Stock options can be a great supplement to your income. Before exercising an option, however, it’s important to know the tax consequences of doing so. This area of tax law gets complicated quickly, so it’s a good idea to talk to a CPA even after learning the basics.

Intro To Employee Stock Options

An employee stock option is essentially a contract between you and your employer. Through said contract, your employer agrees to sell you company stock at a particular price, often below fair market value. In some cases, employers offer incentive stock options, which are also called statutory stock options. You have the option to buy these shares when you or the company meet a specified goal.

When you exercise your stock option (purchase the stock), you need to pay a stock option tax. When and how you pay the tax varies, however. We’ll discuss the simple scenario first. If you received an incentive stock option, you don’t need to worry about the tax man this year unless you owe the alternative minimum tax, which we’ll discuss later. You will owe tax later, however, if and when you sell the stock. Depending on how long you’ve had the stock at that time, you will owe tax on either short or long term capital gains.

Employee stocks that aren’t incentivized are referred to as non qualified stock options. This stock is treated as ordinary income for tax purposes, which means you’ll pay income tax on it just as you would your regular wages. How much tax you pay will depend on the market. Here are some examples:

Let’s say your company offers you the option to buy shares of non qualified stock at $1 per share. This selling price is called the exercise price. You buy 5 shares for $5. But the current fair market value of the stock is $3 a share. You owe tax on the difference between your exercise price and the fair market value of the stock. In this case, you would pay tax on $2 per share, or a total of $10.

If you get a chance to time things right, however, you may not have to pay the tax. In our example, if you paid $1 for the stock and it’s currently worth $1 in the market, you break even and need not pay any tax right now. As is true of incentive stock, however, you’ll still have to pay capital gains later if you sell the stock.

Intro to Equity Stock Options

Equity options are a little different. When a company offers you equity stock, you own only part of it. These programs use a vesting system. Under this system, you own an ever-increasing portion of the stocks as time goes by. How much time depends on your particular equity agreement. If it takes 10 years to become fully vested and you leave the company in 5 years, you may lose the stock altogether or be entitled to only 50 percent of its value, depending on how your plan is written.

Typically, you pay ordinary income tax on your equity stock the year you become vested. You then pay capital gains tax later when you sell the stock. Receiving your stock before you are fully vested is also a taxable event, but the value of the stock will be lower because you weren’t fully vested. This can get quite complicated and is a situation best discussed with an accountant.

What About Non Equity Stock Options

This is where things start to get increasingly difficult. So far, all of the options we’ve discussed had to do with shares of ordinary stock that equated to small shares of ownership in the company. There are lots of different options contracts created on non equity instruments as well. Call or put options on stock indexes, commodities, and currencies are some examples of these.

Internal Revenue Code section 1256 taxes these items under a 60/40 rule. Sixty percent of these investments get taxed at the long term capital gains rate. The other 40 percent get taxed at the short-term capital gains rate. Even if you don’t sell these options, you may need to report unrecognized gains and losses on your income tax. Your cost basis in these commodities changes perpetually as well. Section 1256 rules are as clear as mud and are best navigated with professional help.

How to Report Stock Options on Your Tax Return

stock options taxes

If your stock option is subject to ordinary income tax, your employer should report it to you as income on your Form W-2 at the end of the year. You would then report it along with your other income on your Form 1040. If you sold the stocks and need to report capital gains, you would do so using the Form 1040 Schedule D. This transaction is reported to you on a Form 1099 from your broker.

If your stock is in the form of non equity stock options, remember that you must follow special rules under section 1256 rules. You will need to file IRS form 6781, Gains and Losses From Section 1256 Contracts and Straddles.

Note that many of these same rules and reporting requirements are similar to stock you purchase on the open market. You generally don’t pay any tax when you acquire the stock but do recognize a gain or loss when you sell it. Buying stock on the open market is actually a bit more straightforward, since the price you pay should theoretically always equal the stock’s fir market value.

When filing your taxes, remember that certain events can trigger the Alternative Minimum Tax (AMT), including exercising an incentive stock option. If you’ve done so during the tax year, you need to complete AMT calculations at the end of the year. The AMT is really just another way to calculate tax liability that counts a few more things as taxable income.

If your calculations on the appropriate tax worksheets amount to less than the AMT exemption amount, you don’t have to do anything. If they exceed the amount, the worksheets will have you calculate your tax liability in two different ways. Unfortunately, you’ll then have to pay the higher amount rather than the lower one.

Stock Option Tax Tips

It would be impossible to explain everything you need to know about options here, but there are a few tips and tricks that are helpful to know. One is that timing matters. People often wait to exercise their stock options until they decide to leave the company. Doing so is perfectly acceptable, but it does put you in a bit of a time crunch. If you don’t exercise your option within 90 days of leaving the company you could lose it. Your option agreement will refer to this time period as the post-termination exercise period (PTE).

Some employees exercise their stock options early, before they become fully vested in them. This is a gamble, but it can work to your advantage. On the plus side, you have less risk of paying the AMT if you purchase your stocks before they reach their full potential value. On the downside, you end up paying tax to acquire stock that may never reach its potential value. You could save big, but you could also end up paying tax on a stock that proves worthless in the long run.

Many savvy investors also exercise their stock options during their company’s IPO. You may pay a bit more tax this way, but you also stand to potentially make the most. Depending on the ultimate fate of your company, your stock may never be worth a lot. If the company goes public, however, your stock is all but guaranteed to be worth something. This is a great time to exercise your options. You can then sell your stock right away and get something out of it now if you’re pessimistic about the company’s future, or buy stock now and hang onto it if you’re feeling more optimistic. This is a decision best made with the guidance of your stockbroker, however.

Remember too that you need to file a Form 83(b) with the IRS when applicable if you want preferential tax treatment of stock options exercised before you’re fully vested. We discussed the details of this in another post. You only have 30 days to do this, so be sure to check out that post to see if you should be taking the 83(b) election.

Get Help From A Pro

Confused yet? We hear you. An employee stock option can prove quite lucrative, though, so don’t let the complexities of their taxation keep you away from them. Instead, contact Picnic Tax and let us help you navigate the pros and cons of the specific options available to you. We can demystify the process and help you plan a strategy to minimize your taxes while maximizing your income. When it comes to stock, you’ve got options.