Taxation When Exercising Stock Options
Stock options are derivative contracts that grant the holder the right, although not the obligation, to purchase or to sell a specified amount of an underlying equity security at a specified price during a specified period of time. In the United States, the taxation of stock options can range from relatively straightforward to extremely complex, depending on the nature of the stock options, related transactions and category of investor.
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General
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In general, the Internal Revenue Service (IRS) treats the taxation of stock options in the same manner as any other capital asset. When the holding period of the stock options is equal to or less than a year, the gain or loss on the option is considered short-term and is taxed at ordinary income tax rates. When the holding period of the stock options exceeds one year, reduced income tax rates apply to any gains generated on the transaction, known as long-term capital gains.
Features
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The majority of standardized exchange traded stock options have durations of less than 12 months and thus, in and of themselves, would only qualify for short-term capital gain treatment. The exercise of long stock options (purchasing and retaining the underlying stock), however, may qualify the investor for long-term capital gain treatment on the entire transaction if held in excess of one year. In addition, investors assigning a short option (hedging risk on the ownership of stock) may need to treat the entire transaction as one event when computing gain and loss. This can become highly technical.
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In the Money Calls
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IRS rules also limit the ability to claim long-term capital gain treatment on stock when writing stock option calls that are deeply in-the-money. In-the-money is a term used to describe calls that have an exercise price in excess of the market price of the underlying stock. Writing, or selling, in-the-money call options may be used by investors to reduce the risk in holding a stock while effectively receiving cash for a large portion of the stock's value.
Investor versus Trader
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In addition, the IRS has different taxation rules for investors and traders. The IRS considers investors to be taxpayers who purchase stocks and options primarily for capital appreciation and dividends--a long-term investment approach. Meanwhile, traders are considered to be those who trade regularly and continuously, seeking to profit from short-term fluctuations in the value of stocks and options. Qualifying as an investor may allow option traders to qualify for mark-to-market treatment--recording the price at its current market value rather than its book value--and avoid IRS wash sale rules, which limit losses but not gains.
Significance
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There are numerous technical specifics regarding the tax treatment and reporting of options. For example, one type of treatment, Section 1256 contracts, allows traders to report certain dealer equity options and broad-based stock index options at mark-to-market (market value of the option at year-end) and with 60 percent of the gain-loss recognized as long-term and 40 percent as short-term.
In addition, there are specific rules covering options granted as compensation, typically known as employee stock options.
Taxpayers should always consider consulting a professional when dealing with the tax consequences of stock options.
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