Tax Considerations For Stock Options

Brandon R. Amaral, CFP®, EA
Brandon R. Amaral, CFP®, EA

Founder & Financial Planner, Amaral Financial Planning

Working for a tech start-up or private company can be very exciting. From flexible schedules to working remotely, there are a lot of perks that make staying worth your while. One of the most popular benefits is offering employees stock options.

Stock options can be just as risky as they can be lucrative. While you have likely heard stories of overnight millionaires, there are just as many people who have lost money and had large surprise tax bills. It is important to be aware of the tax consequences before exercising or selling your stock options.

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Here are tax considerations you should take when exercising and selling your stock options:

Exercising Your Options

Once you have been granted the option to purchase stock in your company and have satisfied the vesting period requirements, you will be able to exercise (purchase) the stock options.

Non-Qualified Stock Options

One of the most common types of stock options that are offered is NSOs (Non-Qualified Stock Options). These are typically offered to employees, consultants, directors, business partners, and advisors.

When you decide to exercise your NSOs, the difference between your strike (purchase) price and the current fair market value of the shares will be reported as taxable ordinary income. This means that you will need to pay Federal, State, Social Security, and Medicare taxes. You will need to write your company a check for the taxes owed (if your company is private) or you can elect to have shares sold to cover taxes (if your company is public).

Incentive Stock Options

The more preferred type of stock option offered is ISOs (Incentive Stock Options). These can only be offered to employees, and not consultants or advisors.

For ISOs, the difference between your strike price and the current fair market value is reported as an AMT (Alternative Minimum Tax) preference item rather than as taxable ordinary income. This means that if the fair market value is still close to your strike price, you could potentially exercise your shares without triggering any tax liability. It is important that you work with a tax professional to determine if you will be triggering any AMT.

Selling Your Options

Once your company has gone public and you are out of any trading lock-up or blackout periods, you will have the opportunity to sell your shares on the market.

Same-Day Sales

Whether you didn’t have the funds to exercise your shares before or were still completing your vesting period, you may want to exercise and sell your shares right away.

When you complete a same-day sale, or cashless exercise, you don’t actually need to pay cash for the shares. Instead, you use a short-term loan from your brokerage firm to purchase, and then the sales proceeds are used to repay the loan. For both NSOs and ISOs, the difference between your purchase and sales prices will be reported as taxable ordinary income, and Federal, State, Social Security, and Medicare taxes will be withheld. Depending on your income, you might also be subject to the Additional Medicare tax of 0.9%.

Short-Term Capital Gains

Another common situation is to exercise your shares and later sell them in a few months. In this situation, you would recognize a short-term capital gain.

For NSOs, you would have realized ordinary income on the day you exercised. Any change in value will be reported as a capital gain or loss. When it comes to filing your taxes, you will want to make sure that your cost basis is adjusted to include any income that was already reported on your W-2. Depending on your income, you might also be subject to the Net Investment Income tax of 3.8%.

Long-Term Capital Gains

For those that are fully vested and exercised their options over a year ago, you will recognize a long-term capital gain.

For ISO, you must hold your options for more than one year from the date of exercise and two years from the time of the grant to qualify for more favorable tax treatment. Because this is considered a qualifying disposition, there will be no income included on your W-2 from the exercise or sale. Depending on your income, you might also be subject to the Net Investment Income tax of 3.8%.

Understanding how stock options are taxed is important to optimizing your finances and reducing your tax bill. If you would like to work with a financial planner to walk you through your options, I would love to help you!

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Disclaimer: This blog is for informational purposes only, and should not be considered advice or recommendations. All opinions expressed herein are solely those of Amaral Financial Planning, LLC, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made to another parties’ informational accuracy or completeness. You should consult your financial advisor, tax professional or legal counsel prior to implementation.