How Stock Options Are Taxed & Reported

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How Stock Options Are Taxed & Reported

Shares options are employee perks that allow them to purchase the employer’s stock at a discount from its market value. The options do not transmit an ownership stake in the shares, but executing them does. There are several possibilities, each with its own tax consequences.

Key Takeaways

  • Stock options are classified into two types: statutory options, which are awarded via buy plans or incentive stock option plans, and nonstatutory options, which are issued without the use of a plan.
  • When you sell stocks obtained by exercising statutory stock options, you earn income and pay the alternative minimum tax.
  • If you exercise the nonstatutory option, you must include the stock’s fair market value at the time of acquisition, minus any amount you paid for it.
  • When you sell the stock, you must report capital gains or losses for the difference between your tax basis and the selling price.

Two Types of Stock Options

Stock options fall into two categories:

Tax Rules for Statutory Stock Options

The issuance of an ISO or other statutory stock option results in no immediate income that is taxable. Similarly, exercising the option to purchase the stock generates no immediate income as long as you keep the shares in the year you acquire it. When you sell the stock obtained by executing the option, you earn money.

However, using an ISO results in an adjustment for the purposes of the alternative minimum tax, or AMT—a shadow tax system meant to guarantee that persons who decrease their normal tax liability via deductions and other tax benefits pay at least some tax. The adjustment is the difference between the fair market value of the stock obtained via ISO exercise and the price paid for the shares, plus any fee paid for the ISO. However, the adjustment is necessary only if your stock rights are transferrable and do not face a significant risk of forfeiture in the year the ISO is exercised. And, for the purposes of the adjustment, the fair market value of the stock is calculated without respect to any lapse limitation when rights in the stock first become transferable or when the rights are no longer subject to a considerable risk of forfeiture.

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Form 6251 will assist you in determining if you owe AMT after exercising an ISO.

There is no AMT adjustment necessary if you sell the shares in the same year you exercised the ISO. This is because the tax treatment for ordinary tax and AMT purposes becomes the same.

If you must make an AMT adjustment, raise the stock’s basis by the AMT adjustment. This assures that when the stock is sold in the future, the taxable gain for AMT purposes is restricted, preventing you from paying tax twice on the same amount.

How Reporting Works

When you exercise an ISO, your employer issues Form 3921—Exercise of an Incentive Stock Option Plan according to Section 422(b), which contains the information required for tax reporting. Here’s an example of how to report an ISO exercise using information from Form 3921:

For example, suppose you exercised an ISO this year to purchase 100 shares of stock, the rights to which became instantly transferrable and were not subject to a significant risk of forfeiture. The exercise price was $10 per share, as indicated in box 3 of Form 3921. The fair market value of the stock on the day of exercise was $25 per share, as recorded in box 4 of the form. Box 5 shows the quantity of shares purchased. The AMT adjustment is $1,500 ($2,500 multiplied by box 4 minus $1,000 multiplied by box 3 minus $1,000 multiplied by box 5).

You record a gain or loss on the sale of shares acquired via the execution of an ISO or an employee stock purchase plan. If the stock was obtained at a discount via an employee stock option plan, your employer or the corporation’s transfer agent will send you Form 3922—Transfer of Stock Acquired Through an Employee Stock Purchase Plan. This form’s information assists you in determining the amount of gain or loss and whether it is capital or regular income.

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Tax Rules for Nonstatutory Stock Options

There are three events for this sort of stock option, each having its own tax consequences: the grant of the option, the exercise of the option, and the sale of shares obtained via the execution of the option. Only if the fair market value of these options can be easily recognized is their receipt immediately taxable (e.g., the option is actively traded on an exchange).In most circumstances, however, there is no immediately ascertainable value, hence the award of the options is tax-free.

When you exercise the option, you deduct the fair market value of the stock at the time you obtained it from your income, minus any amount you paid for the shares. This is typical wage income recorded on your W2, which raises your tax basis in the stock.

When you sell the shares obtained via option exercise, you report a capital gain or loss for the difference between your tax basis and the selling price.

The Bottom Line

Employee stock options may be a significant perk. However, the tax laws are complicated. If you get stock options, you should consult with a tax professional to establish how these tax requirements apply to you.

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