Napier & Company, LCC

Stock Options Overview

Many employees receive stock options as part of their compensation packages. From a tax standpoint, there are two kinds of options. The first is statutory options, often knows an Incentive Stock Options (ISOs) and the second is non-statutory stock options (NSOs).

Both kinds of options have tax advantages, but there are quite a few differences between them. Here is some basic information on the taxation of stock options that may help you better understand how they work.

Option grant:

If you have ISOs, you are not taxed on option grant. The same is generally true of NSOs. An NSO is taxed at grant only if it has a “readily ascertainable” fair market value, which is seldom the case. The IRS rules say that an option does not have a readily ascertainable value at grant unless:

(1) the option is actively traded, or
(2) (i) the option is immediately transferable; (ii) the option is fully exercisable; (iii) the option and the option stock are unrestricted; and (iv) the value of the “option privilege” is readily ascertainable.

In the unlikely event that an NSO is taxable at grant, you have compensation income at that point.

The deferred compensation rules under IRC Section 409A, which taxes deferred compensation to the extent not subject to a “substantial risk of forfeiture” unless specific requirements are met, does not apply to the grant of an ISO. However, these rules can apply to the grant of an NSO, unless the exercise price can never be less than the underlying stock's FMV on the date the option is granted and certain other conditions are met.

Option Exercise:

ISO Exercise:
No regular income tax is owed on the exercise of an ISO, but the alternative minimum tax (AMT) may apply. The bargain purchase element at exercise, which is the difference between the value of the ISO stock at exercise and the lower price you pay for it, is considered to be income when figuring your AMT. Even if you're usually not subject to the AMT, exercising ISOs may push you into its range. Note that if you are subject to the AMT in the year you exercise, then you will likely be entitled to an AMT credit carryover for use in some later year. The effect of this can often mean, but not always, that you pay AMT tax at the time of exercise and then when you actually sell the stock, the AMT taxes comes back to you in a the form of an AMT tax credit in the year of the sale.

NSO Exercise:
When you exercise an NSO that was not taxed at grant, then you are taxed at ordinary income rates on the difference between the value of the option stock at that time and the price you paid for it. This compensation is subject to payroll taxes and income tax withholding and is typically reported on your W-2. Taxes may be withheld from your salary or other compensation income, or you may have to sell some of the stock to cover the withholding or make some other arrangement with your employer.

However, if the option stock is nontransferable or subject to a substantial risk of forfeiture, then you aren't charged with compensation income until those restrictions no longer exist. In that case, you can choose to pay tax on exercise so that all gain from that point on would be capital gain.

Sale of option stock:

When you sell ISO stock, you generally are taxed at favorable long-term capital gain rates on the difference between the price you paid for the stock and the amount you realize on its sale. However, if you sell the stock within two years of the option grant or within one year of the option exercise, you will have regular compensation income to the extent of your bargain element at exercise. The balance of your gain is capital gain, which will be taxed at favorable rates if you've held the stock for more than one year on the sale date.

It's important to know how long you need to hold the stock to qualify for long-term capital gain rates on the difference between the price you paid for the stock and the amount you realize on its sale or, if you don't hold the stock long enough for this favorable tax treatment, how much additional compensation income will be attributed to you. We can determine this from information on a statement from your employer. You should receive this statement by January 31 following the close of the year in which you exercised the ISO.

If the option was exercised after October 22, 2004, any income on disposition of the stock isn't subject to FICA or FUTA taxation. Additionally, any income resulting from a disqualifying disposition of stock acquired under an ISO isn't subject to withholding.

When you sell stock acquired by exercise of an NSO, you have capital gain if you were subject to tax either at option grant or exercise, or when restrictions on your option stock lapsed. Otherwise, you have compensation income at the time of the sale.

Summary:

As you can see, the tax rules for compensatory stock options are quite complex. Please call for an appointment if you have additional questions about your options, or if you would like to do some tax planning for them.