How Employee Stock Options Are Taxed

Learn about non-statutory employee stock options.
Find information about wage income related to exercising stock options.
Learn about statutory (incentive) options.
Discover information about capital gains associated with statutory options.
Find out how alternative minimum tax (AMT) comes into play when exercising stock options.

Many companies, as an incentive to employees to help grow the companies’ market value, will offer stock options to key employees. The options give the employee the right to buy up to a specified number of shares of the company’s stock at a future date at a specific price. Generally, options are not immediately vested. Employees must hold them for a period of time before they can exercise them. Then, at some later date, and assuming the stock price has appreciated to a value higher than the option price of the stock, the employee can exercise the options (buy the shares), paying the lower option price for the stock rather than the current market price. This gives the employee the opportunity to participate in the growth of the company through gains from the sale of the stock without the risk of ownership.

There are two basic types of employee stock options for tax purposes, a non-statutory option and a statutory option (also referred to as the incentive stock option). Their tax treatment is significantly different.

Non-statutory employee stock options

The taxability of non-statutory employee stock options occurs at the time the employee exercises the option(s) and not at the time of the grant of the option unless its (the option's) fair market value is readily determinable- which the vast majority are not. The gain, which is the excess of the fair market value at the time of the exercise over its price, is ordinary income (compensation). Employers should include it in the employee's W-2 for the year of exercise. We say “should” because smaller firms often mishandle the reporting.

The employee has the option to sell or hold the stock he or she has just purchased. However, regardless of what he or she does with the stock, the gain, which is the difference between the option price and market price of the stock at the time of the exercise, is immediately taxable. Because of the immediate taxation, most employees who have been granted employee stock options will, when exercising their options, immediately sell at least some of the stock to cover the tax.

Under that scenario, the W-2 will reflect the profit. Tax preparers should prepare Form 8949 (the tax form used to report sales of stock and other capital assets) to show the sale, essentially with no gain or loss. Then, the gross proceeds of the sale reported on the return match the sale reported to the IRS (on Form 1099-B). If the employee incurred a sales cost, such as a broker’s commission, they would report that as a reportable loss, albeit usually a small amount. Since we include the difference between the option price and market price in wages, it is also subject to payroll taxes (FICA).

If an employee chooses to hold the stock, he or she would have to pay the tax on the difference between the option price and exercise price, plus the FICA tax, from other funds. If the stock subsequently declines in value, the employee still assumes the gain reported when they exercised the option. Loss on the subsequent sale of the stock would be limited to the overall capital loss limitation of $3,000 per year.

Statutory (incentive) employee stock options

What makes the taxation of statutory employee stock options different from non-statutory options? We do not include any amount of income in regular income when the employee exercises the option. Thus, the employee can continue to hold the stock without any tax liability; and, if he or she holds it long enough, any gain would become a long-term capital gain. To achieve long-term status, the stock must be held for:

More than 1 year after the employee exercised the stock option, and
More than 2 years after the option was granted.

The advantage of long-term capital gains is that they are taxed at lower maximum rates. For example, the capital gains tax rate is 15% for a taxpayer who might otherwise be in the 32% tax bracket.

There is a dark side to statutory employee stock options, however. The difference between the option price and market price, termed the spread, is what is called a preference item for alternative minimum tax (AMT) purposes. If the spread is great enough, that might cause the AMT to kick in for the year of exercise. If a taxpayer is already subject to the AMT, this would add to the tax; and, even if not, it might push him or her into the AMT. The current year AMT will be in addition to any tax when the employee ultimately sells the stock. However, it will establish a higher tax basis for the AMT should it come into play in the year the employee sells the stock. Fiducial cannot discuss all AMT scenarios in this article in detail, so you may want to seek additional guidance.

What if the employee sells the stock before it achieves the long-term holding period requirements described above? The tax treatment stays essentially the same as for a non-statutory option.

Restricted Stock

Under normal circumstances where an employer compensates an employee for his or her service in the form of stock, we treat the excess of the fair market value of the stock over any amount paid for the stock as income to the employee at the time he or she receives the stock.

However, if the stock is subject to substantial risk or forfeiture because it is restricted (cannot be sold) then income is deferred until the interest in the property either:

(1) is no longer subject to that risk, or

(2) becomes transferable free of the risk, whichever occurs earlier.

The employee has the option to include the FMV of restricted stock (less any amount paid for the stock) in income in the year they receive the stock. They do this by filing the so-called Sec 83(b) election within 30 days of the transfer of the restricted stock. The amount of the income recognized as a result of the election is based on the fair market value (FMV) of the shares on the date of grant less any amount the employee paid for the stock. This amount becomes the basis of the stock. The stock's FMV isn't reduced to reflect the restrictions on the stock unless there is a permanent limitation on the transfer of the stock that would require the employee to resell the stock to the employer at a price determined under a formula.

Making the election permanent

Making the election permanently fixes the compensation element. Then, any appreciation over and above the basis (the compensation included in income) becomes eligible for long-term capital gains rates if the employee holds the stock for more than one year (two years if they acquire the stock from an incentive stock option). Caution: If the employee subsequently forfeits the stock, any loss equals a capital loss subject to the annual $3,000 overall capital loss limitation.

Sec. 83

Code Sec. 83 governs the amount and timing of income inclusion for employer stock, transferred to an employee in connection with the performance of services. Under Code Sec. 83(a), an employee must generally recognize income for the tax year in which the employee's right to the stock is transferable or isn't subject to a substantial risk of forfeiture. The amount includible in income is the excess of the stock's fair market value at the time of substantial vesting over the amount, if any, paid by the employee for the stock.

Planning to exercise employee stock options and have questions? Want to do some tax planning to minimize the tax bite? Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations to discuss your situation.

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