options (ISOs) can only be granted to a company’s employees, and they qualify for a favorable tax treatment if they meet certain criteria.
Assuming all of these criteria are met, the difference between the exercise price and the stock’s fair market value at the time of exercise is not subject to ordinary income tax. (It may, however, be subject to the alternative minimum tax (AMT) — more on that in a bit.)
What are non-qualified stock options (NSOs)?
Non-qualified stock options (NSOs) can be granted to folks who aren’t technically company employees—think contractors, consultants, advisors, and the like. These don’t come with the same tax advantages as ISOs.
As in the example provided above, NSOs are taxed at the ordinary federal income tax rate when they’re exercised. The tax applies to the difference between the strike price and the fair market value of the common shares on the date the options are exercised.
How are incentive stock options (ISOs) taxed?
It’s worth spending a little more time on ISOs, as these come with some interesting tax benefits that don’t apply to NSOs.
The big takeaway with ISOs is that the recipient may be only required to pay federal income taxes when they sell the stock, versus having to pay ordinary income tax at the time of exercise.
Holding period requirements for ISOs
Among the other main requirements for ISOs, a couple stands out with regard to taxation. These requirements relate to holding periods, and they state that:
- ISOs must be held for more than two years from the option grant date.
- Any shares obtained upon exercise must be held for more than one year after the exercise event.
Selling ISOs before these holding period requirements are up triggers what’s known as a disqualifying disposition. In plain speak, this just means that you lose all the tax benefits associated with the ISO.
Selling after the holding period requirements are satisfied is known as a qualifying disposition.
What is the alternative minimum tax (AMT)?
As you can see, ISOs offer some pretty great potential tax benefits! But you should be aware that ISOs may be subject to the alternative minimum tax (AMT).
The AMT is designed to ensure that high-income taxpayers pay at least a minimum tax. It essentially sets a bottom limit of the percentage of taxes a taxpayer is obligated to pay, which means it may limit some tax deductions and exclusions.
You may be exempt from having to pay AMT if you make less than the AMT exemption amount, which can change annually. But if you do have to pay AMT, your taxable income may include the difference between your exercise price and the stock price at the time of exercise (also known as the “spread”).
The AMT can be a tricky thing to navigate, which is why it’s worth talking to a tax advisor or other tax professional prior to exercising ISOs.
When should I exercise my stock options?
The question of when to exercise your stock options isn’t solely related to your exercise price and the stock’s fair market value. Taxes also play an important role.
In Pulley’s guide to exercising stock options, we review some different exercise scenarios and how they may affect your tax obligation. For example, if your company’s equity plan allows you to early exercise, this may result in a more favorable tax treatment or help you qualify for long-term capital gains tax rates sooner.
As with anything options-related, we encourage you to weigh your different options with a trusted tax advisor. In general, every situation is a little bit different, and any exercise event can have tax consequences that are worth mulling over with your tax advisor.
Ready for the next step in your equity journey?
Taxes aren’t anybody’s idea of fun, but they’re worth paying attention to. After all, taxes can end up meaning the difference between a princely equity package and one that’s just so-so.
Keep in mind that different types of equity are taxed differently. The information in this article applies to stock options, but other equity types, such as restricted stock units (RSUs) and stock bought under an Employee Stock Purchase Plans (ESPP), have their own taxation nuances to consider. If you’re interested in learning more, you can start by checking out our guide to stock options vs. RSUs, or by setting up a call with one of our equity experts today.
