Taxes on Employee Stock Options

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Stock options (or ESOP’s) are among the common incentives that corporations use to motivate and reward its workforce. There are several scenarios under which you generate income either by buying, selling, or receiving employee stock options. Regardless of a type of option you receive, income obtained though this form of compensation is taxable.

Common types of employee stock options

There are two types of stock options: statutory stock options and non-statutory stock options. Statutory stock options include employee stock purchase or incentive stock option (ISO) plans. To qualify for these options you have to meet certain employment requirements. There are no tax consequences related to options when they are granted or exercised; tax consequences arise at the sale of shares you acquired when you exercised your right to purchase stock and long-term capital gain tax rates apply.

Non-statutory or non-qualified stock options are more common as they don’t meet all the IRS’s requirements for more favorable tax treatment. Companies typically grant non-qualified stock options because they enjoy greater flexibility in several areas. There may be no limit on vesting period, or the time an employee has to wait before exercising the options. There is no need to have the stock options approved by the shareholders, the options are transferable, and can be granted to more individuals (not only the employees but may include independent contractors). Additionally, corporations benefit when employees exercise their stock options. Since the employees create a liability at the exercise date, the corporations can claim the amount of that liability as a deduction. $100,000 in liabilities generated by employees during a fiscal year means $100,000 in deductions for the corporations.

Do you have to pay taxes on stock options?

Non-qualified stock options are granted to a broader group of employees and will be considered in the following example. Say you decided to exercise your stock options due to favorable market value of the company’s stock price. When the exercise price of your stock option is less than its current market value, you generate a taxable income (difference between market value of the stock purchased and price at which you were allowed to buy the stock); that gain amount will appear on your W-2 form. The employer is required to report to the IRS every time you exercise your stock options and you are responsible to pay tax as well as Social Security and Medicare taxes on that amount. Even if your employer fails to report a gain on your W-2 but you did exercise stock options, you should still report it to the IRS.

What to do with employee stock options?

Exercising your stock options provides you with several ways to proceed. Essentially, when you exercise your options, you acquire stock in the company and you have to make a decision what to do with it. Depending on your investing and financial objectives, there are several situations that will be treated differently for tax purposes:

  • Exercise stock option and hold the shares.
  • Exercise stock option and sell the shares on the date of the exercise.
  • Exercise stock option and sell the shares within a year or less from the exercise date.
  • Exercise stock option and sell the shares more than a year after the exercise date.

In all above scenarios, exercising an option on any given day will generate taxable income. If the employer grants you option with exercise price of $50 and on the day you exercise them the shares trade or can be exchanged for $100, the difference between $100 and $50 times the number of shares you acquired is your gain for tax purposes and one that will be reported by your employer to the IRS.

In case you dispose of shares after exercising your option, you may be liable for additional tax payments depending on the sale price as comparing to the market price of shares at the exercise date. If the share price increased, you may have to pay additional capital gains tax; tax rate for capital gains will depend on how long you held on to the shares (short vs long-term capital gain rates). If you sell the shares at a price that is lower than on the exercise date, you may have capital loss. In either case, you are required to file Schedule D to report your proceeds from sale and establish cost basis for your stock.

For additional information on stock options, refer to Publication 525 – Employee Compensation.



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