Tax Basis for Company Stock Options
Stock options, which grant an employee the right to purchase a company’s stocks at a pre-determined price and an allotted period of time, are a common remuneration practice among many US corporations. But what, if anything, is taxable upon the exercise of these options?
The tax basis of stock options and the resulting potential tax liability depend on the type of stock option exercised. The two primary types of stock options include non-qualified stock options (NQSOs) and incentive stock options (ISOs). While the former is more widely used, the latter offers more tax benefits. These options also split into two forms, namely statutory and non-statutory.
Non-Qualified Stock Options
NQSOs are the most prevalent type of stock options. And because they are not eligible for preferential tax treatment, they are considered taxable income upon exercise. When an employee exercises an NQSO, the fair market value of the stock as of the date of exercise is treated as income, and the tax basis in the stock is equal to the exercise price plus the amount treated as taxable income.
Because taxes on NQSOs are due at the time of exercise, employers and employees must discuss the payroll and cash implications this taxation may impose. Employees should be made aware of the taxes associated with exercising stock options and understand their financial trajectory – including cash flow, items from the exercise of options, and the possibility that their equity may still be underwater.
Incentive Stock Options
ISOs offer preferential tax treatment and are typically reserved for executives and top employees. In contrast to NQSOs, upon exercising ISOs, the employee does not incur a tax liability at the date of exercise. Instead, the tax consequences occur upon the sale of the underlying stock, when the difference between the sale price and the exercise price is treated as capital gain – either long-term or short-term, depending on the holding period.
Further, ISOs do not affect an employee’s taxable income amount on their year-end W-2, making them considerably more favorable than NQSOs due to the tax savings they bring. Moreover, if the employee holds the stock for more than one year, any gains resulting from the sale of the stock will be taxed as long-term capital gains instead of ordinary income, offering lower long-term rates.
Taxable Events and Their Implications
The taxable event for stock options does not occur when the options are granted, but rather when the options are exercised. At that time, the employer must ensure that payroll tax is withheld from the employee’s wages and income tax is paid. An employee recognizes taxable income in an amount equal to the excess of the fair market value of the stock received upon exercise over the exercise price paid for the stock.
The options are also subject to tax at their capital gains rate when the employee eventually sells the shares, which is sometimes referred to as the “double taxation” effect. Changes in current tax regulations, the differing tax implications between the two types of options, and the wide range of terms of the options must all be taken into consideration when evaluating stock option grants.
Voluntary Withholding
In the US, there is no mandatory tax withholding on stock options. It is up to the employer and the employee to decide who pays the withholding taxes on income. Some employers opt to voluntarily increase their payroll tax withholding in order to avoid cash flow issues for the employee. Nonetheless, the fair market value at the time of exercise must be included on the employee’s W-2 form.
To make this additional withholding possible, some employers offer their employees the opportunity to make a “same-day sale”, wherein the employee can instruct the broker to sell a certain number of shares automatically to cover the exercised price and the associated taxes. The sale proceeds then go to the broker, who then pays the taxes as well as the employee’s salary.
Conclusion and Best Practices
It is important to remember that the exercise of options can result in both financial and payroll tax liabilities. In order to avoid the latter, companies and their employees must plan ahead to ensure the proper amount of withholding taxes is paid. Employers should consider instituting a voluntary taxation policy and also offer their employees the option of same-day sales.
Further, employers must educate their employees on the tax basis of stock options and how it will affect their overall financial trajectory, such as cash flow, capital gains, and net worth. Doing so will ensure employees understand and are prepared for the associated costs of taxation and the sales of stocks.
