Stock options are financial derivatives that provide individuals, typically employees of a company, with the right to purchase a specific number of company shares at a predetermined price (known as the “exercise price” or “strike price”) within a specified period of time. It’s important to note that stock options do not represent actual ownership of the company until they are exercised. They have a right to potentially acquire ownership at a later date.
There are 5 steps within the life cycle of stock options: grant, vest, exercise, hold, and sell.
- Grant: The grant is the initial offering of stock options. Most of the time, it’s not a taxable event. However, Section 83(b) election allows individuals who receive stock options to choose to include the value in their income at the time it’s granted rather than when it fully vests. You could likely check your company plan document to confirm whether this is available for you.
- Vest: Vesting refers to the process by which an individual gains ownership rights to the stock options granted to them over a period of time. Vesting schedules are predetermined and can vary. A common vesting schedule might be “4-year vesting with a 1-year cliff.”
- Exercise: Exercise is the act of using your vested stock options to purchase actual company shares. Upon exercising, there may be a difference between the fair market value and the exercise price, which is called “spread” or “bargain element”, A non-qualified stock option (NSO) spread is categorized as ordinary income, whereas incentive stock option (ISO) spread is treated an Alternative Minimum Tax (AMT) adjustment. In other words, you may have to pay AMT in addition to regular tax when the spread is substantial.
- Hold: The holding period could be strategic. The length of the holding period can impact the tax treatment of any gains when you eventually sell the shares. In the case NSOs, holding the shares for one year or more after exercising results in eligibility for long-term capital gain tax treatment. Conversely, with ISOs, meeting a one-year holding period is not enough. To qualify for favorable tax treatment, an additional requirement mandates holding the shares for a minimum of two years following the date of grant.
- Sell: When you sell shares, you realize the financial gain (or loss) based on the difference between the selling price and your cost basis (exercise price plus any associated costs). You will receive 1099-B, and very likely, supplemental statements including basis adjustments information.
Stock options can be complicated, and sometimes overwhelming. Strategic planning during the exercise of stock options can lead to tax savings.
Sally Sun, CPA, is a Tax Manager at Katz, Nannis + Solomon, P.C. If you have any questions or would like to speak with one of our tax professionals, please contact our office at 781-453-8700.