Employee stock options are used by many companies to compensate their workers. Many years ago, it was usually top level officers and managers who received compensation in the form of stock options. But over the years more employees of different levels started to receive stock options as part of their compensation.
Stock option compensation is especially common in the technology industry. But it is also prevalent among other industries as well. It is also commonly see with start-up companies since they may be relatively cash poor.
But compensating with stock options can also serve to attract, motivate, and retain employees by providing an opportunity to profit from ownership in the company.
According to the National Center for Employee Ownership, the 2014 General Social Survey revealed that approximately 8.5% of employees in for-profit-companies hold stock options or similar grants.
Compensation for services received in the form of stock options may be taxed differently depending on the type of stock option received.
Statutory stock options
These are options granted under an employee stock purchase plan or an incentive stock option (ISO) plan. In order for the option to remain a statutory stock option, you must:
- be an employee of the company granting the option (or a related company) and
- such employment must cover the period beginning on the date the option is granted, and end no less than 3 months (1 year if disabled) before the date you exercise the option.
If the above conditions are not met, the option will be a nonstatutory stock option.
Statutory Stock Options May Result in an Alternative Minimum Tax (AMT) Adjustment
You do not report any income upon receipt or exercise of a statutory stock option. However, if you exercise the option but do not dispose of the stock acquired in the same year, you may have an AMT adjustment.
The AMT adjustment is equal to the fair market value (FMV) of the stock when it is substantially vested, minus the strike price of the option. Any AMT adjustment will increase the basis in the stock for AMT purposes.
Stock is considered substantially vested if:
- you can transfer it, OR
- you don’t have a good chance of losing it (substantial risk of forfeiture)
Income Is Recognized on Statutory Stock Options When The Acquired Stock Is Sold
Income for regular tax purposes (non-AMT) on statutory stock options is recognized when the underlying stock is sold. The income is the proceeds upon sale minus the amount you paid for the stock.
The sale of the stock will be a capital transaction, and will generally be treated as a capital gain or loss. It must therefore be reported on form 8949 and schedule D.
Holding period is important when determining capital gain income. Long term capital gains are taxed at preferential tax rates. Your holding period for the property you acquire when you exercise an option begins on the day after you exercise the option.
However, any income may be taxed at ordinary rates (and reported as wages) if either of the following apply:
- The holding period requirement is not met
- The option is granted at a discount under an employee stock purchase plan
Holding Period Requirement for Statutory Stock Options
The holding period requirement is satisfied if you hold the stock until the end of the LATER of:
- the 1 year period after the stock was acquired
- the 2 year period after the option was granted.
Note, however, that you are considered to satisfy the holding period if you sold the stock to comply with conflict of interest requirements.
If the holding period requirement is not met, ordinary income will be limited to the FMV of the stock at exercise minus the exercise price. Any excess income on the sale will be treated as a capital gain. Any loss on the sale will be a capital loss.
Statutory Stock Options Are Granted At A Discount
An option is granted at a discount under an employee stock purchase plan when the option price is less than 100% (but not less than 85%) of the FMV of the stock. If this is the case and the holding period requirement is met, ordinary income results. It is computed as the spread between the FMV of the stock and the option price on the option grant date.
Any excess gain is a capital gain. If there is a loss on the sale, it is a capital loss and no ordinary income is recognized.
If the holding period is not satisfied and the option was acquired at a discount, ordinary income is equal to the difference between the stock FMV on the exercise date and the option strike price. The ordinary income in this case is not limited to your gain from the sale of the stock.
However, you increase your basis in the stock by the amount of this ordinary income. The difference between the increased basis and the sale proceeds is treated as a capital gain or loss.
Statutory Stock Option Tax Reporting By Employer
Ordinary income should be reported by your employer on your form W-2. If it is not, you are still responsible for reporting such income as wages.
You should receive a form 3921 from your employer if you exercise any incentive stock options during the year. If you exercise stock from an employee stock purchase plan, you should receive form 3922.
These forms will include information necessary to report the correct amount of capital gains or ordinary income (if applicable) on your tax return. Keep these forms with your records.
Make Sure You Report the Correct Basis When You Sell Stock Acquired Via Employee Options
Ordinary income reported as wages increases your basis in the related stock. Failure to reflect this adjustment to your stock basis can result in an overstatement in your capital gain. This can in turn result in an overstated tax liability.
When you sell stock, you receive Form 1099-B from the IRS reporting such sales. This form reports the proceeds received, and usually the cost basis of the stock. However, the amount you report as ordinary income (wages) on the sale of the stock may not be reflected in your basis. So it may be up to you to make the appropriate basis adjustments.
Nonstatutory Stock Options
Any option which is not a statutory stock option falls under this category. If you receive a nonstatutory stock option, you will generally have income at the time you receive the option as long as if its (FMV) is readily determinable.
If the FMV is not readily determinable at the time the option is granted, you do not have income until you exercise or transfer the option.
You may exercise a nonstatutory stock option which did not have a readily determinable FMV when it was granted. In such a case, the amount recognized as income is the FMV of the stock (when it becomes substantially vested) minus the amount you pay for it.
Income from nonstatutory stock options should be reported by your employer as wages on your Form W-2.
When you sell stock acquired via a nonstatutory stock option, treat it as you would any other stock sale, and report it on form 8949 and schedule D. The basis in the stock will be the amount you paid for it plus any amount which was included in income upon grant or exercise of the option.
Your holding period begins on the date you acquired the option if it had a readily determinable FMV, or on the exercise date otherwise.
Employee stock options can be a key component of compensation for many workers. But the related tax issues of these options can be tricky. Nonetheless, armed with a little knowledge about the topic you should be able to navigate the complexities. At the very least, you will know what questions to ask your tax professional or your employer.