When an employee decides to exercise stock options, they may end up with an unexpected tax liability. To mitigate that, it’s essential to understand the kinds of stock options that were granted to you and the consequences of the exercise of your stock options.
First, let’s get some basics:
Stock options can be:
Why are they called “statutory”? When employers decide to issue those stock options, they choose to comply with certain “statutory” requirement (requirements set by law/statute), in exchange their employees get special treatment. That special treatment is: no taxable event takes place not at grant of option, not even at the exercise of the option, only when the underlying stock is sold. And even then, the underlying gain would be considered capital gain (if all other requirements are met).
There are two kinds of statutory stock option:
1. Incentive stock options
2. Stock options issued under the employer stock purchase plan
Incentive stock options (ISO)
In general, those options are granted for any reason connected with your employment. To be eligible for ISO treatment three things must happen:
1. Option must satisfy a number of requirements set out in the statute (hence, “statutory”) – we will discuss those requirements a bit later
2. Employee to whom the option is granted (you) must satisfy two “holding period requirements”
– you cannot sell the stock before the later of:
– the two year period from the date of the grant of the option OR
– the one-year period from the date of transfer of the stock to you
So, you must hold the stock until the later of: two years after you got the option or one year after you got the stock.
If you dispose of the stock before satisfying two holding period tests, you may have disqualifying disposition. The effect of that is income you get from sales of stock (less your cost – the exercise price of option) = your compensation.
You need to be aware of the two dollar limitations:
1) Percentage limitation on the total number of shares you can acquire under ISOs
At the time the option is granted to you, you may not own more than 10% of the voting stock of the corporation. This limitation would not apply if, at the time the option is granted, the option price is at least 10% higher than the fair market value of the stock and the option must be exercised within 5 years of the date of grant.
2) Annual dollar limitation on the amount of stock for which you may be granted ISOs
If your ISO was granted after 1986, follow this steps:
1. Get the fair market value of stock on the date of grant of option
2. Multiply the FMV from #1 by number of options you could have exercised for the first time during the calendar year – so, in essence, this is the value of the additional “perk” you received as an employee of the company.
3. Does that amount from #2 exceed $100,000? If yes, some of those options would not be ISOs.
Let’s calculate how much:
Take the number you got in #2 (the value of your “perk”) and subtract $100,000. Then divide the result by the FMV of the stock you got in number 1.
What you have here is the number of “excess” shares that would not be able to get that special ISO treatment as the statute only allows $100,000 in that “perk” to be received by you.
That number of “excess” shares will not be considered ISO and will be treated as nonstatutory stock options.
Back to the statutory requirements for an option to be an ISO:
1) The employer must have a written/electronic plan to grant those options.
2) That plan must specify the total number of option shares that may be issued and the employees who actually can receive the options
3) That plan must be approved by shareholders within 12 months before or after the date of adoption
4) The option must be granted within 10 years of earlier of the plan adoption or shareholder approval
5) The option must not be exercisable after 10 years from grant date
6) Option price must not be less than the fair market value of the stock when option is granted.
7) Employee cannot transfer the option (only if he or she dies)
8) Option must be exercisable only by employee during his or her lifetime.
There is also annual dollar limitation on options that qualify for ISO treatment.
All other stock options are nonstatutory.
What happens when we exercise incentive stock options?
1. We have no regular tax liability until we sell the stock.
2. BUT we may have alternative minimum tax liability. We include in our income for alternative minimum tax the difference between the fair market value of stock and exercise price of the option once your rights became fully vested. So you can follow the same process as we did for the nonstatutory stock options.
Now, if you dispose of the stock in the same year you include the gain in income for AMT purposes, that gain is limited to the difference between the amount you sold the stock for and the price you paid for the stock.
2. Nonstatutory Stock Options
If the option has an “ascertainable fair value” at the time it is granted to you, that fair value becomes part of your compensation (it is taxed to you as ordinary income).
Option does NOT have “ascertainable fair value” at the time it is granted to you (like when you join a start up/company that’s not publicly traded) – no taxable event occurs until you exercise/dispose of the option.
If the stock went up between the date you got the option and the date you exercised the option, that increase in value of the stock becomes part of your compensation (and it is taxed as ordinary income).
However, most times when you are granted the nonstatutory stock option, they are given to you with some kind of conditions (you are to work for the company for 2 years, etc.). If that’s the case, the stock is not considered vested (“belonging to you”) until those conditions are satisfied or removed. So that increase in value will be added to your compensation only when your rights in ownership of that stock become “substantially vested.” And after that any additional increase in value of the stock will be taxed at capital gain rates.
So we have several major time points to keep in mind when we think about tax consequences of nonstatutory stock options:
1) Date of grant of options
2) Date of vesting (conditions removed or satisfied)
3) Date of exercise of option (you purchase the stock at the option price)
4) Date of sale of the stock you bought.
You will need to know the value of the stock at every one of those time points.
The increase in value of the stock between 1 and 2 –> your compensation at date 2 (ordinary income)
The increase in value of the stock between 2 and 4 –> capital gain
The information above takes into consideration the legal guidance as of December 2015. As the law changes, your tax consequences of the stock option exercise may change too. It’s always best to consult your tax professional and get advice tailored to your particular situation.