What Are The Taxes On Stock Options?

What Are The Taxes On Stock Options?

By Megha

Stock options are seen as benefits employees receive from their respective employers. It helps them purchase the stock of their employer at a discount to the usual market price of the stock. The stock options do not give an ownership interest. But exercising them helps to get the stocks of the firm. There are various types of options. All of them have their own tax outcomes. Over the years, stock options have become a common method to get higher-ranking employees and give them some ownership in the firm. According to the National Center for Employee Ownership stats, workers having stock options has increased by eight-fold in the past forty years. Stock options give the right to the employee to purchase the shares at a predetermined price at any future date. It can be a great component of the overall compensation package. But to get the full benefits of these options, it is vital to find out how they function and how taxes on stock options work.


Taxes on Stock Options: Categories


There are a couple of types of stock options. One of them is Statutory stock options. These are given under the incentive stock option plan. The other one is Non-statutory stock options. These are also called non-qualified stock options. They can be given to the employee without any kind of plan.


Stock Options Expiration Date


The stock options given to employees have a set date on which they have to be exercised. Usually, a vesting schedule lasts for a single year to five years. But a few employees may have the option for a decade. If the employee decides to leave the firm for any reason, whether because of retirement, resignation, or layoff, they usually have three months to utilize the stock options. You may have in-the-money options with you. Then it is best to exercise them before the expiration date. Many employees forget about the deadline or wait until the last moment, hoping that the cost will increase even higher. But that strategy can backfire for you. If the employee is close to the expiration date and the share is trading above the price of the option, it is the best time to act. You do not want the thing to expire and be completely worthless.


Create a Diversified Portfolio


A great stock options advantage is a good thing for employees. But it comes with a major risk. It may be that a lot of your wealth may be tied up in one stock. As a thumb rule, you do not want to have more than twenty percent of your portfolio tied to any specific stock. This is because if the firm falls on hard times, your portfolio will not be diversified enough to handle the blow. If you are crossing that limit, you should consider letting go of enough stock each year to keep your wealth safe from any great volatility risk. To account for such fluctuations that keep happening in the financial markets, you can think about dividing the sale into a series of transactions over a period, especially for larger amounts. That amount can then be used to increase the IRA and 401(K) contributions.


Taxes on Stock Options That Are Statutory



The grant of any statutory stock option does not give any immediate income to the employee that is subject to income taxes. The exercise of the option to get the share does not give any instant income as long as the employee holds the share in the year that they buy it. The income happens when they later let go of the share obtained by exercising the option. But exercising the statutory option gives an adjustment for the function of the alternative minimum tax. A shadow tax system has been created to ensure that the people who decrease their regular tax, using deductions and several other tax breaks, will shell out at least some amount of tax. This adjustment is the difference between the fair market value of the share obtained by the exercise of the statutory option against the actual amount paid for the shares and the statutory option.


But the adjustment happens only if the rights in the stock are transferable and are not subject to any major risk of forfeiture in the year if the statutory option is exercised. The fair market value of the stock for the adjustment function is found without regard to the limitations of lapse. This is when the rights in the stock are not subject to any major risk of forfeiture. Suppose the employee sells the stock in the same year that they exercise the statutory option. In that case, no such tax adjustment will be needed. This is because the treatment of tax becomes the same for regular taxation and the purposes of the alternative minimum tax. If the employee wishes to make an adjustment for the latter, they can increase the basis in the share by the tax adjustment. Doing so will ensure that when the share is sold in the future, the taxable profit for the alternative minimum tax is restricted. This means that the employee will not have to pay tax multiple times on the same amount.


How Reporting Works For Taxes on Stock Options


When the employee exercises the statutory option, the employer issues a specific form. It is the exercise of an incentive stock option plan. This gives the required information for the purposes of tax reporting. We can also give an example of how to utilize the data from the form to report the exercise of a statutory option. For instance, this year, the employee exercised a statutory option to get 1000 shares. The rights become instantly transferable and not subject to any major risk of forfeiture. The person paid $5 per share, which was the exercise price. This is reported in a specific form. On the date of the exercise of the statutory options, the share's fair market value was $10 per share. This was reported in another box in the form. The number of shares obtained is also listed in the form. The adjustment for the alternative minimum tax would be 1000*($10-$5) = $5000.


When the shares acquired through the exercise of a statutory option are sold, the employee has to report a loss or gain on the sale. They will get another form when the employee gets the share at a discount. The data in this form assists the employee in finding out the amount of loss or gain and whether it is ordinary or capital income.


Taxes on Stock Options That Are Non-Statutory


For the non-statutory stock options, some events have their very own tax results. These are the grant of the non-statutory option by the employee, the exercise of the said non-statutory option, and the sale of stock obtained through the exercise of the stock option. The receipt of the options is instantly taxable only if the fair market value can be determined easily. This means that the option must be traded on any stock exchange. But in many cases, there is no ascertainable value. Thus, granting the non-statutory options does not culminate in any tax. When these options are exercised, the employee includes the fair market value of the share paid at the time of acquisition, minus what the employee paid for the stock. This is the regular wage income that is reported on the form. This results in increasing the tax basis in the share. Subsequently, when the employee sells the shares obtained through the exercise of the non-statutory options, they get a capital loss or gain for the difference between the tax basis and what they get on the sale.




The stock options given by employers can be a great part of the employee's overall compensation package. This is more so if they work for a firm whose stock has been on a high for some time. To take complete benefit of such a situation, the employees must ensure that they exercise their rights before the expiration and find out about the taxes on stock options.