In today’s start-up culture, it’s common for companies to offer employees the opportunity to own stock in the business. Employee stock options are a great way to boost engagement, attract employees and retain top talent. While most folks know the basic benefits of receiving stock, many employees are taken off guard by the tax implications that follow.
Whether you’re explaining these concepts to your workforce, or you’re an employee trying to better understand your options, it’s important to fully understand how those options can affect your tax planning strategy.
What is an employee stock option?
An employee stock option is a benefit that gives the employee the right, but not the requirement, to buy stock in the company at an agreed-upon price within a certain period of time. The employee’s benefit comes when they can buy the stock (exercise price, A.K.A. strike price) at a price below the current stock value.
Typically, a stock option granted to employees will have a vesting date (the date the employee can buy stock at the exercise price) as well as an expiration date. The option must be exercised within that timeframe. The value of the stock at time of exercise is determined by the current value of the stock, which naturally fluctuates over time. The difference between the value of the stock upon exercise and the price paid for the stock by the employee is the gain from the option, also referred to as the bargaining element.
Types of stock options
There are two types of stock options, Incentive Stock Options (ISO) and Non-Qualified Stock Options (NQSO). This overview will focus on how they are taxed. Profit from ISOs have the potential to be taxed as long-term capital gain, which is a considerably lower rate than NQSOs, which are generally taxed as ordinary income.
Incentive Stock Option (ISO)
Employees with ISOs have some specific tax benefits that other options lack. Unlike NQSOs, taxes are generally deferred until the stock is sold, rather than exercised. The benefit? Any proceeds from an exercise or sale become subject to taxation at the lower, long-term capital gains rate rather than ordinary income rates.
However, there is one critical caveat to be aware of. The difference between the exercise price and the fair market value of the stock on the day of exercise must be calculated as part of the Alternative Minimum Tax (AMT) adjustment. For companies with substantial growth, that number could be very large — an issue many employees fail to account for come tax season. Essentially, the employee will be taxed on the profit they might have made if the stock was sold on that day. For this reason, it’s important to have a good forecast of the tax consequences. In some cases, it’s recommended to sell a portion of stock in order to cover the associated AMT taxes.
It’s often beneficial to do what is referred to as a “Section 83(b)” election. This election allows an employee to “exercise” stock options at the date of (or near) the grant when the exercise price is equal to the fair market value. That means there is no AMT adjustment to report and no added tax liability. Since the stock has yet to vest, this election treats the option as exercised solely for tax purposes. This special election also begins the holding period for long-term gain treatment, meaning holding can start earlier than the actual exercise date. This achieves the potential for long-term gain treatment on a sale at an earlier date. However, the employee still has to have the money to buy the stock at the date they make the election.
Employees that exercise an ISO should receive a form 3921 after calendar year-end. It is common for employers with stock plans to miss this filing, resulting in insufficient information to file a proper tax return for the employee.
Non-Qualified Stock Option (NQSO)
NQSOs are essentially any stock option that does not meet the ISO qualifications. When an employee exercises an NQSO (also known as NSO), the spread between the exercise price and the fair market value on the date of exercise will be reported as ordinary income. This shows on the employee’s W-2 and the expense will be recognized by the employer. Employers are required to withhold both federal and state taxes when an employee’s option is exercised. Companies have a couple of methods to choose from, but the most common is to simply require the employee to pay the withholding amount in full at the time of exercise. This is done by “holding back” some of the stock value in order to pay the withholding taxes. The company must also pay its share of employment taxes at the time of exercise.
If the employee exercises the option and decides to hold the stock, the fair market value on the date of exercise becomes the cost basis (the price point) for when that stock is sold later on. The difference between the sell price and the cost basis is treated as capital gain/loss, which is subject to a 20% favorable rate, if it’s long term.
NSQOs holders can benefit from an 83(b) election and begin their holding period on an earlier date than the exercise date. However, they will still have to pay for the stock out of pocket and risk paying tax on gains if their exercise price does not match the value at grant date.
On the other hand, if the stock option is exercised and sold immediately, referred to as a same-day sale transaction, there is usually no gain or loss on the sale of the stock. In this case, everything is reported under ordinary income because the sell price of the stock is very close, if not the same, to the fair market value of the stock at that time.
If you want to learn more about employee stock options, or want to find out how you can better explain them to your employees, please reach out to Evan Stephens at 408.286.7780 or at firstname.lastname@example.org.