The Truth About Stock Option Exercise Tax Treatment

The Congressional Research Service recently issued its report on the tax issues surrounding employee stock options, including the effects of the Alternative Minimum Tax. As noted in the report, over 10 million employees currently receive stock options as a means of compensation from their employers. With this significant a part of the U.S. population being faced with the complexities of the imposition of the stock options, a review of the Regular Tax and Alternative Minimum Tax treatment is fundamental to basic tax planning for those affected.

The CRS is an agency of the U.S. Government, set within the Library of Congress. Its purpose is to provide politically neutral legal and policy analysis to Members of both the House and the Senate. Its reports provide straightforward and objective analyses of important legal issues.

Just When You Thought You Had Heard It All…

A stock option simply is a right, granted by an employer to an employee, to buy a certain number of shares of the employers stock at a set price. If the stock goes up in value the employee receives additional compensation in the shape of the appreciation in the stocks price. For example, if Employer A grants Employee X the right to buy 1, 000 shares of stock at $10 per share, and the stock price goes to $15 when the employee exercises the option, the individual will have received additional compensation, over and above his or her base salary, in the volume of $5, 000.

There are only two major types of employee stock options qualified and nonqualified. Because qualified options must meet certain requirements so as to be labeled as such, and they have less favorable tax results for the issuing employers, these are less frequently encountered. Nonqualified options, on the other side, are easier to issue because of the absence of these requirements, and together with the more favorable tax treatment to the employer, are more usually found. The Alternative Minimum Tax treatment is significantly different between these two types of options, so it is very important, because a first step that the employee know which type of option he or she has received.

How stock earnings are taxed?
Background – Hold stock options from a non-IPO company. I did not buy (or exercised) any vested stock yet. Recently company got acquired by another company. We have given option to exercise the stock if we want to but not necessary for payouts. Question: 1) Is there any tax benefit to exercise option now? 2) If I don't buy or exercise then would I be paying social security or medicare tax on earnings? Appreciate the quick response.

  • This can be a very complicated situation and I strongly urge you to consult with a tax professional. I am not a tax professional and I have never had to deal with a situation like this. What I understand is that the options you have were issued to you directly by the company as part of a compensation package. When you say a "non-IPO company" I am taking that to mean the company has never had an IPO so there is no publicly traded stock for the company. You have not not disclosed two important facts. (1) Are you an employee of the company? I am guessing you are, but I know some companies issue options to contractors as well as employees so I am not sure. (2) Are the options "Nonqualified Options" or "Incentive Stock Options" for tax purposes? —- If you exercise "Nonqualified Options" the difference between the value of the stock on the exercise date and the amount paid for the stock is considered compensation income just as if the company had paid you a cash bonus. You're not allowed to treat this amount as capital gain. If you're an employee, the company is required to withhold when you exercise your option. Of course the withholding obligation must be satisfied in cash. The IRS won't accept shares of stock! There are various ways the company can handle the withholding requirement. Probably the most common one is simply to require you to pay the withholding amount in cash at the time you exercise the option. The amount paid must cover federal and state income tax withholding, and the employee share of employment taxes as well. (Social Security and Medicare are employment taxes.) If you're not an employee of the company that granted the option, withholding won't apply when you exercise it. The income should be reported to you on Form 1099-MISC instead of Form W-2. Remember that this is compensation for services. In general this income will be subject to the self-employment tax as well as federal and state income tax. —- One of the key differences between incentive stock options (ISOs) and nonqualified stock options is that you don't have to report compensation income when you exercise an ISO. But you may have to pay a significant amount of tax anyway, because of the alternative minimum tax (AMT). Assuming you're using cash (not stock) to exercise your ISO, and that you'll hold the stock for some time rather than sell it immediately, the exercise of an incentive stock option is a non-event. There is no tax — in fact, nothing to report on your tax return — when you exercise an ISO. This is dramatically different from the treatment of nonqualified options. —– <<<1) Is there any tax benefit to exercise option now?>>> I am assuming that the payout you would get if you did not exercise would be the same if you exercised the options and sold the stock to the acquiring company. If that assumption is incorrect, you need to compare the amount you would receive if you exercised to the amount you would receive if you did not exercise. In you have nonqualified stock options I do not think it makes any difference. If you have an ISO there may be an advantage to exercising the ISO now. If you exercise the ISO you will not pay any payroll taxes because the sale of the stock would be considered a short term capital gain. If you do not exercise the ISO and the company gives you a cash bonus instead it probably would be considered compensation instead of a capital gain so you would be paying employment taxes. <<<2) If I don't buy or exercise then would I be paying social security or medicare tax on earnings?>>> I am assuming by "earnings" you mean how much money you get instead of how much the company earns. (How much the company earns is irrelevant.) If you hae nonqualified options I think you will pay employment taxes either way. If you have an ISO I think you might only pay employment taxes if you do not exercise the options. Just remember that my qualifications to answer this question are dubious, at best. I think I understand your situation better than the others who have answered you so far, but don't even count on that. —– Most of what I have said I got from the free online "Guide to Compensation in Stock and Options" at which was written by Kaye Thomas, a tax lawyer. If you have any specific questions about that guide there is also a message board on that site where you can ask. In the past I have received some answers directly from Kaye Thomas on those message boards, but I cannot be sure which specific questions he will answer. I urge you to read the whole guide carefully then contact a tax professional.

  • yes i thnk so

  • You pay capital gains (or take a capital loss) on the difference between the price when you exercise your option and the stock price when the option was granted (less the option cost and commissions). The rules can be complicated. Google "IRS stock options" or consult a tax professional. You do NOT pay Social Security or Medicare on stock options.

  • Social security and Medicare deductions are taken only on earned income

  • Qualified stock options are likewise known by their Internal Revenue Code label Incentive Stock Options, or ISOs. Employees prefer receiving these as there is no tax due on the time of exercise for Regular Tax purposes. So long as certain holding period requirements are met, the employee will have long-term capital gain treatment on subsequent sale of such shares, resulting in a significant tax savings because the capital gains tax rate is much smaller than the tax rate on ordinary income.

    Here’s A Few More Ideas

    Because the AMT was designed to ask a damper on a portion of the favorable Regular Tax treatments contained in the tax law, there is a price to be paid by those exercising ISOs. While there is no Regular Tax to be paid on exercise of an ISO, the spread (the $5 in our example) per share is a tax preference item, and must be part of the employees AMT income (AMTI). By including this amount, the employees AMTI will be more than his or her Regular Tax, thus potentially triggering the AMT in the year of exercise.

    The planning to minimize and in many instances to completely eliminate the AMT impact from exercise of ISOs is fairly easy. All one has something to do is a little planning before the exercise, testing for the AMT using alternative amounts of ISO shares. For example, it could be that the $5, 000 in our example isn’t enough of a tax preference item to trigger the AMT, while exercising several years worth of options at once would trigger the AMT. In this case, the employee is better off spreading the exercise for a number of years instead of doing them all in one year.