Taxation of Non-Qualified Stock Options
Most employees receiving stock options as part of their benefit package receive non-qualified stock options. Non-qualified stock options straddle the realms of income tax and the more favorable capital gains tax, which can become confusing.
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Terms and Definitions
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"Stock options" allow employees to buy company stock below market price, adding to employees' total compensation without costing the company extra cash. Companies offer two types of options: incentive and non-qualified (the IRS prefers the terms "statutory" and "nonstatutory"). Employees exercise options when they buy company stock at a discount.
Taxes
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The IRS states that employees may owe taxes on stock options upon receiving the options, exercising the options to buy company stock and selling the stock on the market. Non-qualified stock options require employees to pay income taxes when exercising options, but remove the need to pay for receiving options.
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Exercise Tax
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The IRS taxes the act of exercising non-qualified stock options. When you exercise your options, you must report the difference between the discounted price and the market price as income in that tax year's return. Usually, you have a specified number of years to use stock options. In a 2000 article, USA Today columnist Sandra Block recommended reviewing your tax information before using your options to determine whether exercising options will place you in a higher tax bracket for that year.
Capital Gains Tax
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Once you exercise the options, you have the choice of selling the stock immediately, adding the profit to your income and paying tax on it once, or holding. Holding adds the possibility of greater profits, and holding the company stock for more than a year makes any profit subject to the favorable capital gains tax, which for most people is 20 percent. If you hold the stock for several years and sell at a profit, you still have to pay additional taxes, though the IRS counts the profit as a capital gain, not income, and taxes it as such.
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References
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