In this lesson, you will learn some of the basics about employee stock options and their tax consequences.
If all the tax talk in the preceding chapter hasn't thoroughly muddled your brain, let's move on to applying this newfound knowledge to your options.
I discussed in earlier chapters the tax consequences of exercising nonqualified stock options (NSOs). Here is a recap:
Employee stock options have no tax liability associated with them.
When you exercise nonqualified options, you must pay ordinary income tax on the difference between the grant price of the stock and the fair market value on the day you exercise.
You also incur a tax liability when you sell the stock. How long you own the stock determines whether it is a long-term or short-term gain.
Let's look at a couple of scenarios and see how this all fits together.
Most people exercise nonqualified stock options and sell the stock as soon as the options are vested.
Tip
If you are planning to sell your stock immediately, the cashless transaction, explained in Lesson 8, "Exercising Your Options," is the best way to go.
This is a two-step process and that is the way the tax code regards it.
For example, the company awards you a grant for 100 shares at an exercise price of $15 per share. The fair market price of the stock when you exercise the options is $35 per share. You will pay ordinary income tax on the $20 per share difference between the grant price and market price.
Your basis in the stock is $35 per share.
For simplicity's sake, I will not consider broker's fees in these examples. Please refer to the discussion of basis in Lesson 9, "Taxes and Options."
For example, you sell the stock for $45 per share. You now owe tax on the $10 per share difference between the sale price ($45 per share) and your basis ($35 per share) or $10 per share.
If you held the stock for one year and one day or more, the tax will be a long-term capital gain. If you held the stock for less than one year and one day, the tax is a short-term capital gain or the same as ordinary income tax.
Since your objective is to exercise the options and sell the stock, there is little you can do in the way of tax planning to avoid the second taxable event.
There is one strategy that can put off and possibly lower your tax on the sale of the stock. It shifts the tax liability to another tax year, but only makes sense if you don't have access to the cashless transaction I discussed in Lesson 8 and the stock price is moving up. Here is how it might work.
Your goal is to exercise your options and sell the stock sooner than the requirement for long-term capital gains. However, you want to minimize the ordinary income tax you must pay on the difference between your basis and the sale's price.
You can exercise the options in one year and sell the stock in the next year. This has the effect of placing the two taxable events in separate tax years.
This could be important if your income in the new year was going to be substantially lower than in the previous year. For example, you plan to retire next year and want to convert your stock options to cash. You exercise the options this year and pay the tax on the difference between the grant price and the fair market value.
Next year, when you are in a lower tax bracket, you sell the stock. Your tax bill for the difference between your basis and the sale price is less than it would have been the previous year when you were in a higher income tax bracket.
Quite frankly, this is a stretch. You are better off selling the stock immediately after exercising the options under most cases. If you sell immediately, as in a cashless transaction, you may owe no or very little tax on the sale. This is because your basis is established when you exercise the options and buy the stock. If you sell almost immediately, there is little chance the stock will have gone up significantly in the hours or single day between the transactions. In fact, it is possible the stock could dip below your basis, in which case you would owe no tax on the sale at all.
I describe the cashless transaction in Lesson 8. This is where your company has an agreement with a stockbroker that allows you to exercise your options and sell the stock in one step. For those folks wanting to convert their options into cash, this is the best way to do it. Even though it appears as one step to you, it is still the two-step process described earlier.
In fact, it is possible that due to the delay between exercising your options and selling the stock, you may register a small gain or loss on the stock. The broker will report the gain or loss to you.
In Lesson 7, "When to Exercise Your Options," I discuss the timing of exercising your options. There are many reasons you may want to exercise your options and sell the stock or exercise your options and hold the stock or do nothing at all.
One of the reasons for thinking carefully about when you exercise your nonqualified stock options is the tax implication. As I mention in the first section of this lesson, NSOs do not give you much in the way of tax planning alternatives.
One alternative you do have some control over is when you exercise your options. For example, you want to own or control the stock to participate in the hoped-for long-term growth and you are in the upper income tax brackets. You have two possibilities:
Which is the better tax strategy?
In the first scenario, you can hold the option at no cost to you for as long as the term permits. When you do exercise the option, you will pay ordinary income tax on the spread between the exercise price and the fair market value of the stock.
If you are in one of the upper tax brackets, this can be a big bite out of your profit. Some companies allow retirees to exercise their options after retirement, which, assuming a lower tax bracket, could be a big savings.
The second scenario may be more appropriate for folks who aren't near retirement. The logic here is to exercise the options as soon as possible, ideally before the spread is large. This means you would pay ordinary income tax on the gain, but if you are able to take advantage of this before the spread becomes too large, you won't face a huge tax bill. Now you own the stock, which was your goal.
If you hold the stock for more than one year and one day, the tax is at the capital gains rate when you sell, which is much lower than the tax rate for the upper income tax brackets.
Caution
When you try to guess the direction the stock will move over a short time period, you are timing the market. That is a dangerous and often futile exercise because the stock market can be very erratic over a short time period.
This strategy will work even if you are in the 15 percent tax bracket, because the capital gains rate for that bracket is 10 percent. It may not be the huge savings possible for the upper income tax brackets, but it is a savings of one-third over paying 15 percent ordinary income tax.
One of the primary investment rules is keep your costs low. Taking advantage of the capital gains rates may be a way to do just that.
However, this strategy of shifting the tax burden to the lower capital gains rate has its own perils as described in Lesson 9, where I discuss the alternative minimum tax (AMT) that a large long-term capital gain could trigger.
One strategy you can use to avoid AMT is to take your gains over a several-year period. For example, you own 1,000 shares with a basis of $15 per share. The current market value is $65 per share. It might make sense to spread the sale of the stock over a three- or four-year period to avoid the AMT. Of course, the stock could decline in value during the period. This is why it is important to consult a tax professional when deciding AMT issues. Your particular tax situation dictates whether AMT is an issue for you or not. It is not possible to summarize AMT in a way that meets every individual's circumstances.
Tip
Incentive stock options are more attractive to folks in the higher income tax brackets, but can benefit anyone.
To review the basic rules regarding exercising incentive stock options (ISOs) and their tax treatment, see Lesson 5, "Incentive Stock Options."
No ordinary income tax is due when you exercise ISOs, although it may trigger an alternative minimum tax problem.
The ISO holding period is one year after the exercise and two years after the grant.
Stock acquired through an ISO is at the long-term capital gains rate if held for the required period.
If you violate any of the ISO rules, the options become nonqualified and you owe ordinary income tax on the spread.
Under normal circumstances, exercising an incentive stock option is not a taxable incident. The lower your income, the less likely you will have to deal with an alternative minimum tax when you exercise ISOs.
You can hold stock bought through incentive stock options that meet all the requirements without tax liability until sold. This feature makes them very attractive, especially to people in the higher income tax brackets.
You have to hold the stock at least one year to keep the favorable tax status of ISOs. After that year, your tax is 20 percent on any gain from the price you paid for the stock.
The largest tax trap for incentive stock options is the alternative minimum tax. There are two places in the process where AMT is a factor:
Caution
Dealing with the alternative minimum tax is not for the ill-prepared.
If you are not a tax expert, you will need to consult one to deal with AMT and incentive stock options.
If you violate the rules regarding ISO holding periods, they automatically become nonqualified stock options and you owe ordinary income tax on the spread.
There are circumstances, such as death, where transferring the ISO to another person before the holding period expires does not cause the options to lose ISO status. Consult a tax expert for more information on early disposition and tax status.
As a rule, nonqualified stock options present fewer tax problems than incentive tax options.
Timing may help you work around some tax issues by shifting or splitting tax liabilities into different tax years.
The alternative minimum tax is very complicated. Summarizing it with any accuracy for each individual taxpayer is impossible.
Incentive stock options present special circumstances that trigger the alternative minimum tax.