Employee Stock Options
Tax issues for
incentive stock options and non-qualified stock options
If you were granted nonqualified stock options (NSO) from your
employer, consider your other income before you exercise the options. Try
to exercise them during a year when your income keeps you in the lower tax
brackets. Why? Once you exercise the options, the difference between the
fair market value of the stock on the date of exercise and the amount you
paid for the option is included as additional compensation on your W-2. A
later sale of the stock is reported as long-term capital gain income
provided you held the stock for more than one year.
If you were granted an incentive stock option (ISO), the tax consequences
are a bit different. The character of the income depends on when the stock
is sold. If the ISO stock is held for at least one year and the ISO was
granted at least two years before the sale, the gain upon sale is treated
as long-term capital gain.
However, a disqualifying disposition occurs if the stock is sold within
two years of the grant date or within one year of the exercise date. In
this case, the difference between the fair market value of the stock and
the option price on the date of exercise is treated as ordinary income and
is included in taxable wages on your Form W-2 in the year the stock is
sold. The remainder of the gain would be ordinary income or capital gain,
depending on how long you held the stock.
ISOs are also subject to an alternative minimum tax (AMT) trap. If you
exercise the ISO, but do not sell the underlying stock in the same tax
year, the difference between the fair market value on the date of exercise
and the option price are included in your income to calculate AMT.
If your income fluctuates from year to year, or you are considering
retirement, exercising your stock options in a low-income year will save
you tax dollars. Careful planning also may help you avoid AMT.
