Employee stock options are a great incentive that can be integrated into many compensation packages. Often, employees are able to buy company shares at a discount, which provides a great opportunity to accumulate wealth if the stock performs well.
But the second piece of the puzzle tries to understand how taxes for employee stock options work. It can easily become a nightmare if you have never considered stock options before. Here are a few insights to clear up the confusion so you can maximize the potential of this incredible work benefit.
This is how stock options work
There are two main types of stock options that you can receive as part of your compensation gift: incentive stock options and unqualified stock options. The main difference between these two is how they are treated for tax purposes when you exercise the options.
Incentive stock options (ISOs), also known as statutory stock options, are granted under a share purchase plan. However, unqualified stock options (NSOs) are granted without a specific type of plan and are often called non-statutory stock options. As we will see below, NSOs do not qualify for the same tax benefits that ISOs receive.
When you have employee stock options, there are three special occasions you need to be aware of: the date your company granted you the options when you exercised them and how long you have the shares you receive on the exercise before you sell them. These moments play an important role in your tax calculation.
Most of the time, there is an earnings plan tied to your employees ’stock options. In short, you cannot exercise your stock option benefits until you have been in your business for a certain period of time. Once busy, you can exercise the settings at any time before they expire.
Incentive stock options
Incentive stock options are simpler than unqualified stock options from a tax perspective. Employees who have ISOs do not have to worry about taxes when they receive a stock option grant or exercise the options.
The order of operations works as follows: You receive a stock option grant, and then you exercise the options when you are eligible and ready to do so. Once you have taken advantage of your opportunities, you will have to make the ultimate decision: When will I sell my stock?
Let’s say you were allotted 2,000 shares at an exercise price of $ 10. On the date you decide to exercise your shares, the share is actually worth $ 30 per share. If you sell right away, you pay $ 20,000 for something worth $ 60,000, but you’ll have to pay regular tax rates to lock in those gains now.
Your second option: exercise your options for a period of time and sell your shares later. You may be able to unlock favorable long-term tax rates for capital gains (a top rate of 20%) if you have ISOs for at least two years from the date the options are granted and longer than one year from the exercise date before you sell; Otherwise, you give up the right to exclusive tax benefits and risk being stuck with it ordinary income tax it can be as high as 37%.
The double tax for unqualified stock options
It is important to have a tax strategy when practicing NSOs because you will be hit by a tax twice and it can get a little complicated.
First, you typically have to pay regular income tax when you exercise the options. You must pay the difference between what you paid for the share (the exercise price) and the fair value of the shares when you exercised them. The IRS considers this as compensatory income even if you have not actually made any money.
You then pay capital gains tax if you sell the shares at a profit. If the sale results in a loss, you report a capital loss for the difference between your tax base and what you received. You pay either short-term or long-term capital gains tax depending on how long you have had the stock. When you have your investment for over a year, you qualify for the preferential long-term capital gains rates of 0%, 15% or 20% based on your income range for the year.
More taxes to consider
Although ISOs are typically seen as a tax savior compared to NSOs, you need to consider alternative minimum fee (AMT) if you are a high wage earner. There is also a limit of $ 100,000 that limits the total value of ISOs that can be exercised in a given year if you want to enjoy the incredible tax benefits.
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