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Employee Stock Options Can Be Taxing

by
Spencer Wilson
on
10/16/2019
Employee Stock Options Can Be Taxing

Whether you’re a long-time employee or a new hire, if your company offers stock options it is important for you to understand exactly what they are and how they will affect your tax liability. Options are a benefit that companies offer as a reward for their employees’ contributions to their growth. They provide the opportunity for those who receive them to buy stock in the company at a particular point in the future, at a specified price that may or may not be lower than the rate available to the rest of the market.

Here are some useful terms to understand:

  • Option price – This is the amount that the company establishes as your purchase price for shares should you choose to take advantage of the stock option offer. The option price is available regardless of whether the stock’s price at the time that the option can be exercised is significantly higher.
  • Fair market value – This is the actual trading price that is available to the general public at the time that the employee is able to exercise their option.

Employees are often provided stock option opportunities on a continuing basis, so they may be able to exercise several different options at specific times and at set prices.

To understand how this works in practice, consider this example:

In 2010, an employee of Smith Co. in was given an option to purchase 100 shares of company stock for $20 a share between May 1 and July 30, 2018, no matter what the stock’s Fair Market Value would be at the time. On June 1, 2018, the employee purchased 100 shares of the stock for $20 each, when the stock was trading at $60 per share.

Though this example outlines the basic process of exercising stock options, it does not address the tax liabilities that stock options create.

Stock options can be classified as either qualified or non-qualified, with the two categories of receiving very different tax treatments.

Qualified Stock Options

These are also known as incentive stock options (ISOs). They offer the advantage of delayed taxation of the aforementioned difference ($4,000 in the example above). The benefit of this to the employee is the ability to hold onto the stock and then, when they sell it at a later date, take advantage of long-term capital gains rates.

There are certain restrictions on the process, including not permitting the stock to be sold before two years have passed between the granting of the option and the sale of the stock. Further, the stock cannot be sold until at least one year has passed since the employee exercised the stock option.

The obvious benefit to ISOs is countered by the fact that the difference between exercise price and Fair Market Value ($4,000 in the example) is considered a preference item for Alternative Minimum Tax purposes, and this means that in the year that the option was exercised, it may be counted as AMT income.

For significant amounts, the Alternative Minimum Tax will be triggered, essentially punishing the taxpayer in the way that tax deductions and preferences can be taken and resulting in higher tax liability. The computation of whether AMT will be triggered is important, as it can mean that the costs of the ISO can outweigh the benefit that it offers. Though this negative result can be balanced by taking an AMT credit in the future, these credits are not always available: they can only be used in years where an AMT is triggered in the first place.

Fortunately, the recently passed tax reform law has eliminated many of the deductions that trigger the AMT and boosted the exemptions available to many taxpayers, making this less of a possibility than was true in the past. Also, the issue can be avoided by selling the stock in the same year that the option was exercised, thus creating a situation where the difference is simply treated as ordinary income.

The calculation of where the greater benefit lies is complex, and it is wise for employees who find themselves facing this dilemma to consult with a qualified tax professional to determine how to derive the greatest possible benefit from an ISO option. In some cases, the AMT can be minimized or avoided, and long-term capital gain rates can be optimized, by exercising small blocks of stock over extended periods of time.

Non-Qualified Stock Options

NSOs treat the difference between the exercise price and the stock’s fair market value as ordinary income. This difference is taxed in the same year that the employee exercises the option, so in the example above the difference of $40 per share for the 100 shares would be $4,000 taxed as income. The $4,000 would be reflected on the employee’s W-2, though it would be reported on Schedule D.

In some cases this type of stock sale can result in a loss, particularly if sales costs or purchase and sale don’t occur at the same time and therefore result in a gain or a loss due to shifts in the stock’s price. To avoid this, employees are able to make arrangements with the brokerage firm for them to virtually loan them money for their purchase of the stock and them immediately transition the purchase into the sale of the stock. The transaction is accomplished and the loan is immediately repaid with no cash exchanging hands, and the employee simply takes on the realized gains.

The potential complexity created by stock options often creates a need for taxpayers to seek the advice of those with far greater understanding of their impact. If you need assistance understanding how this benefit affects you, contact a tax professional today.

Spencer Wilson writes for TaxBuzz, a tax news and advice website. Reach him at [email protected].

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Spencer Wilson

Spencer Wilson

Spencer Wilson, EA is a tax preparer based in Long Beach, CA. Spencer Wilson Financial Management Services has been serving the Greater Los Angeles Area and Orange County since 2004. <br /> We began in the heart of Naples in Long Beach and we continue to work hard offering tax preparation and planning, business accounting and bookkeeping and payroll services . <br /> We have helped many different people and businesses succeed financially and take control over their finances.

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