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Stocks
Employee Stock Option Basics
By Jeff Goldman
Investment Professional, NEXT Financial Group
If you have employee stock options, consider yourself lucky. If those stock options are "in the money," consider yourself even luckier. Being "in the money" means having a positive spread between the exercise price of the option and the current value of the stock. In contrast, when the strike price of the options is below the current value of the stock, your options are said to be "under water."
Whether or not your options are worth anything at the moment, it pays to understand the type of stock options you have, and the possible impact their exercise could have on your federal income tax.
ISOs and NQSOs
There are two types of stock options: incentive stock options (ISOs) and nonqualified stock options (NQSOs). ISOs can only be granted to employees, while NQSOs may also be granted to independent directors, consultants, or other parties. To find out what type of options you own, check your option agreement.
NQSO tax treatment
When you exercise a NQSO, the difference between the amount you paid for the stock and the stock's fair market value on the day the option is exercised is generally taxed as compensation income.
ISO tax treatment
When you exercise an ISO, you don't have to report any ordinary income as long as you meet a minimum holding period. The minimum holding period to receive favorable tax treatment for the shares you purchase is the later of one year from the exercise date or two years from the option grant date. As long as
you hold the stock for the minimum holding period, your gains are taxed as long-term capital gains, not as ordinary income or short-term capital gains. Long-term capital gain tax rates currently max out at 15% and can be as low as 5% for individuals in lower income tax brackets. For tax payers in the higher brackets, the 15% long-term capital gains rate offers an especially significant benefit versus the top ordinary income tax rate of 35%, allowing much more of the benefit gained from the stock option to be harvested.
Alternative minimum tax (AMT)
A major consideration for ISO tax planning, however, is the AMT. The AMT is essentially a separate federal income tax system with its own tax rates, and its own set of rules governing the recognition and timing of income and expenses. The AMT has a number of "adjustments" to figure the minimum tax due. For example, under the AMT calculation, no deduction is allowed for state and local taxes paid, and personal exemptions are also excluded. Under the regular tax system, tax is generally deferred until you sell the acquired stock. But for AMT purposes, when you exercise an ISO, income is generally recognized to the extent that the fair market value of the acquired shares exceeds the price paid for them. This means that a significant ISO exercise in a year can trigger AMT liability. If ISOs are exercised and sold in the same year, however, no AMT adjustment is needed, since any income would be recognized for regular tax purposes as well.
Given the complexity of the AMT, it is essential to work closely with your investment and tax advisors, who can consider all aspects of your financial situation. Careful planning will ensure that you, not the IRS, reap the largest benefit from your ISO exercise.
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