Purchasing, or being issued, stock options means you are guaranteed the right to buy or sell that stock at an agreed-upon price. As the market fluctuates, you can make decisions about when to exercise that option to maximize your gains. While stock price is a big factor in exercising stock options, so are taxes. Understanding your tax obligations and alternatives when exercising stock options is important so you know not only how much you can take home, but how much the IRS will let you keep. Many investors and stockholders consider exercising stock options before year-end and here are a few things to consider before you do the same.
STATUTORY VS. NONSTATUTORY STOCK OPTIONS
We often see rapid-growth tech companies and early-stage startups issue incentive stock options as an added incentive for new hires or as a tool for management teams to continue to reap the rewards of a successful launch. Many large and publicly-traded companies also include non-qualified stock options as part of their compensation packages, and they can be a lucrative source of additional income if managed wisely. Companies can issue two types of stock options; below are the main distinctions.
| STATUTORY:
Incentive stock options (ISOs) |
NONSTATUTORY:
Non-qualified stock options (NSOs) |
| Can only be granted to employees | Can also be granted to non-employees such as advisors and consultants |
| Limit of $100,000 per calendar year
(any amount over becomes NSOs) |
No limit |
| When exercised: the spread* is subject to alternative minimum tax | When exercised: the spread* is taxed as ordinary income |
| When sold: profit is taxed at capital gains rate as long as holding period requirements are met. Alternative minimum tax was likely paid at exercise and a credit may be allowed when disposed. | When sold: profit is taxed at short-term or long-term capital gains rate based on length of time held |
*difference between the exercise price and the current fair market value at the time of purchase
TAX IMPLICATIONS OF EXERCISING STOCK OPTIONS
While some companies may withhold tax when options are exercised (and not all do, so it’s important to find out); it is not a given that the amount withheld will satisfy your tax obligation. Tax on exercised stock options can vary based on the type of stock option and the individual’s current year tax situation. Once exercised, the treatment of the stock going forward is the same as normal stock; however, there are special rules regarding cost basis for both ISOs and NSOs.
Incentive Stock Option Tax
While exercising ISOs does not cause ordinary income, it will trigger an adjustment to AMT income that can have a material impact depending on the number of options exercised and the current spread between the exercise price and the fair market value. It is important to be aware of the amounts prior to exercising so that you are not faced with an unexpected tax bill.
ISOs are also subject to “qualifying disposition.” Once the stock has been purchased, it must be held for either two years from the grant date or one year from the exercise date, whichever is greater, in order to qualify for capital gains tax treatment. If sold prior to the required holding period, the sale is taxed as ordinary income, a much higher rate.
Non-qualified Stock Option Tax
When exercising NSOs, the spread is always treated as ordinary income. Again, depending on the amount of options exercised, this can result in a significant amount owed. Planning for the tax obligation in the overall transaction can substantially affect the outcome. Recently, one of our clients was able to execute a cashless exercise of NSOs by selling enough stock after exercising to pay both the taxes and the strike price, resulting in an all upside position.
When the purchased stocks are later sold, the profit is taxed at the long-term capital gains rate if held for longer than one year or the short-term capital gains rate if held for less than one year. If the value of the stock is lower than the purchase price at the time of the sale, the loss can be applied towards other capital gains in that year. (Dramatic losses can also be carried forward to offset future gains.)
FACTORS IN DETERMINING WHEN TO EXERCISE OPTIONS
Once stock options are fully vested, it is up to the recipient to decide if, when, and how much stock they want to purchase. Depending on taxpayer-specific items like the below, exercising options can help with your overall tax position and income for the year.
- Other income/losses for the current tax year and marginal tax bracket
- Availability of funds to use in the purchase of the stock (and to cover taxes)
- Expiration date of the stock options
- Upcoming IPO or major price-related events
Some additional contributing factors to consider when determining your approach include:
Stock Value
First and foremost is the value of the stock. Once there is a confidence level in the stock at the current share price, exercising fully-vested options allows the holder to take advantage of the strike price set at the time the options were issued and purchase the stock at a lower price than the current fair market value.
Current Holdings
Individuals who already hold stock in the company may consider exercising their options as soon as they are vested to start the clock on the holding period and attempt to shift what would be ordinary income to capital gains instead. But beware of holding too much stock in one company. A good general rule of thumb is to have no more than 10-15% of your total portfolio in any one stock.
Long-term Plans
For those who feel strongly about a company’s future, holding onto options (while keeping expiration dates in mind) can allow the value to grow without any tax consequences, versus exercising the options early and holding the actual stock, which creates taxable income as it increases in value.
Which brings us to another item of note – how long will the purchased stock be held? As mentioned earlier, if bought and sold in the same year, it will have a different tax treatment than if it is held for twelve months. Exercising options and immediately selling the stock is not necessarily a “good” or “bad” decision from a tax perspective; it all depends on the goal for those particular funds and the individual’s tax situation for the current year.
Given these factors and the nuances in the treatment of ISO tax and NSO tax, it is highly recommended to consult with a financial advisor and CPA before exercising options to determine the best approach to minimize your tax burden. We’d love to help you navigate the process. Contact us today!
Disclosure: Investment advisory services offered through WealthSource Partners, LLC (“WealthSource”). Tax advisory, bookkeeping, tax return preparation and filing services offered through David French & Associates, PLLC. WealthSource and David French & Associates, PLLC are independent and unaffiliated entities. All investments include the risk of loss and nothing herein should be construed as a guarantee of any specific outcome or profit, or construed as an offer to sell or a solicitation of an offer to buy any security. You should consult with your legal and tax advisors to determine how the information contained in this communication may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation. The information described herein is distributed for informational and educational purposes only and should not be construed as investment, tax or legal advice. Furthermore, the information described herein is derived from sources believed to be accurate, but no guarantee can be made as to its accuracy or completeness. Any opinions stated herein are current only as of the date of original publication and are subject to change without notice. WealthSource makes no warranties and is not responsible for your use of the information described herein or for any error, cost, loss, or penalty resulting from your use.
