Federal Taxes on Employee Stock Options
Stock options have complex tax ramifications for both the employee who gets them and potentially for the employer. Fortunately, there are only a few basic scenarios in which stock options are taxed. Each of these scenarios is well-understood by tax professionals, so it's possible for an option owner to file simply and easily.
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Paying Taxes on Stock Option Grants
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Rule 409A is a set of guidelines for when options are considered taxable income on the date that they are granted. Most companies are able to comply with these guidelines, ensuring that they can grant employees options without the employees owing taxes on that immediate grant. This makes options a tax-efficient and cash-efficient means of compensation, since they provide some value to the employee without either costing the employer cash flow or creating an immediate tax liability.
Exercising and Selling Options
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When an option reaches the end of its term, an investor can exercise it and potentially sell their stock. When an option is exercised, the owner pays the "strike" price of the option, and gets shares at that price. If the market price of the stock is higher than the strike price, the investor makes a profit on this transaction. However, to realize this profit the investor must sell the shares purchased through the stock options.
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Short-Term Capital Gains
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If an investor sells these shares immediately, they are treated as short-term capital gains and taxed at 20 percent. In this case, according to tax law, the investor has made a short-term trade: he or she purchased stock, and immediately sold it. This tax liability only applies to the profits from the trade, not to the total amount derived from the trade. So if an investor buys $20,000 worth of stock for $15,000, he or she will owe taxes on the $5,000 difference.
Long-Term Capital Gains
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If an investor exercises stock options but then sells the stock a year or more later, the total tax burden is 15 percent of capital gains, not 20 percent. This strategy requires investors to tie up some resources on buying the stock, which can be costly. It also creates a risk: an investor may show a profit when they exercise their options, but show a loss a year later. Investors who borrow money to exercise their options may lose even more money.
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References
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