Companies may grant employees stock options as a form of noncash compensation. This allows the employees to purchase shares of the employer’s stock at a given price after a predetermined period of time has passed. The intent of stock option compensation is to align the interests of the employees with that of the company: The employee’s compensation increases as the stock price increases.
Stock options can be either qualified or non-qualified, and the primary difference is how they are taxed. A qualified stock option is traditionally referred to as an Incentive Stock Option (ISO). In practice, ISOs create complex tax compliance and planning issues for both employers and employees. Non-Qualified Stock Options (NQSOs) are significantly easier to understand and plan for.
Here are a few terms to note associated with stock options:
- Grant date – When a company first issues, or grants, a stock option (typically multiple) to the employee
- Strike price (or grant/exercise price) – The price at which the employee can purchase a share when the option is exercised (typically, the strike price is equal to the share price on the grant date)
- Vesting period – The length of time between the grant date and the vest date
- Vest date – the pre-determined date an option becomes exercisable, or vests
- Market price – The current price of the stock; also refers to the share price at the point of exercise
- Spread – The difference between the strike price and the market price; whether in cash or stock, the net value that the employee receives is equal to the spread less applicable fees
- Holding period – The length of time between when the options are exercised and when the resulting shares are sold
Note: For illustration purposes, we’ll assume that the share price will increases over time, as you would not exercise an option when the market price is below the strike price (known as being “underwater”).
Non-Qualified Stock Options (NQSOs)
As previously stated, NQSOs are comparatively simpler than ISOs in and out of the tax return. For NQSOs, there is no taxable event until the option is exercised. Depending on the plan agreement, there are several ways to “pay” for the stock at the strike price. The employee may:
- Front the cash to buy the stock at the strike price when exercising
- Swap other wholly owned company shares with an equivalent value
- Enact a cashless exercise and receive the shares without fronting any cash
In all cases, the value of the net stock proceeds will equal that of the spread. (Technically, the amount of shares actually received is typically reduced as a portion of the shares are sold to cover statutory income and payroll tax withholding.) At this point, the value of the spread/stock proceeds is taxable as ordinary income, often as W-2 wages.
The employee may or may not decide to sell the newly acquired shares, but the difference between the market price at exercise and the sales price is taxed as a capital gain or loss. The employee’s basis is equal to the exercise price and for the purposes of determining whether the gain is short- or long-term, the exercise date is considered the acquisition date.
Generally, NQSOs have a vesting period of one year or more and once vested, the employee is able to exercise and sell as desired (subject to corporate blackout policies and option expiration dates).
Figure 1 – Taxation of Non-Qualified Stock Options
Incentive Stock Options (ISOs)
ISOs are bit more complicated. Like NQSOs, there is no taxable event on the grant and vest dates. However, taxability on the exercise date depends on how long the holding period was leading up to the sale date. A sale of stock acquired via ISO is considered either a qualifying disposition or a disqualifying disposition.
- Qualifying disposition – The shares must be sold at least two years after the grant date and at least one year after the exercise date
- Disqualifying disposition – A sale that does not meet the above requirements
How Qualifying Dispositions Are Taxed
Qualifying dispositions are taxed in the following manner: On exercise, the spread is reported as an alternative minimum tax (AMT) preference item, which increases the alternative minimum taxable income (AMTI). Then, a capital gain will be recognized on the share’s appreciation upon sale above the strike price (not the market price at exercise) on the sale date. Additionally, AMTI is reduced by the amount of the previously mentioned preference item when the shares are sold.
What Is Alternative Minimum Tax (AMT)?
AMT is a separate (“alternative”) calculation of tax that involves certain adjustments to taxable income resulting in what is called AMTI. AMTI is subject to a two tax brackets, 26% and 28%, after a certain income level. When AMT exceeds regular income tax, the difference must be paid by the taxpayer. There is an offset however, as the AMT basis of the share is equal to the market price at exercise. As the AMT basis is higher than the regular basis, a stock sale results in lower AMTI.
Figure 2 – Taxation of Incentive Stock Options, Qualifying Disposition
How Disqualifying Dispositions Are Taxed
Disqualifying dispositions forego the preferred capital gains rate and the sale price, less the strike price, is treated as ordinary income and taxed at the higher ordinary income tax rates. The AMT preference item is still applicable on exercise, and the AMTI is reduced when the shares are sold. However, if the shares are sold in the same tax year as the exercise, there is no AMT preference item for that year as they offset.
In practice, a disqualified disposition, especially if sold in the same year, functions effectively the same as a NQSO. But while NQSOs are subject to FICA taxes on exercise, ISO transactions are not
Tax Considerations for Stock Options
Statutory Withholding Shortfalls
A big concern with non-salary compensation, which includes bonuses and equity compensation, is that supplemental compensation paid in a lump-sum is subject to a 22% statutory federal withholding rate until supplemental income exceeds $1 million (at which point the rate is 37%).
For high earners, this can create a huge shortfall between the effective tax rate on option income and the 22% withholding rate, up to 15% percent. For someone with $200,000 of option income, that could mean up to a $30,000 shortfall on the tax return.
Planning for this liability by increasing salary withholding and/or making estimated payments reduces sticker shock, avoids underpayment penalties on the return, and helps to better manage cash flow.
ISO Tax Implications and Strategies
While ISOs may be tax advantageous — the income is considered long-term capital gain income not subject to ordinary rates if the shares are held for longer than one year and sold in a qualifying disposition — employees need to be careful when exercising and selling ISOs.
Although the Tax Cuts and Jobs Act raised the AMT thresholds and reduced the number of taxpayers affected by AMT,1 employees who are otherwise below the AMT threshold can be subject to AMT when ISOs are exercised. Additionally, stock options are typically granted to management and C-suite employees whose base compensation levels may place the employees above the AMT threshold. As such, it is necessary to factor in AMT when planning for ISOs. Without proper planning, employees may find themselves with a large unexpected tax liability in April. While no one wants to be staring at a large tax bill, a bigger issue can arise: AMT can be triggered and result in a tax liability without a corresponding cash inflow, as the offending shares have not been sold yet.
To illustrate, let’s assume Liam and Dana have taxable income of $200,000 and traditionally pay around $20,000 in federal income taxes, all of which is withheld in payroll. As previous years have been relatively predictable, Liam and Dana are not concerned with tax planning. The following March, they provide their tax preparer with their tax documents, including information regarding Liam’s ISO exercises that year. Liam was excited as this was his first equity grant and the spread on exercise was $200,000 – a full year’s worth of income for the couple – and he only needs to wait a few more months before he can sell the stock at lower tax rate. Unfortunately, although Liam has not actually sold the stock yet, the $200,000 is added to AMTI and now the couple owes a significant amount of tax due to the AMT rules. Liam and Dana were not planning on owing taxes that year and are forced to tap into their emergency savings to cover the tax liability.
If Liam had consulted a financial planner or tax advisor when granted the ISOs, proper planning may have made the liability more palatable. Liam may also have disqualified a portion of the options by selling some shares in the year of exercise, as their effective ordinary tax rate on the net income would be closer to the AMT rates and Liam would have the corresponding cash flow to pay the associated tax liability.
Conversely, if Liam had exercised ISOs in prior years and sold shares in a qualifying disposition in the current year, the dispositions would reduce the AMTI and potentially offset the AMTI additions from the ISO exercises.
One strategy for offsetting AMT is to recognize enough ordinary income to bring the effective tax rate above the AMT rate. An employee may accomplish this by disqualifying a portion of the shares from ISO exercises and holding the rest until the one year holding period is met. Besides disqualifying ISOs, the employee may look at other ordinary income items that may be shifted from year to year, such as exercising NQSOs, or shifting deductions, such as a large charitable contribution, that would otherwise reduce ordinary income tax that year.
Besides the AMT adjustments stemming from ISO exercises and dispositions, the actual AMT calculation is affected by other AMT adjustments, AMT credit carryforwards, etc. Given the variety of factors that come into play, proper tax planning considers prior year exercises and future exercises and dispositions.
The following are four key takeaways when considering how to manage your stock options:
- Understand your equity compensation plan and how ISOs are taxed versus NQSOs, should you have them.
- Track your awards, holdings, and transactions throughout each year as such information is necessary to properly prepare your tax return.
- ISO transactions have current and future year tax implications, so it’s best to create a multi-year plan for exercising ISOs and selling the resulting shares.
- Plan for the shortfall caused by the statutory withholding rate and adjust withholding or make estimated payments as needed.
As always, consult with a trusted advisor and/or tax professional if you have any questions.
1 The 2019 AMT exclusion is $81,300 for single taxpayers and $126,500 for married coupled filing jointly