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Investment Planning |
Basics of Employee Stock Options
Here are some basic definitions on the two types of stock options available to employees. The grant date is the day you receive the options to purchase company stock at a stated price, called the option price or strike price. Your stock options generally vest over a period of years, so that you have incentive to stay with your current employer and to contribute to a rising stock price.
The exercise date is the date that you purchase shares of stock with your options. Dispositions are just sales of the company stock. If you own incentive stock options (ISOs), dispositions can be either qualifying or disqualifying. A disqualifying disposition effectively turns ISOs into non-qualified stock options.
Incentive Stock Options
Grant Date - No tax consequences
Exercise Date - You do not recognize taxable income for regular tax purposes; however, the spread between the fair market value (FMV) on the date of exercise and the option's purchase price (the "bargain element") may be taxable for alternative minimum tax (AMT) purposes.
Qualifying Dispositions - You must hold the stock for two years from the date of the grant, and one year from the date of exercise to have a qualifying disposition. A gain on the sale of ISOs in a qualifying disposition is taxed at the favorable long-term capital gain rates.
Disqualifying Dispositions - If you fail to meet the two holding period tests (two years from grant date and one year from exercise date), the amount by which the FMV on the date of exercise exceeds the option price is treated as ordinary income, or compensation income, in the year that you dispose of the stock. This income should be included on your W-2.
Non Qualified Stock Options
Grant Date - generally, no tax consequences Exercise Date - You recognize ordinary income to the extent that the FMV of stock on the date of exercise exceeds the option price. This is normally included in your W-2. Remember that this W-2 income increases your basis in the stock!
Disposition - You recognize capital gain or loss to the extent of the difference between the sales price and the FMV of the stock on the date of exercise. Gain will be short-term if the stock is held for one year or less. Gain will be long term if the stock is held for at least a year and a day.
Tip - A very common mistake that occurs when stock is sold is that the employee forgets to include the entire basis when calculating his or her capital gain. The stock's basis includes the price paid at exercise plus the amount that was included in your W-2. Keeping this in mind can minimize your tax burden.
Questions to Consider When You Have Employee Stock Options
Whether you have Incentive Stock Options (ISOs) or Non Qualified Stock Options (NQSOs), there are a variety of tax planning strategies available to you. This section contains a very brief discussion of the topic. Since there are many nuances to stock option planning, a complete understanding and assessment of your specific circumstances should be undertaken before you take any action with your options.
Consider the following factors when deciding when to exercise your ISOs:
- The price of the stock at the end of 12 months and one day after exercise
- Your marginal income tax rate on ordinary income
- The income tax rate on long term capital gains
- The relationship between the exercise price of the option and the stock price on the day you exercise
- Whether or not you fall into the Alternative Minimum Tax (AMT) system
- The date you exercise (to determine when you must pay any taxes due)
- The dividend yield on the stock
- Whether you must make estimated tax payments Tax planning opportunities are also available if you hold NQSOs. Some of the important issues to consider include the following:
- Whether you have the cash to exercise the options
- Your investment portfolio diversification
- Your cash flow needs
- Whether you must make estimated tax payments
- Non-financial factors, such as how long you will remain at this company, and when you expect to retire
- The price of the stock at the end of 12 months and one day after exercise
- Whether you have capital loss carryovers
- Loss of tax deductions from not exercising and generating additional taxable income
Tips Disclaimer
These tips contain information that may change over time as a result of new tax legislation. Although we make efforts to keep this information current, you should check with your tax advisor before taking action based upon any information contained in these tips.