Understanding the nature of stock options , taxation and the impact on personal income is key to maximizing such a potentially lucrative perk. Income does not need to be reported when the options are granted or when exercised, only when the stock is sold. To begin, employees are typically not granted full ownership of the options on the initiation date of the contract, also know as the grant date. If you're an employee or were an employee when you received the option , the company is required to withhold when you exercise your option. Individuals abroad and more. Incentive stock options ISO receive special tax treatment:
The bargain element of a non-qualified stock option is considered "compensation" and is taxed at ordinary income tax rates. For example, if an employee is granted shares of Stock A at an exercise price of $25, the market value of .
BREAKING DOWN 'Non-Qualified Stock Option (NSO)'
If the regular amount is greater, you can claim that as a credit, and carry forward any unused credits for future years. This explanation is, of course, the simplified version of a potentially complex matter. Anyone potentially subject to the AMT should use a tax advisor to make sure everything is done appropriately.
One way to deal with the AMT trap would be for the employee to sell some of the shares right away to generate enough cash to buy the options in the first place. So an employee would buy and sell enough shares to cover the purchase price, plus any taxes that would be due, then keeps the remaining shares as ISOs.
For instance, an employee might buy 5, shares on which he or she has options and keep 5, But the employee will have more than enough cash left over to deal with this. Another good strategy is to exercise incentive options early in the year. That's because the employee can avoid the AMT if shares are sold prior to the end of the calendar year in which the options are exercised.
John holds on to the shares, but watches the price closely. John is a higher-income taxpayer. If, however, John sells before December 31, he can protect his gains. The rule here is that is the sale price is less than the fair market value at exercise but more than the grant price, then ordinary income tax is due on the spread.
On the other hand, if in December the stock price still looks strong, John can hold on for another month and qualify for capital gains treatment. By exercising early in the year, he has minimized the period after December 31 he must hold the shares before making a decision to sell. The later in the year he exercises, the greater the risk that in the following tax year the price of the stock will fall precipitously. If John waits until after December 31 to sell his shares, but sells them before a one-year holding period is up, then things are really bleak.
He is still subject to the AMT and has to pay ordinary income tax on the spread as well. Fortunately, almost in every case, this will push his ordinary income tax above the AMT calculation and he won't have to pay taxes twice. Finally, if John has a lot of non-qualified options available, he could exercise a lot of those in a year in which he is also exercising his ISOs. This will raise the amount of ordinary income tax he pays and could push his total ordinary tax bill high enough so that it exceeds his AMT calculation.
That would mean he would have no AMT next year to pay. It is worth remembering that ISOs provide a tax benefit to employees who willingly take the risk of holding on to their shares. Sometimes this risk does not pan out for employees.
Moreover, the real cost of the AMT is not the total amount paid on this tax but the amount by which it exceeds ordinary taxes. The real tragedy is not those who take a risk knowingly and lose, but those employees who hold onto their shares without really knowing the consequences, as the AMT is still something many employees know little or nothing about and are surprised too late to learn they have to pay.
Email this page Printer-friendly version. You might be interested in our publications on this topic area; see, for example: If I'd Only Known That True stories illustrating common mistakes in implementing and operating equity compensation plans and what to do about them. Model Equity Compensation Plans Sample plan documents and brief explanations for employee stock option and stock purchase plans includes CD.
Securities Sources for Equity Compensation, ed. A book with source documents for those working with equity compensation. Performance-Based Equity Compensation Provides the insight needed to create and manage a successful performance equity program.
However, the employee will pay income tax against the difference with market share price of the stock when the option is exercised. Once the options are exercised, the employee can choose to sell the shares immediately or retain them. As with other types of stock options, non-qualified stock options can be a way to reduce the cash compensation that companies pay directly to their employees while also connecting part of their compensation to the growth of the companies.
The terms of the options may require employees to wait a period of time for the options to vest. Furthermore, the employee could lose the options if they left the company before the stock options are vested.
There might also be clawback provisions that allow the company to reclaim NSOs for a variety of reasons. This can include insolvency of the company or a buyout. For smaller and younger businesses with limited resources, such options that can be offered in lieu of salary increases.
They can also be used as a recruiting tool to make up for shortcomings in the salaries offered when hiring talent. What is a 'Non-Qualified Stock Option NSO ' A non-qualified stock option NSO is a type of employee stock option wherein you pay ordinary income tax on the difference between the grant price and the price at which you exercise the option.
An option agreement is a legal contract between two parties outlining Stock options can be lucrative for employees who know how to avoid unnecessary taxes. To make the most of employee stock options it's key to understand their risks, tax consequences and how they fit into your financial plan.
Know these things and talk to a professional to get the most out of your employee stock options.
What's an Employee Stock Option?
Jan 31, · Refer to Publication for specific details on the type of stock option, as well as rules for when income is reported and how income is reported for income tax purposes. Incentive Stock Option - After exercising an ISO, you should receive from your employer a Form pdf, Exercise of an Incentive Stock Option Under Section (b). Non-Qualified Stock Options (NQSO) Frequently Asked Questions Do you know the tax implications of your non-qualified stock options? For general information, request Michael Gray’s special report, “Non-Qualified Stock Options – Executive Tax and Financial Planning Strategies”. Qualified vs. Non-qualified Stock Options Diffen › Finance › Personal Finance › Taxation Depending upon the tax treatment of stock options, they can be classified as either qualified stock options or non-qualified stock options.