How are my employee stock options taxed?

It’s this time of year we usually get the question, can I use TurboTax to file my taxes? Having been a user of TurboTax in the past, I know they make it easy.  If you’re a W2 employee who receives a salary and a bonus, and you have a simple investment account structure, it’s a cost effective way to get your taxes filed. However, if you earn restricted stock units (RSUs), incentive stock options (ISOs), non-qualified stock options (NSOs), have an employee stock purchase plan (ESPP), or earn other forms of stock compensation as part of your income, having a CPA who is experienced in stock compensation can really pay off. 

If you earn RSUs and are wondering how those work, we wrote about it in our blog: I have RSUs, but didn’t sell any. Why is my tax bill so crazy? For this week, we’re focusing on taxes and stock options. Our goal isn’t to teach you to file your own taxes (we like to leave that job to the experts!), but rather to empower you to have informed dialogue with your CPA about the actions taken during the year that are considered taxable events. 

Let’s start with the basics. There are two types of stock options: non-qualified stock options (sometimes referred to as NQSOs or NSOs), and incentive stock options (ISOs). They work similarly from an investment perspective: A stock option is the right, but not the obligation, to purchase a stock at a certain price (the strike price) before a certain date (the expiration date). The difference relates to how they are taxed. The latter is called an incentive stock option, because there is a tax incentive to holding the stock over the long run. 

Stock options are typically granted on a vesting schedule, whereby you receive a certain number of options every month, quarter, or year based on the time you work for a company. Even though there is inherent value to owning stock options, the vesting itself is not actually considered a taxable event. However, as soon as you exercise a stock option, you have created a taxable event. How you are taxed depends on the type of option. 

Taxes on non-qualified stock options

When you exercise NSOs, you are taxed on the difference between the strike price (the price you pay) and the fair market value of the stock at the time of exercise. This is considered earned income, and you’re required to pay tax on that income upon exercising. This gets processed through your W2, where your company should automatically withhold taxes as they would on a normal paycheck (including federal, state, local, social security, and medicare taxes). Sounds simple enough, right? Well, not exactly. 

1. Your company is required to withhold 22% for federal income taxes, but you may be in a higher tax bracket. 

2. If you work for a private company, you may need to cut a check to your company to cover your tax obligation. 

3. If you work for a private company, and your marginal tax bracket is higher than 22%, you may need to cut a check to your company to pay for taxes, and then you may still owe some!  

Stock Option Tax Tip 1: If you’re exercising your non-qualified stock options, make sure you have enough money set aside for the cost to exercise (strike price x number of shares), and your full tax obligation. You’ll owe taxes (federal, state, local, social security, and Medicare taxes) on the difference between the market value of your shares and the cost you paid to exercise them. 

Now that you own your company stock and you’ve paid taxes on the exercise, your tax obligations will be similar to owning any company’s stock. You’ll receive a 1099 each year on any dividends you receive, and on any capital gains or losses from selling the stock at a profit or loss. Capital gains will be defined as short term if you sell within a year of exercising, and long-term if you sell after at least one year of holding the stock. Sounds simple enough, right? Well, not exactly.

Your W2 should reflect the earned income (the difference between the market value of your stock and the price you paid), and the 1099 should reflect the capital gains (the difference between the price you sold your stock and the market value at the time of exercise). However, in a scenario where you exercise and sell your stock at the same time (AKA a cashless exercise), the 1099-B may not reflect the appropriate cost basis. 

Let’s illustrate this through an example:

• You own 1000 shares of vested stock options, and these have an exercise price of 5 cents per share. The current stock price is $1.00 and you decide you want to do a cashless exercise and sale. 

• You pay $50 to exercise the stock options, and your W2 reflects $950 of income. You pay tax on this income through your paycheck. 

• You receive a 1099 that shows you have short-term capital gains of $950 of income. But this is incorrect, because you already paid tax on this income through your W2.

• In order to resolve this issue, you must adjust your cost basis using Form 8949. It may seem odd that the 1099-B tax form is incorrect, and sometimes you’ll receive a supplemental 1099-B that contains the adjusted cost basis, but ultimately it is your responsibility to ensure that your Form 8949 is correct.   

Stock Option Tax Tip 2: If you sell stock options, be sure to double-check your cost basis, and know the 1099-B tax form may not have the accurate numbers. This issue is not limited to stock options, but cost basis issues can also arise with RSUs and ESPPs.  

Taxes on Incentive Stock Options (ISOs)

As we mentioned earlier, incentive stock options are treated similarly to non-qualified stock options from an investment perspective, but they have an additional incentive - preferential tax treatment.  Unfortunately that preference comes with added (and sometimes costly) complications.

The tax event for incentive stock options isn’t exactly at the time of exercise, which means that upon exercising, the only price you pay is the cost to exercise the option. This also means that your company will not issue a W2 for the stock exercise. However, for any incentive stock options held at year end (12/31 of the year they are exercised), you must complete an AMT return (Form 6251) to reflect the amount of income you received by exercising the stock. This is referred to as the “Bargain Element” and, similar to non-qualified stock options, is calculated as the difference of the market value at the time of exercise and the cost paid to exercise. 

AMT is short for alternative minimum tax. Just because you are calculating AMT does not mean you necessarily will owe it. AMT is an alternative tax calculation, and you will only owe AMT if your AMT is higher than your ordinary income tax. 

How to find the bargain element is by locating the IRS Form 3921, which should be issued by your stock plan administrator with similar timing to other tax forms (February in the following year). Form 3921 should report the date the option was granted, date the option was exercised, the exercise price per share, the fair market value per share on the exercise date, and the number of shares transferred. This data will enable you to calculate the bargain element, which should appear on line i of your AMT tax return.

Stock Option Tax Tip 3:  If you’re exercising your incentive stock options, make sure you have enough money set aside for any alternative minimum tax obligations. The calculation is complicated, so if you can’t pay 50% of the bargain element in cash, consult with an experienced CPA to evaluate how exercising ISOs will impact your tax bill.  

While incentive stock options do provide a tax incentive if you hold them for at least one year since they were exercised, and two years from when they were granted, the potential for a high AMT brings added complication to the tax benefit. You may not see the benefit right away, but by reporting the bargain element on Form 6251, and paying AMT, you have the potential for AMT credits in the future. These credits are calculated using Form 8801. For any AMT paid, you have the opportunity for a credit in the future. For example, if you paid $100,000 in AMT due to exercising stock options, you will be able to carry forward the $100,000 of AMT credit until you have fully used it up. 

Stock Option Tax Tip 4: If you’ve paid AMT due to exercising incentive stock options, each year you will want to file Form 6251 and Form 8801 to maintain records of your AMT credit, and ensure you have the best opportunity to fully utilize the credit. 

While exercising stock in a fast growing company may seem like a great investment opportunity, understanding your full tax obligation is essential when it comes to making this decision. In a public company, you have the benefit of being able to sell your shares to meet your tax obligations, but in a private company, you don’t have the luxury of being able to sell your shares on demand. Working with an experienced tax professional and financial planner can arm you to make informed decisions that best enable you to participate in the upside without breaking the bank on taxes. 

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Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.