Frequently asked questions about stock options and tax implications

Nov 21, 2022
Employee benefit plans Federal tax Employee benefits Compensation & benefits

Equity compensation incentivizes employees with payments tied to the equity value of the employer. Stock options, in particular, give employees the right to purchase company stock at a specified price for a specific time period. Following the exercise of the option, the employee becomes a partial owner of the entity. Understanding how stock options work economically and are taxed will help you make informed decisions.

What is a stock option?

A stock option grants individuals (hereinafter referred to as “employees,” although certain options can be granted to non-employees) the right to purchase stock from a company at a stated price within a given timeframe. Employees acquire the optioned stock by paying the exercise price (also referred to as the “strike price”). Stock options allow employees to benefit from appreciation in the value of the company if the company’s value rises over the exercise price.

When an employee exercises a stock option, the employee becomes the legal owner of the stock on that date. The timing, type and amount of income inclusion depend on whether you receive an incentive stock option (ISO) or a nonqualified stock option (NSO).

What is an ISO?

An ISO is the right to purchase company stock according to a written plan designed to meet a number of requirements in section 422 of the Internal Revenue Code (Code). For economic and legal purposes, an ISO is essentially the same as a NSO (i.e., you are provided a right to purchase a certain number of shares at a stated price, and you will become the owner of those shares if you choose to exercise the options), but the tax consequences are different.

What are the tax consequences of ISOs to employees?

If the stock options are designed to meet all the ISO requirements, the following tax consequences should result:

  • No income is reportable or includible at the time of the grant.
  • No income is reportable or includible to the employee upon exercise of the option, except as noted below regarding the alternative minimum tax (AMT). Special rules apply upon a disqualifying disposition of the shares (see below), which may be concurrent with the exercise.
  • The difference between the exercise price and the fair market value (FMV) of the stock at the time of exercise (i.e., the value spread) is an adjustment for AMT purposes and could cause the employee to become subject to the AMT.
  • The employee’s basis in the ISO stock is equal to the amount paid upon exercise of the options. If the ISO stock is disposed of in a disqualifying disposition (see below), the basis of the stock is increased by the amount taxable as ordinary income due to such disposition.
  • The holding period of the stock begins on the date of the exercise.
  • If the stock received upon exercise of the ISO is held until a date that is 1) two years from the date the ISO was granted, and 2) one year from the date of exercise, any gain or loss upon disposition of the stock should result in capital gain or loss treatment, and there is no ordinary income.
  • If the stock received upon exercise of the ISO is disposed of prior to the later of 1) more than two years after the ISO is granted, or 2) more than one year from the date of exercise, it is treated as a disqualifying disposition of the stock. In the case of a disqualifying disposition, the difference between the exercise price and the FMV of the stock on the date of exercise is considered ordinary income to the employee. However, if the value received by the employee upon disposition is less than the FMV on the date of exercise, the income recognized by the employee does not exceed the difference between the disposition price and the exercise price of the ISO stock. This income is taxable in the year of disposition of the stock. It should be noted that certain transfers of stock may not be considered dispositions for this purpose (e.g., the exchange of the ISO stock in a tax-free merger or reorganization transaction, a transfer incident to a divorce, a transfer from a decedent to his or her estate, or a transfer by bequest).

Example 1

An employer granted its employee an ISO to buy 100 company shares at $5 a share. The employee exercises the option three years later when the value is $10 a share. He then sells the shares for $12 a share two years after the date of exercise. Because it is an ISO, the employee will not owe tax until disposition (but he does report an AMT adjustment at exercise of $5 per share for the appreciation between grant and exercise and may pay AMT). Upon disposition, the difference between the selling price ($12 x 100 shares) and the purchase price ($5 x 100 shares) will be taxed as a capital gain ($700).

For economic and legal purposes, an ISO is essentially the same as a NSO, but the tax consequences are different.

Example 2

If the facts are the same as in Example 1, except that the employee sold the stock only 10 months after exercising the option, then the result is a disqualifying disposition. The employee must report the difference between the option price ($5) and the value of the stock when exercised ($10) as wages [($10 x 100 shares) – ($5 x 100 shares) = $500] as ordinary income (more specifically, compensation for services) on the date of disposition. The remaining portion of the gain is reported as a capital gain [($12 x 100 shares) – ($10 x 100 shares) = $200].

What is an NSO?

Any stock option that does not meet the requirements to qualify as an ISO is treated as an NSO. As mentioned above, the significance of holding an NSO instead of an ISO comes down to the tax consequences that apply.

Example 3

An employer granted its employee an NSO to buy 100 company shares at $5 a share. At the time of the grant, the options do not have a readily ascertainable FMV. The employee exercises the option three years later when the value is $10 a share. Upon exercise, the employee must include in income the difference between the FMV ($10 x 100 shares) and the amount paid to exercise ($5 x 100 shares). If the shares are sold two years later for $12 per share, the further appreciation is a capital gain [($12 x 100 shares) – ($10 x 100 shares) = $200]. In this case, the amount reported as ordinary income and capital gain is the same as in Example 2 for a disqualifying disposition, but there are some differences. A disqualifying disposition results in ordinary income on the disposition date rather than the exercise date (although those may sometimes be the same date), and the ordinary income from a disqualifying disposition is not subject to income and payroll tax withholding, but ordinary income from the exercise of an NSO is subject to income and payroll tax withholding.

What are the tax consequences of NSOs to employees?

An employee is generally taxed upon exercise of the option on the difference between the exercise price and the FMV on that date. The gain is treated as ordinary income, reportable as compensation. This result assumes the option does not have a readily available FMV. If the option has a readily available FMV, which is rare, employees are taxed upon grant rather than upon exercise.

An employer must address how to handle the tax withholding obligations of NSOs as the exercise of a stock option results in a stock transfer instead of cash, yet taxes must be withheld. Option plans may require that the employee pay the employer the cash amount needed to cover the income and payroll withholding tax obligations together with the exercise price. Alternatively, the employee and employer can agree that any required withholding taxes will be withheld from other wages payable to the employee, or agree to reduce the number of shares transferred upon the exercise by the value of the withholding obligation. In some cases, the employer may be willing to gross up the benefit by agreeing to cover the withholding costs. However, in such instances, the gross up itself results in additional taxable wages.

How do the tax consequences of ISOs and NSOs differ?

Refer to this chart:

Note: This chart is a summary only. Please consult your tax advisor for specific tax consequences.

What does it mean if I have an ESPP?

An employee stock purchase plan (ESPP) grants employees options to purchase company stock at a slightly discounted price. Generally, ESPPs are designed so that the employee pays no tax on the option until the disposition of the share purchased after the option is exercised. Similar to an ISO, any gain upon disposition is treated as a capital gain. Also like an ISO, this treatment applies so long as the employer sets the ESPP up to meet a number of requirements. Important aspects of ESPPs include not setting the option price too low, and specific holding-period requirements like an ISO disqualifying disposition. The major difference between options granted under an ESPP as compared to ISOs is that ESPPs have nondiscrimination rules and are offered to a larger group of employees and may generally be tied in with the payroll process of your employer.

Is a section 83(b) election available?

Section 83(b) allows employees to elect to defer income tax on property received in connection with the performance of services. Section 83 regulations provide a distinction between the direct acquisition of property by a person, and a person acquiring an option to purchase property. Generally, the grant of an option is not the transfer of the underlying property; thus, a section 83(b) election does not apply. An exception exists when the fair market value of the option is “readily ascertainable” at the date of the grant, and as mentioned above this is a rare occurrence.

What should an individual consider before exercising a stock option?

There are many factors to consider in deciding when to exercise a stock option:

  • When will you be able to liquidate the stock if you exercise? Factors that will affect this consideration include whether the company is public or private, and whether there is an expectation of a future sale of the company.
  • How will the exercise price and any withholding triggered upon exercise be covered? Some methods include the employee paying these to the employer, the employer loaning the amounts to the employee, or cashless exercises in which you surrender shares worth the exercise price and withholding to cover your obligation.
  • Is there an expectation of value increasing? Stock options are inherently more valuable if the stock price increases over time. The more you expect the stock price to increase, the more income you can shift to capital gains rates for an NSO by exercising sooner, or the sooner you can start the clock running to have a qualifying disposition of an ISO.

Options can be very rewarding to holders, but they also can be complex to understand. You should consult with your tax advisor to better understand your specific options and how they interact with your overall tax and financial situation.

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