How stock options are taxed?
Stock options are a common form of compensation provided to employees, allowing them to purchase company stock at a predetermined price. The tax treatment of stock options depends on whether they are classified as nonstatutory stock options (NSOs) or incentive stock options (ISOs). This article will explore the tax implications of both types of stock options, referencing relevant sections of the Internal Revenue Code (IRC) and Treasury Regulations.
Nonstatutory Stock Options (NSOs)
Grant and Exercise
Nonstatutory stock options are not taxed at the time of grant if they do not have a readily ascertainable fair market value. According to IRC § 83(a), the taxation event occurs at the time of exercise. The employee must include in their gross income the difference between the fair market value of the stock at the time of exercise and the exercise price paid for the stock. This amount is considered compensation income and is subject to ordinary income tax, as well as employment taxes (FICA and FUTA) [1].
Example
If an employee is granted an NSO to purchase 1,000 shares at $10 per share, and the stock’s fair market value at the time of exercise is $30 per share, the employee recognizes $20,000 ($30,000 fair market value – $10,000 exercise price) as compensation income.
Sale of Stock
Upon the sale of the stock, the employee may realize a capital gain or loss. The holding period for determining whether the gain or loss is short-term or long-term begins on the date the stock becomes substantially vested (i.e., when it is no longer subject to a substantial risk of forfeiture).
Incentive Stock Options (ISOs)
Grant and Exercise
Incentive stock options are not taxed at the time of grant or exercise, provided certain conditions are met. Under IRC § 422(a), no income is recognized upon the exercise of an ISO if the stock is held for at least two years from the date of grant and one year from the date of exercise. However, the difference between the exercise price and the fair market value of the stock at the time of exercise is a preference item for the alternative minimum tax (AMT).
Example
If an employee is granted an ISO to purchase 1,000 shares at $10 per share, and the stock’s fair market value at the time of exercise is $30 per share, no regular income tax is due at exercise. However, the $20,000 difference is included in the AMT calculation.
Sale of Stock
If the holding period requirements are met, any gain or loss upon the sale of the stock is treated as a long-term capital gain or loss. If the stock is sold before meeting the holding period requirements (a disqualifying disposition), the difference between the exercise price and the fair market value at the time of exercise is taxed as ordinary income, and any additional gain is treated as a capital gain.
Special Considerations
Section 83(b) Election
Employees receiving stock options may make a § 83(b) election to include the fair market value of the stock at the time of transfer in their gross income, even if the stock is subject to a substantial risk of forfeiture. This election must be made within 30 days of the transfer and can result in significant tax savings if the stock appreciates substantially.
Reporting Requirements
Employers must report compensation income from NSOs on Form W-2 and may need to withhold taxes. For ISOs, no withholding is required, but the income must be reported for AMT purposes. Brokers executing same-day sales of stock acquired through option exercises may be exempt from reporting the sale on Form 1099-B if certain conditions are met.
Conclusion
The tax treatment of stock options can be complex, involving various rules and regulations. Understanding the differences between NSOs and ISOs, the timing of income recognition, and the potential impact of the AMT is crucial for employees and employers alike. Consulting with a tax advisor is recommended to navigate these complexities and optimize tax outcomes.
Author of this article Jack Chaudhary specializes in Individual, Corporate Tax returns, Foreign Taxes, Expats, Non-resident Taxes, Payroll, Crypto and e-Commerce. With the Enrolled Agent credential, Jack represents taxpayers before the IRS and state taxing authorities. He zealously advocates for his clients to ensure the best results are achieved. Book an appointment here with him for a consultation call.
