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A Simple Guide to Stock Options & Their Tax Impact

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Unfortunately, stock options aren't well understood by many people, including accountants. In his latest piece, Mark Pierce offers an overview of both incentive and nonqualified stock options and explains their tax impact and financial planning strategies individuals can use to make the most of the stocks they own.

Sep 7th 2021
Attorney Cloud Peak Law
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A stock option is an agreement between a buyer and a seller to exchange stock for a pre-set price within a specific period. Employee stock options, for example, are agreements between the corporation and the employee to purchase common stock at a price set by the corporation. The stock must be purchased within a specified time, or else it expires. Many companies do not defer to offering stock options as a benefit to their employees. 

Exercising a stock option means executing the purchase at the preferred price. When the price provided by the seller is below the market price, then exercising the option seems like a good decision. If the offered price is above the market price, it's usually not a good idea to exercise the option just yet.

Vesting and Expiration

Some options become immediately available upon the agreement, but others don't. The stocks that don't instantly become available for exercising the option have a vesting date, which refers to the earliest time a buyer can exercise their option. Many employee packages have a vesting date, ensuring that employees don't immediately sell their common stock options. 

Expiration is a feature of all options, since they are time-limited. If the buyer doesn't exercise their option to purchase by the expiration date, they lose that option. Many investors use options to earn more money on their shares by offering options on the market. Buyers usually snap up these options hoping that the stock price will go in one direction or another, but wind up letting them expire when the prediction doesn't pan out.

Entries for Stock Option Exercises

In accounting, when options are exercised, there are typically three common entries that are used:

1. Debit Cash: The cash amount is entered as debit as received from the sale.

2. Credit APIC: The extra money paid above the par cost of the stock is known as Additional Paid-In Capital (APIC).

3. Credit Common Stock: Since the option-holder purchases the common stock, they now have control of it as indicated by the account entry.

Options can come in both incentive stock options (ISO) or nonqualified stock options (NSO), and each has its own methodology for taxation.

ISOs and NSOs and Their Tax Impact

Incentive stock options are tax-free to the employee when they exercise the option to buy the stock. However, if the employee fails to dispose of the stock within two years of the buy date, they are liable to pay capital gains tax on any resulting gains from holding the stock. If an employee sells the stock within a year of exercising the option, gain from that sale is taxed as income, not capital gains. Typically, ISO plans mean the employee must exercise the option within 90 days of the employee's termination.

Waiting two years after the initial offer of the option is a risk to the employee. There's a chance that the stock will decline between the offer and the two-year period, meaning that the earnings from the stock will also fall, offsetting the long-term capital gains tax. There's also the consideration of alternative minimum tax (AMT). AMT is required to be paid on the difference between the market price at the time of exercising the option and the option price. 

Unfortunately, this practice may lead to the employee selling the stock to pay the related taxes. This problem usually occurs in companies that have gone IPO but restrict their employees from selling stock until a specific date. The IPO price spike will have long since dissipated, and the chance for those employees to realize gains on their stock diminish significantly. ISOs are only able to be issued to employees and may run up to ten years in limit.

The IRS does not give nonqualified stock options any favorable tax treatment. An NSO holder doesn't owe any taxes initially when the option is granted. If the option is on a public exchange, they may be required to pay taxes if they exercise the option and sell the stock immediately. NSOs are taxed when they are exercised. The taxes paid are based on the stock's fair market value and the amount that the buyer paid for it when exercising the option. Any gain in value is taxed as ordinary income. If the stock price goes up after the option holder buys it, then the profits will be taxed as capital gains. There aren't any specific rules governing NSOs, so their prices might even be lower than the fair market price at the grant date. When this happens, it's termed a premium grant.

Strategies for Exercising Stock Options

In exercising stock options, an individual has three potential methods that they can use. These are:

1. Cash for Stock: Exercise and Hold

The buyer purchases the stock with cash on hand. They then hold the stock over the long term, offering potential gains in value and dividends (if any are provided). If the buyer is using a brokerage account and trading on the margin, they may be required to deposit money into their account. Any loans from the margin, as well as costs associated with buying the stock, will need to be paid to the brokerage as per usual.

2. Cashless: Exercise and Sell

In this event, you don't see any money from holding the stock but immediately exercise the option and sell it to someone else. In some cases, a brokerage may allow an option holder the choice to sell on their option without having cash within their account. The sale price of the stock will cover commissions and brokerage fees associated with the sale of the stock. This choice gives the seller liquid assets, which can then be used to purchase stock they want.

3. Cashless: Exercise and Sell-to-Cover

Exercising the option means that the buyer will need to pay the fees on the transaction. In some cases, the buyer may not have enough funds in their brokerage account and may sell on some of the stock from the option to cover the fees. The rest of the stock acquired in the agreement remains in the form of company stock held by the buyer.

Stock Swaps

Occasionally, a person may already own company stock and may wish to exchange those to pay their fees when exercising their option. This transaction is also cashless but is subject to the stipulation that the shares used in the exchange must be held for a period (usually up to two years). This action ensures the transaction isn't recognized as a sale and taxed as such.

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