We all have heard and know of people becoming millionaires overnight with “stock option” money, especially in Silicon Valley. Stock options are an important part of the compensation package for many employees in the technology sector. For companies, it is a tool to retain employees and motivate them to perform better as the company’s growth and success translates to their success.
The most common types of stock options are Incentive Stock Options (ISO’s) and Non-Qualified Stock Options (NQSO’s). The tax consequences to employees are as follows:
Incentive Stock Options (ISO)
- Grant of ISO – No tax consequence to the employee.
- Exercise of ISO – No regular income tax consequence from the exercise of an ISO. There will be alternative minimum tax (AMT) consequence if, the amount by which the fair market value of the stock received upon the exercise exceeds the exercise price. The company provides form 3921 to the employee when the ISO is exercised.
- Sale and disposition of ISO – If the stock that was acquired with an ISO is sold with
- Two years from the date the ISO is granted or
- One year from the date the ISO is exercised.
The difference between the fair market value of the stock on the exercise date and the exercise price (spread) will be considered ordinary income. This amount will be reported on Form W-2. If the employee disposes the stock after meeting the holding period (see above), the employee will be required to recognize the difference between the amount received in such disposition over the employee’s basis in the ISO stock as capital gain or loss.
Non-Qualified Stock Options (NQSO)
- Grant of NQSO – No tax consequence to the employee.
- Exercise of NQSO – Taxed at the time of exercise. The difference between the exercise and the option price is ordinary income and included as compensation on Form W-2.
- Sale and disposition of NQSO – The difference between the sale price and the tax basis. The tax basis in the stock includes both compensation income on which taxes are paid plus the exercise price. Based on the holding period it can be considered short-term or long-term capital gain.
How is equity compensation going to be affected by Trump Presidency?
Trump’s tax plan proposes to cut the existing seven tax brackets to three: 12%, 25%, and 33% as well as to eliminate AMT and the net investment tax (3.8%). There is no proposed change to the capital gains tax rate (15% / 20%).
Tax planning will be affected with the decrease in the difference between the ordinary income rates and capital gain rates. Elimination of AMT and 3.8% net investment tax will also play a major part in tax planning for individuals with stock options. It remains to be seen if Trump’s proposals will see the light of the day, given the huge budget deficit and the votes needed for the major tax overhaul.
In addition to ISO’s and NQSO’s, employees get restricted stock units (RSU’s), stock appreciation rights (SARS) and employees participate in the stock purchase plan (ESPP). Taxation of stock options has myriads of rules and can get complex. Planning ahead of time can reduce the tax exposure on stock option income.