Congratulations, you’ve got a job with stock options! Now you’re wondering how this affects your taxes.
What are Stock Options?
Stock options are the right to buy shares of company stock at a fixed price, also known as the strike price, exercise price, or grant price. That price is usually equivalent to the fair market value, or FMV, of the shares at the time you’re granted your options, but sometimes it is less, which can cause a taxable difference.
When you exercise stock options, you’re hoping for the value of the shares to increase so you can sell them for more than you paid. That’s the potential positive outcome—the potential negative outcome is that the value of your shares aren’t worth anything when you sell them.
So similar to how you might buy stock in Apple or General Motors on the open market and the price can go up and down, you can get stock in the company you work for at a predetermined price as a benefit of your employment, and that stock can go up and down.
However, having stock options is not the same as owning shares outright. It’s simply the option to buy stock at a set price, you are not obligated to do so. To actually own the stock, you must purchase the stock, also known as exercising your stock option.
Types of Stock Options
There are two common types of stock options granted to employees:
1. Incentive Stock Options ,or ISOs
2. Nonqualified stock options, or NSOs
While both offer employees the chance to acquire company stock, they differ significantly in terms of tax treatment.
In this blog post, we will explore the tax differences between ISOs and NSOs to help you understand their implications and make informed decisions.
ISOs come with specific eligibility criteria that not all employees meet
To qualify for ISOs, someone must:
- Be an employee of the issuing company or its subsidiary, and
- The option plan must be approved by the company’s board of directors and shareholders.
On the other hand, NSOs do not have any specific qualification requirements, and they can be granted to employees, consultants, and other service providers.
Taxation Upon Exercise
One of the big differences between ISOs and NSOs is the taxation upon exercise, or how much money you have to pay the IRS when you purchase your shares at the special stock option price.
Taxation of ISO’s on Purchase
With ISOs, there are generally no immediate tax consequences at the time you exercise your right, or buy the stock.
With ISO’s the difference between the fair market value of the shares on the date you sell them and the selling price is referred to as the “bargain element.”
This bargain element is not taxable for regular income tax purposes but may be subject to alternative minimum tax calculations, so you will still want to talk to your accountant about the tax ramifications of exercising your stock options.
Taxation of NSO’s on Purchase
In contrast, NSOs are subject to immediate taxation when you exercise them, or buy the stock. The bargain element — or difference between fair market value and your selling price – is considered ordinary income and is subject to income tax withholding by the employer.
If you have non qualified stock options, talk to your accountant about how to include the bargain element in your taxable income for that year.
Capital Gains Tax in Relation to ISOs and NSOs
Along with tax differences when you purchase your shares with stock options, ISO’s and NSO’s also differ in how they’re taxed when you sell the shares you bought.
Taxation of ISO’s When Selling Shares
For ISOs, there is what’s called a holding period, which is generally at least two years from the grant date – the date you were given the option to purchase – and one year from the exercise date – the date you purchased shares. Any subsequent gain or loss upon the sale of the shares after this holding period will be taxed as a long-term capital gain or loss.
This could potentially allow you to benefit from more favorable tax rates on the capital gains.
Selling your shares before this holding period could make you subject to paying ordinary income taxes as well as short-term capital gains taxes. That’s why it’s always good to talk with your accountant before buying or selling a stock option.
Taxation of NSO’s When Selling Shares
In the case of NSOs, any gain or loss realized upon the sale of shares is treated as a capital gain or loss, depending on the holding period of the shares.
If the shares are held for one year or less from the exercise date, the gain is considered a short-term capital gain, subject to ordinary income tax rates. If the shares are held for longer than a year, it’s considered a long-term capital gain and taxed as such.
Payroll Taxes for NSO’s
ISO’s are not subject to payroll taxes, but NSO’s are. When you exercise your option to purchase NSO shares, your employer will have to withhold all payroll taxes (such as Social Security and Medicare taxes) at the time of exercise. Be sure to talk with your accountant about this before you exercise your stock option and at the end of your fiscal year.
When to Talk to Your Accountant
If you get stock options and plan to exercise that right, it’s a great idea to make a meeting before you do with your tax strategist. Tax law changes often and by the time it’s the end of year filing you often can make any changes to help with your tax liability, so we suggest meeting with your tax strategist quarterly to make the most up-to-date decisions.
I hope that helped you feel more confident about your tax burden when taking ISO’s and NSO’s as compensation. If you’d like personalized support in figuring out when and how to exercise your stock options, we’d love to help you here at Paragon Accountants.
Contact us today to set up an appointment.