Exercising stock options has immediate and delayed tax implications, which you can manage for maximum tax benefit by staying aware of key elements. The tax assessed on exercised stock options depends upon the type of option and when the acquired stock is sold.
Regular or ISO
Employees usually receive regular stock options, but may be granted incentive stock options (ISOs). Income tax is assessed in the year regular stock options are exercised. The taxable income is the “bargain element”—the difference between the cost to exercise the option and the market value of the acquired stock. The bargain element is taxed as ordinary income and added to the W-2 of the employee. Since tax is owed simply from exercising the options, an employee may need to sell at least some of the stock in order to pay the income tax withholding on a paycheck.
There are special tax features embodied in ISOs. The bargain element is not taxed as ordinary income in the exercise year. However, the bargain element is added to income using the Alternative Minimum Tax (AMT) calculation. Employees subject to the AMT will owe additional tax from exercising ISOs. Alternatively, a large bargain element may result in AMT for an employee who would not otherwise be subject to this tax.
When stock acquired from exercising ISOs is sold upon exercise, the bargain element is added to ordinary income just as if the transaction had involved regular stock options.
Selling Regular Options
When stock is sold that was acquired from exercising regular stock options, there is a capital gain. The gain is the difference between the sale proceeds and the cost basis. To determine a basis, the cost of exercising the option is added to the bargain element already taxed as ordinary income. If the stock is sold more than one year after exercise, the gain will be taxed at more favorable long-term rates than a short-term gain occurring in one year or less.
When stock is sold that was acquired from exercising ISOs, the tax implications depend upon when the sale occurs. If the stock is sold more than one year after exercising the options and more than two years after the options were granted, there are special tax implications. This qualified sale receives favorable long-term capital gain treatment on the difference between the sale proceeds and the cost for exercising the options. If both conditions are not met, the bargain element is added to ordinary income in the year of stock sale. That causes tax on the bargain element at a higher rate than long-term capital gain.
If the stock is sold more than one year after option exercise but less than two years after option grant, the transaction is still a long-term capital gain. However, the basis is the bargain element plus the original cost to exercise the options.
When the stock is sold in a different year than the exercise year, another AMT calculation is made. The basis in the stock under AMT is different than under the regular income tax system because the bargain element is added to basis for AMT in the exercise year.