How Are Stock Options Taxed?
There are three types of stock options, and they are taxed differently.
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Employee Stock Purchase Plans (ESPP)
Stock in an ESPP is usually purchased at a 15% discount from what it's selling for on the open market. Your purchases are deducted from your paycheck. When you sell the stock, you pay tax on the difference between what you paid for the stock and what you sell it for. If you are selling at a profit, an amount up to your original discount is included in your W2 wages and taxes are withheld immediately. Any additional profit is taxed as capital gain, usually short-term. Your employer does not withhold taxes on that portion.
Incentive Stock Options (ISO)
The company "grants" an option to an employee to purchase the company's stock at a certain price on or after a certain date (the "vesting" date.) Usually, the employee will exercise his right to acquire the stock on the vesting day and then sell it the same day (a "same-day sale".) The profit is treated as additional salary, taxes are withheld, and the net amount is paid to the employee.
If the employee exercises the option but then holds the stock and meets a special holding period requirement, the employee generally does not pay tax until the stock is sold, and then recognizes capital gains. However, the difference between what the employee pays for the stock and the value of the stock is an adjustment item for the alternative minimum tax. It is important to check with an experienced CPA about the effect of this AMT item on your income taxes.
Nonqualified / Restricted Stock (RSU)
Sometimes, employees are given stock options as payment for their services or as bonuses. If the employee has immediate possession of the options, and if they have a readily ascertainable fair market value (actively traded on an established market) the employee recognizes income at the time of the grant. Otherwise, the employee is subject to tax when he becomes substantially vested in the shares and they have a readily ascertainable fair market value. An amount equal to the value of the stock is included in his taxable compensation, and taxes are withheld. At that point, he has 3 options: Sell all of the shares ("same day sale"), sell just enough shares to cover the tax ("sell to cover") or pay his employer cash to cover the taxes.
Other Fun Facts
Options that would otherwise be ISOs are treated as nonqualified stock options to the extent that the aggregate fair market value of the stock a taxpayer may acquire pursuant to ISOs that are exercisable for the first time during any tax year exceeds $100,000. (Code Sec. 422(d)
Income from either ESPP or ISO/RSU stock is not subject to FICA tax.
If you have questions / concerns, or would like to enlist the tax services of an experienced CPA, please contact me.
M. Bess Kane, CPA bess@besskanecpa.com
November, 2011
