Stock options are typically given to employees of either a startup or a privately held company. They’re generally offered because when the options are granted, they are not taxable to the employer. Typically, the employee, in turn, accepts lower wages because the stock options that were granted can be worth a lot of money in the future.
Basically, there are two different types of stock options. An incentive stock option (ISO) is granted with no tax at issuance as the option vests or at exercise. Only employees of the company, not contractors, are allowed to receive ISOs. If the individual holds the stock received upon exercise until a date that is more than two years from the date of grant and one year from the date of exercise, the difference between the sale price and the exercise price will be a long-term capital gain (or loss).
However, if either of those holding periods is not met, then at the time the stock is sold, the option holder will have compensation income equal to the difference between the fair market value of the stock at exercise and the exercise price—or the option holder’s profit, if it is less. Any profit in excess of that amount will be capital gain. While the exercise of an ISO is not an income event for regular federal income tax purposes, note that the difference between the exercise price and the fair market value of the stock at exercise is income for alternative minimum tax (AMT) purposes.
If the option is a non-statutory stock option (NSO)—also known as a non-qualified stock option—there’s no tax at grant or as the option vests. The option holder will have compensation income equal to the difference between the exercise price and the fair market value of the stock on the date of exercise and, upon sale of the stock, will have a capital gain or loss equal to the difference between the sales proceeds and the value of the stock on the day of exercise. This capital gain or loss will be long term if it was held for more than one year; otherwise, it will be short term.
Both an ISO and an NSO are restricted stock. If either is exercised early, the holders of these stocks have to pay capitál gains tax, whether or not they received cash or just exercised the option. However, you have 30 days from the date the options are granted to make an IRC §83(b) election.
If you earn shares through vesting by remaining with a company, the Internal Revenue Service treats that equity as taxable income as it vests if it is worth more than you initially paid for it. If you exercise options prior to full vesting, or if you receive shares of restricted stock, you can elect to pay taxes on it immediately (on the grant date) rather than waiting to pay at the time the shares vest. This accelerates your ordinary income tax and can save you a lot of money if the value of the stock is likely to increase over time.
For example, pretend you are granted 100 restricted shares valued at $.01 per share that vest in one year and elect to file an 83(b) election: Your taxable income is only $1.00. Now pretend it is a year later. These shares are fully vested and are now worth $1 per share: Your taxable income would be $100 if you chose not to file an 83(b) election. Note: Section 83(b) election is only effective if it is filed with the IRS within 30 days of the date the person acquires the equity that is subject to vesting.
ISOs have a major disadvantage to the employee: The spread between the purchase and grant price is subject to the AMT. This was enacted to prevent higher-income taxpayers from paying too little because they were able to take a variety of tax deductions or exclusions (such as the spread on the exercise of an ISO).
It requires that taxpayers who may be subject to the tax calculate what they owe in two ways. First, they figure out how much tax they would owe using the normal tax rules. Then, they add back into their taxable income certain deductions and exclusions they took when figuring their regular tax and, using this now higher number, calculate the AMT. These "add-backs" are called "preference items," and the spread on an ISO (but not an NSO) is one of these items. For taxable income up to $175,000 or less, the AMT tax rate can be substantial. If the AMT is higher, the taxpayer pays that tax instead.
NSOs do not have this problem. When the stock is exercised, the difference between the amount purchased and sale price is simply added to the employee’s W-2.
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...