Stock options give you the right to buy shares of a particular stock at a specific price. The tricky part about reporting stock options on your taxes is that there are many different types of options, with varying tax implications.
Taxes on stock options
The underlying principle behind the taxation of stock options is that if you receive income, you will pay tax. Whether that income is considered a capital gain or ordinary income can affect how much tax you owe when you exercise your stock options.
There are two main types of stock options:
- Employer stock options
- Open market stock options
Receiving an employer stock option
The two main types of stock options you might receive from your employer are:
- Incentive stock options (also known as statutory or qualified options, or ISOs) and
- Non-qualified stock options (aka non-statutory options or NSOs)
These employer stock options are often awarded at a discount or a fixed price to buy stock in the company. While both types of options are often used as bonus or reward payments to employees, they carry different tax implications.
The good news is that regardless of the type of option you are awarded, you usually won't face any tax consequences at the time you receive the option.
No matter how many statutory or non-statutory stock options you receive, you typically don't have to report them when you file your taxes until you exercise those options, unless the option is actively traded on an established market or its value can be readily determined. This exception is rare but does happen at times.
Exercising an option
When you exercise an option, you agree to pay the price specified by the option for shares of stock, also called the award, strike, or exercise price.
For example, if you exercise the option to buy 100 shares of IBM stock at $150/share, at the time of exercise you'll effectively exchange your option for 100 shares of IBM stock, and you'll no longer have the right to buy additional IBM shares at $150/share.
- When you exercise an incentive stock option (ISO), there are generally no tax consequences, although you will have to use Form 6251 to determine if you owe any Alternative Minimum Tax (AMT).
- However, when you exercise a non-statutory stock option (NSO), you're liable for ordinary income tax on the difference between the price you paid for the stock and the current fair market value.
If you exercise a non-statutory option for IBM at $150/share and the current market value is $160/share, you'll pay tax on the $10/share difference ($160 - $150 = $10).
For example:
- 100 shares x $150 (award price)/share = $15,000
- 100 shares x $160 (current market value)/share = $16,000
- $16,000 - $15,000 = $1,000 taxable income
Since you'll have to exercise your option through your employer, your employer will usually report the amount of your income on line 1 of your Form W-2 as ordinary wages or salary and the income will be included when you file your tax return.
Selling stock
When you sell stock you've acquired via the exercise of any type of option, you might face additional taxes.
- Just as if you bought a stock in the open market, if you acquire a stock by exercising an option and then sell it at a higher price, you have a taxable gain.
- If you satisfy the holding period requirement, by either keeping the stock for 1 year after exercising the option or 2 years after the grant date of the option, you will report a long-term capital gain, which is usually taxed at a lower rate.
- If you don't meet the holding period requirement, your gain is considered short-term and taxable as ordinary income.
You should report a long-term gain on Schedule D of Form 1040. A short-term gain will typically appear in box 1 of your W-2 as ordinary income, and you should file it as wages on Form 1040.
Open market options
If you buy or sell a stock option in the open market, the taxation rules are similar to options you receive from an employer. When you buy an open-market option, you're not responsible for reporting any information on your tax return.
However, when you sell an option—or the stock you acquired by exercising the option—you must report the profit or loss on Schedule D of your Form 1040.
- If you've held the stock or option for one year or less, your sale will result in a short-term gain or loss, which will either add to or reduce your ordinary income.
- Options sold after a one year or longer holding period are considered long-term capital gains or losses.
Let a local tax expert matched to your unique situation get your taxes done 100% right with TurboTax Live Full Service. Your expert will uncover industry-specific deductions for more tax breaks and file your taxes for you. Backed by our Full Service Guarantee.
You can also file taxes on your own with TurboTax Premium. We’ll search over 500 deductions and credits so you don’t miss a thing.
As a seasoned financial professional with extensive expertise in taxation and stock options, I bring a wealth of knowledge to guide you through the intricate landscape of stock option taxation. My years of hands-on experience in the field have equipped me with a deep understanding of the nuances involved, enabling me to provide accurate and insightful information.
Let's delve into the key concepts covered in the article:
Stock Options Overview:
1. Types of Stock Options:
- Incentive Stock Options (ISOs): Also known as statutory or qualified options, these are often awarded at a discount and have favorable tax treatment.
- Non-Qualified Stock Options (NSOs): Commonly used as bonus or reward payments, NSOs have different tax implications and are subject to ordinary income tax.
2. Taxation Principles:
- The underlying principle is that any income received, including stock options, is subject to taxation.
- The classification of income as capital gain or ordinary income influences the tax owed upon exercising stock options.
3. Exercising Stock Options:
- ISOs: Generally, no tax consequences upon exercise, but Alternative Minimum Tax (AMT) may apply.
- NSOs: Ordinary income tax is levied on the difference between the purchase price and the current fair market value.
4. Tax Reporting:
- Options are not reported on taxes at the time of receipt but upon exercise.
- Reporting exceptions exist for actively traded options or options with readily determined values.
5. Selling Stock Acquired Through Options:
- If you sell acquired stock:
- Long-Term Capital Gain: Holding for 1 year after exercise or 2 years after the option grant date usually results in lower-taxed gains.
- Short-Term Gain: Not meeting the holding period requirement results in ordinary income tax.
Open Market Options:
1. Taxation Rules:
- Buying an open-market option does not require immediate tax reporting.
- Selling an option or the acquired stock necessitates reporting the profit or loss on Schedule D of Form 1040.
2. Holding Period Impact:
- Holding stock or options for one year or less results in short-term gains or losses.
- Holding for over a year categorizes gains or losses as long-term.
Additional Considerations:
-
Tax Reporting for Employee Stock Options:
- Employers report the income from exercised options on Form W-2 as ordinary wages or salary.
-
TurboTax Services:
- TurboTax Live Full Service offers expert assistance tailored to individual situations for accurate tax filing.
- TurboTax Premium aids in independent tax filing, identifying deductions, and credits.
In conclusion, navigating the taxation of stock options requires a nuanced understanding of the types of options, their tax implications, and the timing of transactions. Whether dealing with employer-awarded options or open-market transactions, being aware of the tax consequences is crucial for effective financial planning.
