Taxes on Employee Share Options
It is critical that you remain informed of tax ramifications concerning your use of employee share options. Tax law associated with employee stock options is highly complex, because these vehicles combine employee compensation alongside an investment component. To plan effectively, you must first learn the basics of how employee stock options actually work.
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Identification
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Employee stock options grant you the right to purchase shares of company stock at a set strike price. You exercise, or use, options to buy stock when your strike price is lower than the corporation's stock market price. For example, you may have been granted Corporation Z stock options to purchase company shares at $50. You would exercise these options if Corporation Z were to trade above $50 in the market.
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Tax considerations come into play when you actually exercise employee options, and not when the stock options were originally granted. When you exercise options to buy shares, you may immediately be responsible for paying ordinary income taxes. In the future, you may owe capital gains taxes when you sell the shares you bought through options at a profit.
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Ordinary Income Taxes
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On employee stock options, the difference between your strike price and stock market value may be treated as compensation. Compensation is subject to ordinary income tax rates, which may be as high as 35 percent. For example, you may exercise options on Corporation Z at a strike price of $50 per share when it trades for $95 in the market. For the tax year, you may owe ordinary income taxes on $45 worth of compensation.
Capital Gains Taxes
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You owe taxes on realized capital gains when you sell shares of stock at a profit. When trading shares through employee stock options, a stock's cost basis is actually its market value at the time you exercised the options. With Corporation Z, you exercised options at a $50 strike price to buy into the company when it was trading at $95. After three years, you then sold Corporation Z shares for $120. After the sale, you will owe capital gains taxes on $25 ($120 - $95) in profits. Capital gains tax rates range between zero and 35 percent.
Incentive Stock Options
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Incentive stock options are a special class of options where you may only be responsible for capital gains taxes on acquired stock. To qualify for this favorable tax treatment, you must hold shares of stock for at least two years after your original option grant date, and for at least one year after you exercised options. If shares are sold earlier than the qualifying holding period, you may owe both ordinary income and capital gains taxes on your series of incentive stock option transactions.
When calculating capital gains, your strike price represents the initial cost basis. For example, you could have exercised incentive stock options to buy Corporation X shares at a $15 strike price when it actually trades for $25. After four years, you sell Corporation X shares for $75. You would then owe capital gains taxes on $60 worth of profits ($75 - $15).
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