Understanding Stock Option Taxability Consequences
One of the more common questions I am asked from clients is “What are the tax consequences of owning stock options?” This remains a hot topic for discussion at any time of the year. As tax season quickly approaches, having a thorough understanding of the tax implications involved can be crucial to minimizing taxation exposure . A more in-depth, comprehensive look at the tax consequences will be explored in a later blog to come. For the purposes of this discussion, I intend to illustrate a general understanding including a hypothetical example.
Taxability-wise, stock option plans raise a number of questions. For example, is the exercise of the option taxable? If not, when is the transaction subject to tax? These questions are very broad and there a many determinants of the taxability of stock options. For tax purposes, there are basically two types of stock options. Lets break this down in simple form.
Differentiation:
The first step is determining whether the options are Type 1: Non-qualified or Type 2: ISO’s (Incentive stock options).
ISO’s receive special tax treatment and can be very complicated. (In a later blog we will delve deeper into the special tax treatments and elaborate on taxability issues and how they relate.)
The tax implications of non-qualified stock options are fairly straight forward.
Implications:
Simply stated, the employee does not report income at the time they receive the options or when they vest. Upon exercising the option, they would report compensation (ordinary) income equal to the difference the amount paid to buy the option (grant price) and the current value of the stock. This income is reported whether the stock is sold immediately in a cashless exercise or if the stock is held. If the stock is held, the current market price is the new basis for the shares.
Example: (This is a hypothetical example and is not representative of any specific investment. Your results may vary)
Steve has 5,000 shares of non-qualified stock options with a grant price of $15/share. The current price of the stock is $25/share. If he paid $75,000 (5,000 x $15) to exercise the shares that are worth $125,000 (5,000 x$25) he would report compensation income of $50,000 ($125,000-$75,000).
Dan’s Moral: Understanding your stock option tax consequences can be daunting and ultimately, careful consideration of how and when to exercise those options to minimize your tax liability is essential.
Daniel Langworthy is the founder and president of Executive Capital, LLC, an investment firm working exclusively with Executives of public companies.
Daniel Langworthy does not provide tax advice. Please consult a qualified tax advisor.
Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC