How Are Stock Options Taxed?

There are three common types of stock options, and they are taxed differently.

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 with after-tax dollars. If you hold the stock for two years after the option is granted and one year after you buy the stock and you remain employed by the company for at least three months after you exercise the option, the gain (or loss) will qualify for capital gain treatment.  If the sale does not qualify for capital gain treatment, it is ordinary income and will be included in your W2 income.  When you sell the non-qualify stock, the ordinary income already recognized is included in your basis.  If you purchased the stock at a discount greater than 15%, the tax treatment is different.

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.  The difference between what the employee pays for the stock and the value of the stock when received is an adjustment item for the alternative minimum tax, however, under the new tax laws, the AMT is eliminated for almost everyone. 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 shares and if they have a readily ascertainable fair market value (actively traded on an established market) the employee generally 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.  Unless a Section 83(b) election has been filed, 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. 

Important:  Under the new tax laws, employees of certain private corporations can now defer (for up to 5 years) income inclusion related to equity.  An election under new IRC Section 83(i) must be made within 30 days after the stock vests or the option is exercised.  There are many other requirements, too, so please contact me for additional information.

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.

The information above does not cover all of the details regarding purchases and sales of stock acquired from options.  If you have questions / concerns, or would like to enlist the services of an experienced CPA tax accountant, please contact me.

M. Bess Kane, CPA
December, 2019