- What Is the Tax Rate on Stock Options?
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- How Stock Options Are Taxed & Reported
Many taxpayers will use a financial advisor to help them develop the best tax strategy for their investments. While both are non-traditional forms of compensation, the two types of stock options work differently. Employees are more likely to receive NQSOs. If the value of the stock goes up, you have the ability to sell it for a profit. Incentive stock options are similar to NQSOs but they include a special tax provision, discussed below, which makes them more attractive for employees. Executives or other high-ranking officials at a company are more likely to receive ISOs.
Thus, the income attributable to the exercise of the option the FMV of the stock at the time it is substantially vested less the exercise price is treated by the option holder as ordinary compensation income for regular tax purposes in the tax year the disqualifying disposition occurs. However, if the disqualifying disposition of the stock is a sale or exchange for a price less than the price of the stock at exercise, the amount that is includible as compensation attributable to the exercise of the option is limited to the excess if any of the amount realized on the sale or exchange over the adjusted basis of the stock.
What Is the Tax Rate on Stock Options?
If the disqualifying disposition occurs in the same year as the exercise, the tax treatment is similar to that for an NQSO, with the bargain element in the stock at the time of exercise being ordinary income for the option holder in the year of exercise for both regular tax and AMT purposes, so that no AMT adjustment is necessary in that year.
If the stock is disposed of in a disqualifying disposition for an amount greater than the FMV of the stock at exercise, the character of the amount of gain is determined under the Sec. AMT considerations and planning opportunities. Between the limitation and removal of typical itemized deductions that have caused taxpayers to be subject to the AMT, plus an increase in the AMT exemption amount, an environment has been created where many individuals who have historically been subject to the AMT will no longer find themselves in that situation.
Individuals with high ordinary income, such as wages, could be even further immunized from the AMT regime. On the surface, a taxpayer's being subject to the AMT in the year of exercise seemingly thwarts the strategy behind owning ISOs. This situation somewhat hinders the option holder's enjoyment of the coveted ISO benefits. It is important to remember that all is not necessarily lost if clients find themselves subject to the AMT during the year of exercise due to the AMT credit, which is explored further below.
The following are some planning options associated with ISOs:. Exercising and immediately selling will trigger a disqualifying disposition. Similar to the strategy discussed in the NQSO section, this strategy may appeal to those clients looking to limit their cash outlay or exposure to a concentrated position in company stock. The options are exercised and the shares are sold more than two years after the grant date and more than one year after exercise.
The tax results of a qualifying disposition are described above. As noted, in this scenario, appreciation in the value of the stock above the exercise price will be taxed at long - term capital gains rates. Intentional disqualifyingdisposition. Prior to the dot - com bubble of the late s, many individuals in the tech industry exercised highly valued ISOs, incurring a large AMT liability on top of the price paid to exercise options. After the market crash and subsequent rapid devaluation of their position, some were left holding stock worth significantly less than the price they paid to acquire it and were unable to pay the AMT incurred due to the exercise of the ISOs.
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A method to potentially avoid a disaster like this would be to exercise early in the year, or some other time that is deemed advantageous, and track the stock value throughout the year. If the value greatly depreciates, the stock can be sold before year end. This would intentionally trigger a disqualifying disposition, thus avoiding the positive AMT adjustment and any accompanying AMT tax liability.
This is a mix of the exercise - and - sell and the exercise - and - hold strategies.
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Like the strategy discussed in the NQSO planning section, this can be used to improve cash flow during the exercise event. The immediate sale of the shares to cover the AMT is a disqualifying disposition. The remaining shares received can be held for future appreciation and, if the holding period requirements are met, favorable qualifying disposition treatment. If an individual already owns shares of company stock and wants to limit the cash outlay on the exercise of ISOs, a swap could be of value.
The existing shares will be exchanged with the issuing company for the new ISO shares. It is important to note that the swap itself is tax - free , but not necessarily the exercise, as this could generate an AMT liability. Consideration should be given for special situations, such as if the shares being swapped in are ISO shares themselves.
Incentive Stock Options - TurboTax Tax Tips & Videos
The company's stock plan must allow for swapping. When taxpayers find themselves subject to the AMT as a result of the exercise of ISOs, all or part of the AMT paid will generate a credit to be used against regular tax in future years. Often, the principal event that will unlock use of this credit is when the ISO shares are ultimately sold. The regular tax stock basis is lower due to the absence of any income inclusion at exercise.
This difference in basis for regular tax versus AMT purposes generally causes the regular - tax income to be higher than AMTI as a result of the sale. While paying AMT upfront may appear to be a loss, in many cases it will be a "timing" issue that balances out in the future. At times for CPAs, it is easy to focus narrowly on obtaining the best tax result possible. It is important to take a step back and remember that the most favorable tax result is not always the best overall financial result for the client.
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Any stock option planning should be done as part of a comprehensive financial plan. It is crucial for CPAs to be proactive in gathering information from clients to provide timely and prudent advice. Whether it is a routine situation, or something more nuanced, such as planning ahead of a possible merger or acquisition, the goal should be to maximize the value that clients receive from their option exercise and sale events.
The various strategies discussed in this column represent many viable options to tackle a wide array of interpretations of the word "value. COVID upended tax season. Read the results of our annual tax software survey.
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Stock options fall into two categories:. The grant of an ISO or other statutory stock option does not produce any immediate income subject to regular income taxes. Similarly, the exercise of the option to obtain the stock does not produce any immediate income as long as you hold the stock in the year you acquire it. Income results when you later sell the stock acquired by exercising the option. The adjustment is the difference between the fair market value of the stock acquired through the exercise of the ISO over the amount paid for the stock, plus the amount paid for the ISO if any. However, the adjustment is required only if your rights in the stock are transferable and not subject to a substantial risk of forfeiture in the year the ISO is exercised.
And the fair market value of the stock for purposes of the adjustment is determined without regard to any lapse restriction when rights in the stock first become transferable or when the rights are no longer subject to a substantial risk of forfeiture. This is because the tax treatment becomes the same for regular tax and AMT purposes.
How Stock Options Are Taxed & Reported
When you exercise an ISO, your employer issues Form —Exercise of an Incentive Stock Option Plan under Section b , which provides the information needed for tax-reporting purposes. For example, this year you exercised an ISO to acquire shares of stock, the rights of which became immediately transferable and not subject to a substantial risk of forfeiture. The number of shares acquired is listed in box 5.