You finally made it big! You landed a job as a C-suite executive or manager-level employee at a publicly traded company or a company that will soon go public. As a part of your compensation, you are offered a nice lot of stock options for every year of service. Now what? How do you exercise the options? When and how are you taxed on the granting, exercise, and sale of the options? Stay tuned for a great deal of helpful information regarding your new stock options.
The Granting of the Stock Options
The first step in your journey is the granting of the stock options by your employer. Often times, you will receive these options over time. For example, your employer grants you 100 stock options, and you will be able to exercise 20 per year for the next five years. Most commonly, you will receive incentive stock options for your service (shares held at least a year after exercise and 2 years after options were granted). There is often no tax due upon the granting of your stock options, so there is not much to worry about now.
However, you are not off the hook indefinitely. As we all know, the government will come for you one way or another. Non-qualified stock options are usually granted to the higher-level executives, and are not as favorably taxed. You will pay ordinary income tax rates as well as Medicare and Social Security (often not applicable due to income limits of these higher income earners) on the difference between the strike price and fair market value.
The Exercise of Stock Options
When you exercise your options (essentially purchasing the stock granted by your options), you are paying a pre-determined strike price (often times lower than the current fair market value). During this time, if you were granted incentive stock options, you will not be subject to ordinary income tax rates.
You think you are in the clear? Not so fast! At this time, the difference between the strike price and fair market value will be subject to the AMT (alternative minimum tax), which can often be as high as 28%. Although this is normally lower than the regular income tax rates, you will often be surprised that your state and real estate taxes, among other deductions, are not deductible when it comes to the AMT.
The Sale of Your Stock
Now it is time to sell your shares. When you get to this point, it is similar to any other sale of securities. Hopefully you have held the stock for more than a year, and you will be subject to the lower capital gains rates (most likely 15% or 20% depending upon your highest ordinary income rate), the 3.8% net investment income tax, and your state tax on the difference between the purchase price and sale proceeds.
Keep in mind that your AMT cost basis might be different from your regular cost basis due to the options already being subject to the AMT tax.
In summary, the granting of stock options can be a very exciting time, especially if you are new to the game. There are several tax implications to be mindful of throughout the process, including being subject to the AMT when exercising, and the payment of capital gains taxes on the sale of the stock.
If you don’t already have someone to assist you through the process, it is time to find an experienced and knowledgeable accountant. I hope the above information was useful for you. I look forward to assisting you with all of your future tax, accounting, and financial planning needs.