Stock options are employee benefits that enable them to buy the employer’s stock at a discount to the stock’s market price. The options do not convey an ownership interest, but exercising them to acquire the stock does. There are different types of options, each with their own tax results.
Two Types of Stock Options
Stock options fall into two categories:
There are different tax implications for ISOs and nonstatutory stock options.
Tax Rules for Statutory Stock Options
The grant of an ISO or other statutory stock option does not produce any immediate income subject to regular income taxes. Similarly, the exercise of the option to obtain the stock does not produce any immediate income as long as you hold the stock in the year you acquire it. Income results when you later sell the stock acquired by exercising the option.
However, exercising an ISO produces an adjustment for purposes of the alternative minimum tax, or AMT—a shadow tax system designed to ensure that those who reduce their regular tax through deductions and other tax breaks will pay at least some tax. The adjustment is the difference between the fair market value of the stock acquired through the exercise of the ISO over the amount paid for the stock, plus the amount paid for the ISO if any. However, the adjustment is required only if your rights in the stock are transferable and not subject to a substantial risk of forfeiture in the year the ISO is exercised. And the fair market value of the stock for purposes of the adjustment is determined without regard to any lapse restriction when rights in the stock first become transferable or when the rights are no longer subject to a substantial risk of forfeiture.
Form 6251 will help you figure out if you owe any AMT after you exercise an ISO.
If you sell the stock in the same year you exercised the ISO, no AMT adjustment is required. This is because the tax treatment becomes the same for regular tax and AMT purposes.
If you have to make an AMT adjustment, increase the basis in the stock by the AMT adjustment. Doing this ensures when the stock is sold in the future, the taxable gain for AMT purposes is limited, which means you don’t pay 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 under Section 423(c), which provides the information needed for tax-reporting purposes. Here’s an example of how to use the information from Form 3921 to report the exercise of an ISO:
For example, this year you exercised an ISO to acquire 100 shares of stock, the rights of which became immediately transferable and not subject to a substantial risk of forfeiture. You paid $10 per share (the exercise price), which is reported in box 3 of Form 3921. On the date of exercise, the fair market value of the stock was $25 per share, which is reported in box 4 of the form. The number of shares acquired is listed in box 5. The AMT adjustment is $1,500 ($2,500 [box 4 multiplied by box 5] minus $1,000 [box 3 multiplied by box 5]).
When you sell the stock acquired through the exercise of an ISO or an employee stock purchase plan, you report a gain or loss on the sale. When the stock was acquired at a discount under an employee stock option plan, you’ll receive Form 3922—Transfer of Stock Acquired Through an Employee Stock Purchase Plan from your employer or the corporation’s transfer agent. The information on this form helps you determine the amount of gain or loss, and whether it is capital or ordinary income.
Tax Rules for Nonstatutory Stock Options
For this type of stock option, there are three events, each with their own tax results: The grant of the option, the exercise of the option, and the sale of stock acquired through the exercise of the option. The receipt of these options is immediately taxable only if their fair market value can be readily determined (e.g., the option is actively traded on an exchange). In most cases, however, there is no readily ascertainable value so the granting of the options does not result in any tax.
When you exercise the option, you include, in income, the fair market value of the stock at the time you acquired it, less any amount you paid for the stock. This is ordinary wage income reported on your W2, therefore increasing your tax basis in the stock.
Later, when you sell the stock acquired through exercise of the options, you report a capital gain or loss for the difference between your tax basis and what you receive on the sale.
- Stock options fall into two different categories: Statutory—granted under purchase plans or incentive stock options plans—and nonstatutory options that come with no plans.
- Income results when you sell stocks acquired by exercising statutory stock options, which produces the alternative minimum tax.
- If you exercise the nonstatutory option, you must include the fair market value of the stock when you acquired it, less any amount you paid for the stock.
- When you sell the stock, you report capital gains or losses for the difference between your tax basis and what you receive on the sale.
The Bottom Line
Stock options can be a valuable employee benefit. However, the tax rules are complex. If you receive stock options, you should talk to your tax advisor to determine how these tax rules affect you.