Stock Options That Are Federal Withholding Exempt
For tax withholding purposes, the Internal Revenue Service recognizes two types of stock options programs: incentive stock options and nonqualified options. Incentive stock options receive greater tax benefits, since they're not treated as income and subject to income tax withholding; these options are usually only extended to CEOs and other members of a company's board. Nonqualified options are granted to a wider range of employees, but are subject to income tax withholding.
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ISOs and Income Tax
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Incentive stock options are an attractive part of any compensation package because they're not taxed as income in the year in which they are issued. Because of this, deferred compensation packages that include ISO packages reduce taxpayer's ultimate tax liability, providing tax-free options to purchase stock at a later date in lieu of traditional compensation. Incentive stock options come with a small downside: unlike traditional wage-based compensation, those who receive incentive stock options must wait until the options mature to capitalize on the compensation package.
Gains Tax on Exercised Options
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Incentive stock options aren't entirely out of the taxman's grasp, however. Although those who receive them don't have to report them as income, they're still subject to capital gains taxes on the difference between the stock's excise price (the price stock is sold as part of the option agreement) and the price at which it was sold. For example, 100 shares of stock purchased with a $20 per share excise price and sold on the market for $32 per share, creates $12 of gains per share, or $1,200 in taxable gains for the entire transaction. Capital gains taxes are generally more favorable than income-tax rates, and they're assessed on a variable scale where the amount of time an option was held before excising it, the amount of time a stock was held after exercising the stock option and income brackets used in figuring gains tax rates.
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Alternative Minimum Tax
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Employees who exercise a stock option but hold the stock for at least a year are subject to reporting the stock as part of the alternative minimum tax. Taxpayers must report the bargain-price differential between the excise price and stock value as part of calculations figuring their AMT. For example, 100 shares of stock purchased for $10 per share in May and held at the end of the tax year, when the stock is valued at $12 per share, the bargain value of $2 per share, or $200 total, must be reported as part of calculating the AMT.
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References
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