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Do You Understand Your Stock Options?

Many employers are now offering stock options as part of their compensation program.  It is important to understand the types of options you are receiving, and to understand how these will be taxed.

Executives may receive Incentive Stock Options (ISO's).  These offer more favorable tax treatment, but it is important to be aware of the dates you exercise and sell the stock so that it can be classified as a qualifying disposition. If the stock is not held for two years from the date the options were granted AND one year from the date the stock was purchased, the employee is required to recognize part of the proceeds as compensation income, subject to payroll and regular income tax rates, which are usually much higher than the long term capital gains rate. 

ISO's are granted, and then are usually vested over a period of time.  Once the options are vested, they can then be exercised, which means you can purchase the company stock at the strike price, which is the price that was determined when the option was granted.  The employee does not recognize any income at the time the options are exercised and the stock is purchased.  The employee does recognize income upon the sale of the stock, however.  

If it is a qualifying disposition, which means that they stock was held for one year after the date of exercise, AND two years from the date the option was granted, then the employee recognizes long term capital gain based upon the difference in the market price at the date of the sale less the  price of  the stock when purchased.  If the stock is not held for two years from the date of grant, and one year from the date of exercise, it is known as a disqualifying disposition. The employee must recognize compensation income, subject to both payroll and income taxes, in the amount of the difference in the market price at the date of purchase and the strike price at the date of exercise. The employee also needs to recognize long term capital gain in the amount of the difference between the sales price and the price at the time of exercise.  Because of these rules, it is really important to pay attention to these dates  to receive the most favorable tax treatment for your ISO's. 

Another type of stock option is offered by many employers on a larger scale to all employees.  These are known as Non Qualified Stock Options.  The tax treatment is different, and not as favorable as with the Incentive Stock Options.  The employee must recognize compensation income upon the exercise of the stock.  This "bargain element" is calculated by taking the difference between the market price of the stock when purchased less the strike price that was determined at the time the stock was granted. Payroll taxes need to be withheld from this "bargain element" as it is considered compensation, and will be shown on the W-2 form.  When the stock is sold, there is capital gain recognized as well.  This is either short or long term, depending on how long the stock was held.

Stock options are a great form of compensation for employees, as they can buy stock in their company at a lower price, and can either hold the stock in the hopes that it will appreciate further, or sell it and receive the income. It is important to understand what type of options you have, and then to pay attention to the dates you sell the stock to receive the most favorable tax treatment.

About the Author

Patti Hughes is a Chicago Fee-Only Financial Planner.  Lake Life Wealth Advisory Group provides comprehensive and objective financial planning, retirement planning, and investment management to help clients organize, grow and protect their assets through life’s transitions.  She is a fiduciary, and does not sell products or earn commissions, so she truly acts in the best interests of her clients.