Taxation of Employee Stock Options: Before we get too deep into this, it’s necessary to understand that there are two kinds of stock options, nonqualified options (NSO) and incentive stock options (ISO). With either kind of option, the employee gets the right to buy stock at a price fixed today for a defined number of years into the future, usually 10. When employees choose to buy the shares, they are said to “exercise” the option.
For example, an employee might have the right to buy 100 shares of stock at $10 per share for 10 years. After seven years, for instance, the stock might be at $50, and the employee could buy $50 stock for $10.
Taxation of NSO’s
If the option is an NSO, the employee will immediately pay tax on the $40 difference (called the “spread”) at ordinary income tax rates. This holds whether the employee keeps the shares or sells the stock. This income is also subject to payroll taxes.
Taxation of ISO’s
With an ISO, the employee pays no tax on exercise. Instead, if the employee holds the shares for two years after grant and one year after exercise, the employee only pays capital gains tax on the ultimate difference between the exercise and sale price. If these conditions are not met, then the options are taxed like a non-qualified option. Unlike NSO’s, gain on ISO’s is not subject to payroll taxes
Sounds good so far but ISOs have a major disadvantage to the employee. The spread between the purchase and grant price is subject to the Alternative Minimum Tax (AMT). AMT was enacted to prevent higher-income taxpayers from paying too little tax because they were able to take a variety of tax deductions or exclusions (such as the spread on the exercise of an ISO). The new tax law changed the rules for AMT so that most taxpayers will not be subject to it however; a significant exercise of options could easily subject you to AMT.
All is not lost if hit with the AMT though, if the amount paid under the AMT exceeds what would have been paid under normal tax rules because of the AMT preference from ISO’s, the AMT excess becomes a “minimum tax credit” (MTC) that can be applied to reduce future year taxes.
One final stop before we wrap up, let’s review the funding options and tax treatment for the exercise of ISO’s
1) If using cash to exercise the options; the ISO exercise is not taxable; however; this does create a tax preference for Alternative Minimum Tax purposes (AMT).
2) If borrowing money to fund the exercise price, Interest paid on the loan will generally qualify as investment interest expense, which is deductible to the extent of the taxpayer’s net investment income. The taxpayer must itemize deductions, to get benefit for this though. The standard deduction has been greatly increased under the new tax rules.
3) Many times, an executive will opt for a “cash less” exercise whereas they borrow funds needed from a broker and immediately sell stock available from the options to repay the loan. The selling of a portion of the stock to repay the loan results in taxable income on form W-2 (treated as a NSO). Of course, there will be AMT preference on the spread of the shares not sold (the ISO portion).
4) The best case scenario is a “stock swap exercise”. The employee gives the brokerage firm shares of previously acquired company stock in lieu of cash. Exchanging existing shares for new shares is a tax-free exchange under §1036(a). The basis and holding period of the shares exchanged carries over to an equal number of the shares received. Shares more than that amount have a zero basis the carryover basis applies for both regular tax and AMT purposes.
Please contact John Csargo, CPA at firstname.lastname@example.org if you need guidance on ways to time the exercise of your options to pay the least tax possible.