The underlying principle behind the taxation of stock options is that if you receive income, you will pay tax. Whether that income is considered a capital gain or ordinary income can affect how much tax you owe when you exercise your stock options.
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There are two main types of stock options:
- Employer stock options
- Open market stock options
Receiving an employer stock option
The two main types of stock options you might receive from your employer are:
- Incentive stock options (also known as statutory or qualified options, or ISOs) and
- Non-qualified stock options (aka non-statutory options or NSOs)
These employer stock options are often awarded at a discount or a fixed price to buy stock in the company. While both types of options are often used as bonus or reward payments to employees, they carry different tax implications.
The good news is that regardless of the type of option you are awarded, you usually won't face any tax consequences at the time you receive the option.
No matter how many statutory or non-statutory stock options you receive, you typically don't have to report them when you file your taxes until you exercise those options unless the option is actively traded on an established market or its value can be readily determined. This exception is rare but does happen at times.
Exercising an option
When you exercise an option, you agree to pay the price specified by the option for shares of stock, also called the award, strike, or exercise price.
For example, if you exercise the option to buy 100 shares of IBM stock at $150/share, at the time of exercise you'll effectively exchange your option for 100 shares of IBM stock, and you'll no longer have the right to buy additional IBM shares at $150/share.
- When you exercise an incentive stock option (ISO), there are generally no tax consequences, although you will have to use Form 6251 to determine if you owe any Alternative Minimum Tax (AMT).
- However, when you exercise a non-statutory stock option (NSO), you're liable for ordinary income tax on the difference between the price you paid for the stock and the current fair market value.
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If you exercise a non-statutory option for IBM at $150/share and the current market value is $160/share, you'll pay tax on the $10/share difference ($160 - $150 = $10).
For example:
- 100 shares x $150 (award price)/share = $15,000
- 100 shares x $160 (current market value)/share = $16,000
- $16,000 - $15,000 = $1,000 taxable income
Since you'll have to exercise your option through your employer, your employer will usually report the amount of your income on line 1 of your Form W-2 as ordinary wages or salary and the income will be included when you file your tax return.
Selling stock
When you sell stock you've acquired via the exercise of any type of option, you might face additional taxes.
- Just as if you bought a stock in the open market, if you acquire stock by exercising an option and then sell it at a higher price, you have a taxable gain.
- If you satisfy the holding period requirement, by either keeping the stock for 1 year after exercising the option or 2 years after the grant date of the option, you will report a long-term capital gain, which is usually taxed at a lower rate.
- If you don't meet the holding period requirement, your gain is considered short-term and taxable as ordinary income.
You should report a long-term gain on Schedule D of Form 1040. A short-term gain will typically appear in box 1 of your W-2 as ordinary income, and you should file it as wages on Form 1040.
Open market options
If you buy or sell a stock option in the open market, the taxation rules are similar to options you receive from an employer. When you buy an open-market option, you're not responsible for reporting any information on your tax return.
However, when you sell an option—or the stock you acquired by exercising the option—you must report the profit or loss on Schedule D of your Form 1040.
- If you've held the stock or option for less than one year, your sale will result in a short-term gain or loss, which will either add to or reduce your ordinary income.
- Options sold after a one-year or longer holding period are considered long-term capital gains or losses.
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