by Evan Stephens, tax manager at Sensiba San Filippo
In today’s start-up culture, it’s common for companies to offer employees the opportunity to own stock in the business. While most folks know the basic benefits of receiving stock, many employees are taken off guard by the tax implications that follow.
There are two types of stock options, Incentive Stock Options (ISO) and Non-Qualified Stock Options (NQSO). Profit from ISOs have the potential to be taxed as long-term capital gain, which is a considerably lower rate than NQSOs, which are generally taxed as ordinary income.
Incentive Stock Option (ISO).
Employees with ISOs have some specific tax benefits that other options lack. Unlike NQSOs, taxes are generally deferred until the stock is sold, rather than exercised. Any proceeds from an exercise or sale become subject to taxation at the lower, long-term capital gains rate rather than ordinary income rates.
However, there is a caveat to be aware of. The difference between exercise price and the fair market value of the stock on the day of exercise must be calculated as part of Alternative Minimum Tax (AMT) adjustment. For companies with substantial growth, that number can be very large — something many employees fail to account for come tax season. Essentially, the employee will be taxed on the profit they might have made if the stock was sold on that day. In some cases, it’s recommended to sell a portion of stock in order to cover the associated AMT taxes.
Employees can benefit from a Section 83(b) election, which allows an employee to “exercise” stock options at the date of (or near) the grant when exercise price is equal to the fair market value. That means there is no AMT adjustment to report and no added tax liability. Since the stock has yet to vest, this election treats the option as exercised solely for tax purposes. This special election also begins the holding period for long-term gain treatment, meaning holding can start earlier than the actual exercise date. This achieves the potential for long-term gain treatment on a sale at an earlier date. However, the employee has to have the money to buy the stock on the date they make the election.
Non-Qualified Stock Option (NQSO).
NQSOs are essentially any stock option that does not meet the ISO qualifications. When an employee exercises a NQSO (or NSO), the spread between exercise price and the fair market value on the date of exercise is reported as ordinary income. This shows on the employee’s W-2 and the expense is recognized by the employer. Employers are required to withhold both federal and state taxes when an employee’s option is exercised. Companies have a couple of methods to choose from, but the most common is to require the employee to pay the withholding amount in full at time of exercise. This is done by “holding back” some of the stock value in order to pay the withholding taxes. The company must also pay their share of employment taxes at the time of exercise.
If the employee exercises the option and decides to hold the stock, the fair market value on the date of exercise becomes the cost basis (price point) for when that stock is sold later on. The difference between the sell price and the cost basis is treated as capital gain/loss and is subject to a 20% favorable rate, if long term.
NSQO holders can benefit from an 83(b) election and begin their holding period on an earlier date than exercise date. They will still have to pay for the stock out of pocket and risk paying tax on gains if their exercise price does not match the value at grant date.
If the employee exercises their stock option and sells immediately, referred to as same-day sale transaction, there is usually no gain or loss on the sale of the stock. In this case, everything is reported under ordinary income since the sell price of the stock is close, if not the same, as the fair market value of the stock at that time.
Evan Stephens is a tax manager at Sensiba San Filippo. He specializes in tax planning, compliance, and tax consulting for startups, technology and software companies. He can be reached at 408-286-7780 or estephens@ssfllp.com.
