Tax Calulation on Stock Options
Stock options are contracts conferring the right to buy (call options) or sell (put options) a stated number of shares at a specified price, called the exercise or strike price. The option contract is good until a specified expiration date. Some stock options receive different tax treatment than others, so calculating taxes varies accordingly.
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Employee Stock Options
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Non-qualified and qualified (or incentive) stock options are call options granted by companies to employees. If the company's stock price rises above the strike price, the employee can exercise the option, sell the stock at the market price and make a profit. As the name suggests, profits from non-qualified stock options are taxed as ordinary income and may not qualify for favorable capital gains tax rates. According to Smart Money, profits from qualified stock options are considered long-term capital gains provided IRS rules are followed. The employee must wait at least one year after the options are granted to exercise them and then hold the stock for at least a year before selling it.
Traded Options
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Traded options are securities bought and sold on markets like the Chicago Board of Options Exchange. If the underlying security for an options contract is a capital asset such as stock, profits from traded options is treated as short- or long-term capital gains. For the most part, investors rarely hold traded options for very long, so profits are short-term capital and taxed as ordinary income. However, occasionally a trader may hold an options contract for more than 365 days. According to the website Trade Log, in this event profits from a stock option contract qualify as long-term capital gains.
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Cost Basis
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Before taxes can be calculated on stock options profits, you must figure out the cost basis of the investment. The procedure is the same for any type of stock option. Cost basis is equal to the price paid for the option contract (for employee stock options this is zero) plus the exercise price plus any transaction costs like brokers commissions. Subtract the cost basis from the total proceeds of the stock sale to find the total capital gain or loss. If the option is allowed to expire, it becomes worthless, so any expenses incurred are a capital loss. Losses may be taken as a tax deduction to offset capital gains or other income.
Tax Calculation
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Nonqualified stock options and short-term capital gains from traded options are taxed as ordinary income at your marginal tax rate. Marginal tax rate is the highest percentage income tax bracket you pay on ordinary income like wages. For instance, if you made $5,000 on a stock option transaction and your marginal tax rate is 25 percent, the income tax you owe equals 25 percent of $5,000 or $1,250. The calculation is the same for profits on qualified stock options and traded options that qualify as long-term capital gains, except you use the lower capital gains tax rates. Suppose you have $5,000 in long-term capital gains from an options contract. According to the website Fairmark, if your marginal tax rate is 25 percent or higher, you would pay the maximum capital gains tax rate of 15 percent and your tax would be $750. If you fall into a lower tax bracket, the long-term capital gains rate is zero.
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