Tax Implications of Exercising Stock Options

In companies that offer employee stock options, the benefit provides a valuable incentive for retaining employees, especially during times when the company is successful. An employee stock option plan gives your employees an opportunity to purchase discounted shares of your common stock during a specified period of time. Any time that someone stands to make a profit from their stock options, there are important tax implications to consider.

Employee stock options don’t have any immediate tax implications because they don’t give your employees any interest in ownership until they exercise their options. Official ownership takes place when the owners of stock options act on their rights to exercise it.

There is a rare exception to this rule. If the stock options are being actively traded on an established market or their value can readily be determined, employees may have to report them on their tax returns. It’s not something that happens often but be aware that it does happen.

At the time that an employee sells their stock options, the tax implications become important to consider. After the sale of their stock, employees are required to report capital gains or losses based on the difference between their tax basis and the amount they receive or lose from the sale.

Understanding Tax Rules for Employee Stock Options

There are two main types of stock options that employers issue:

1. Incentive stock options (also referred to as statutory options, qualified options, or ISOs).
2. Non-qualified stock options (also referred to as non-statutory options or NSOs).

Employers may issue either type of stock option to reward their employees. Each type carries different tax implications.

Since your employees don’t receive income from their stock options at the time of purchase, they only need to be concerned with paying taxes on them when they actually receive a profit from them. They’re not required to report gains or losses until the year that they sell them.

The profits from stock options are taxed differently than traditional income taxes. Gains from the sale of stock options are taxed at the capital gains rate. The tax rules for incentive stock options and non-statutory stock options are significantly different.

With non-statutory stock options, employees are liable for ordinary income tax on the difference between the purchase price and the fair market value. Non-statutory stock options are taxable for income tax and employment tax. Unlike statutory stock options, non-statutory stock options aren’t subject to alternative minimum tax (AMT). Non-statutory stock options are withholding taxes.

For incentive stock options, the process is more complicated. The federal government imposes AMT in addition to the regular income tax. AMT applies to certain individuals, estates, trusts, and the sale of employee stock options. When an employee exercises their stock options, they get the benefit of adjusted taxes.

AMT is essentially a shadow tax that was set up to make sure that people that reduce their taxes through deductions or other tax breaks pay at least some tax. At the time of its inception, the intent of AMT was aimed at high earners with incomes over $200,000. It became known that the tax laws put many individuals earning high incomes in a legal position where they didn’t have to pay any taxes at all. For non-executive employees that make a moderate wage, the tax implications are minimal.

Calculating AMT is fairly complicated. It’s beneficial for employees to consult with a tax accountant to help them understand and calculate AMT. Taxpayers and anyone that processes their income tax return will use IRS Form 6251 to figure out and report AMT.

To arrive at AMT, taxpayers need to calculate their adjusted gross income, and then they can add certain items back in. The next step is to subtract the applicable AMT exemption amount and multiply that amount by the applicable AMT tax rate. Next, the employee or their tax representative should subtract the AMT foreign tax credit to calculate a “tentative minimum” tax. If the calculation is higher than the employee’s regular income tax, they’re required to pay the AMT.

Employees or executives that have an income above a certain amount have to calculate their tax liability according to AMT rules and the regular rules to evaluate which method yields a higher tax.

Employees only need to make this tax adjustment if their rights in the stock are transferable, and they aren’t subject to a substantial risk of forfeiture in the year they exercise their stock options.

For the purpose of the tax adjustment, the fair value of the stock is determined without regard to a restriction lapse for when employees can transfer their rights, or they’re not at substantial risk of forfeiture.

One notable exception to the process is if an employee sells their stock options in the same year that they exercise them. In this case, they don’t need to consider the AMT adjustment. Taxes will be calculated the same for regular tax and AMT.

If the stock falls before the end of the current year, employees can sell their stock to avoid AMT. Tax accountants may use tax planning software to forecast tax consequences. This gives employees a chance to sell some of their stock in the year of exercise to account for the tax due.

How Tax Reporting Works for Employee Stock Options

As an employer, you will issue IRS Form 3921 (Exercise of an Incentive Stock Option Plan), which provides them with the information they need for tax-reporting purposes.

When an employee sells the stock they acquired through exercising their stock options, they have to report a gain or loss on the sale.

After an employee acquires stock options at the discounted price, you or your transfer agent will need to give them IRS Form 3922 (Transfer of Stock Acquired Through an Employee Stock Purchase Plan). The information on the form will help your employees determine the amount of gain or loss and whether it reflects capital or ordinary income.

The tax implications around employee stock options can be complicated until you get more familiar with them. The right consultants and the right tools, such as cap table management software from Diligent Equity, will simplify the process significantly for you. You chose to offer stock options to your employees because you value their service. You’re investing in them, and you’ll want to keep them in your employment for a long time. That alone is worth taking the time to get it right.