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Understanding Stock Options
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ShareDespite the controversy they have garnered lately, stock options are still fairly popular incentives for employees. Whether you work for a public or private company, you may reap the benefits of these plans either today or in the future. We will focus on two types of stock options, non qualified stock options (NQSO) and incentive stock options (ISO) and how you could be taxed on these plans.
First let’s go over some terminology for stock options.
- Grant date: The date you are given stock options.
- Vesting Period: Dates you are eligible to exercise the stock options.
- Exercise price: Amount you pay to exercise your stock options.
- Fair Market Value: current price of your stock.
- Bargain element: The difference between the exercise price and the fair market value of the stock. For example you exercise your stock for $10 a share and the current price is $20. Your bargain element is $10.
- Alternative minimum tax (AMT): This is an extra tax some of you may have to pay above your regular income tax. The idea behind it is to prevent people with really high incomes from paying little or no tax via special tax benefits or deductions.
Non Qualified Stock Options (NQSO)
Non qualified stock options are options that don’t receive favorable tax treatment or deferrals. Your company does get a tax deduction on these plans and NQSO’s are taxable at exercise.
To illustrate the tax situation, let’s use the example from above with the stock currently trading at $30. You exercise at $10. You will pay ordinary tax on the $20 gain ($30 market value minus $10 exercise). Your cost basis is now $30. What if the stock hits $50 a year later? Then you will owe long term capital gains tax on the subsequent $20 gain ($50-$30).
Incentive Stock Option (ISO)
This is also known as qualified stock options and is a tax favored plan. No taxes are due when you exercise ISO’s. Typically only $100,000 worth of ISO’s granted in one calendar year gets favorable tax treatment. Anything above that gets treated as non qualified stock options.
You have to be aware of the alternative minimum tax (AMT) on the bargain element at exercise. Suppose you were granted options and exercise them at $10 per share and the stock is valued at $30. The discount or bargain element equals $20. No taxes are due at this time. However the $20 bargain element could put you in AMT territory creating a higher tax bill for you.
Remember you must hold the stock for two years after the grant date and one year after your exercise date to get favored long term capital gains treatment. If you sell the stock earlier, you will pay ordinary income tax on the bargain element ($20 gain above the exercise in this case), and any ensuing gains since the exercise. Let’s say the stock goes to $50 one year after the exercise at $10.00 and 2 years after the stock has been granted to you. The subsequent $40.00 gain will receive long term capital gains treatment.
There is a lot more to discuss, especially on when you should exercise these options. We will discuss them in the coming weeks. For now know that the main difference between NQSO’s and ISO’s relates to their taxation. NQSO’s are subject to regular income tax at exercise whereas ISO’s are not. If you are in a high income bracket, you must pay attention to AMT when it comes to ISO’s as it may apply to you in the year of exercise. These are difficult financial planning issues so please go to an advisor familiar with the ins and outs of these plans.
Jonas Zamora is a Certified Financial PlannerTMprofessional
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| Market Summary | May 24, 2012 08:36 am ET |
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