Exercising stock options can be a great way to feel personally invested in the company you work at. Even better, if the company is successful, your shares could end up being worth a lot.
But exercising your options is a big decision that shouldn’t be made lightly—as with other forms of compensation, Uncle Sam wants his cut of your profit (and sometimes your not-yet-realized profit).
We chatted with Jack Meccia, a federally authorized tax practitioner who’s currently the managing director of tax strategy at Allegoriq, to summarize what you need to know and prepare for if you exercised and/or sold stock options this year, including:
Before we get into specific scenarios, here’s a quick recap of how stock options work:
- Stock options are the opportunity to purchase company shares at a predetermined price, usually called the strike, exercise, or grant price.
- Your strike price is usually what the shares are worth when you get your grant.
- Even if the shares become more valuable, you still get to exercise your stock options (purchase shares) at your strike price.
- The difference between your strike price and the value of the shares when you exercise is called your “spread” or “bargain element.”
- Depending on when you exercise and sell, you may be taxed different rates on the spread and on any increase in the shares’ value when you sell them.
Reminder: A lot can impact how much you’ll be taxed, so the best way to figure out how much you’ll owe is to talk to a tax advisor.
Incentive stock options (ISOs)
ISO exercises qualify for special tax treatment if you meet certain requirements. How you’re taxed typically depends on when you decide to exercise and sell.
You exercise and sell ISOs within the same calendar year
In this scenario, you’ll pay ordinary income tax on the difference between your strike price and the price at which you sell.
- Example: You exercise 100 ISOs for $1 each and sell all 100 shares for $5 each in a cashless tender offer. In this situation, you’ll pay ordinary income tax on $400 [100 x ($5 – $1)].
You exercise ISOs and don’t sell within the calendar year
In general, you usually don’t have to pay taxes until you sell your shares. However, if you exercise ISOs and don’t sell your shares in the same year, you may have to pay the alternative minimum tax (AMT).
Think of AMT as a deposit. The government sees that you got to buy ISOs for less than they’re worth and makes you pay taxes on your profit upfront. Ideally, you recover most or all of that deposit as a dollar-for-dollar tax credit before and during the tax year you sell those shares.
Don’t forget about this credit. If you changed tax preparation software, your tax returns might not be keeping a running total of this tax credit. Almost every week, Jack amends a tax return because an AMT credit was missed. If you paid $30,000 of AMT when you exercised ISOs, you’ll want to position yourself to recover that $30,000 when you sell.
How much is AMT? You can typically exercise some amount of ISOs before you start to owe the AMT deposit, which is 26-28% of the difference between the spread at the federal level. Some states also have their own version of AMT. California, for example, has a 7% AMT rate.
You sell the shares from your ISO exercise the calendar year after exercising them but less than 12 months after purchasing them
If you don’t meet the holding period (selling shares before you’ve held them at least one year after exercising and two years after your grant date), it’s called a disqualifying disposition. In this situation, you’ll pay ordinary income tax on your spread and short-term capital gains tax on any profit between your selling price and the value of the shares when you exercised.
- Example: You exercised 100 ISOs for $1 each in April 2019. When you exercised your options, they were worth $5. In March 2020, you sell all of your shares for $10 each. In this situation, you’ll pay ordinary income tax on $400 [100 x ($5 – $1)] and short-term capital gains tax on $500 [100 x ($10 – $5)].
You sell the shares from your ISO exercise after holding them for at least one year after exercising and two years after your ISO grant date
If you meet the holding period (waiting to sell your shares until at least one year after exercising and two years after your grant date), it’s called a qualifying disposition. This means your transaction qualifies for a more favorable tax treatment. In this situation, you’ll pay the long-term capital gains tax rate on the difference between your strike price and the selling price.
- Example: Once you’ve been at your company for a year, you hit your one year vesting cliff and exercise 100 ISOs for $1 each. 15 months after exercising, you sell all of your shares for $10 each. In this situation, you’ll pay long-term capital gains tax on $900 [100 x ($10 – $1)].
Nonqualified stock options (NSOs)
You exercise NSOs
If the fair market value of your company’s shares is higher than your strike price and you decide to exercise your NSOs, your company must report the spread as an addition to your wages on your Form W-2 because they’re allowing you to buy shares for less than they’re worth. This means you’ll pay ordinary income tax plus payroll taxes on your spread.
- Example: You exercise 100 NSOs at $1 each when the shares are worth $5 each. In this situation, you’ll pay ordinary income tax plus payroll taxes on $400 [100 x ($5 – $1)].
You sell shares less than a year after exercising NSOs
If you sell shares less than a year after exercising NSOs, you’ll pay short-term capital gains tax on the difference between the selling price and the value of the shares when you exercised.
- Example: In April 2019, you exercised 100 NSOs at $1 each when the shares were worth $5 each. In March 2020, you sold all of your shares for $10 each. In this situation, you’ll pay short-term capital gains tax on $500 [100 x [$10 – $5]).
You sell shares more than a year after exercising NSOs
If you sell shares more than a year after exercising NSOs, you’ll pay long-term capital gains tax on the difference between the selling price and the value of the shares when you exercised.
- Example: In April 2019, you exercised 100 NSOs at $1 each when the shares were worth $5 each. In September 2020, you sold all of your shares for $10 each. In this situation, you’ll pay long-term capital gains tax on $500 [100 x [$10 – $5]).
When you sell an NSO or an RSU, be sure to double-check the math. Otherwise, you're at risk of being double taxed.
Let's say you exercise an NSO with a strike price of $1 when the NSO is worth $10. This creates $9 of income (the difference between the value of the share when you exercised and strike price), and $9 gets included in your W-2.
If you sell the NSO for $15, you have $4 of gain: $15 minus the $1 strike price and $10 value of the shares when you exercised.
Here's where you need to be careful: The form that reports the sale might not give you credit for the $9 that was already included in your income. Or it may bury that $9 in a footnote at the end of the tax form. If you don't give yourself credit for the $9, you could be taxed on the $9 as income and then taxed a second time on that $10 when you sell the NSO!
Similarly, RSUs are included as income in your W-2, but the brokerage 1099 might not give you credit for the income already included in your W-2. If so, that indicates you need to make an adjustment on your tax return.
Before filing your taxes, be sure to gather the following documents:
|Type of option||If you exercised||If you sold|
|ISOs||• Your employer will issue Form 3921, which provides the information you need for tax-reporting purposes||• Your employer will report the amount on your Form W-2 |
• Form 1099-B reports any capital gains or losses
• Final 2019 paystub*
|NSOs||• Your employer will report the amount on your Form W-2 (box 12, code “V” shows income from an exercise of NSOs)
• Final 2019 paystub*
*Not mandatory, but it’s a helpful index
Also, keep in mind that the following tax forms could be affected if you exercised and/or sold stock options:
- Form 6251 (if you exercised ISOs)
- Form 6251 (if you sold ISOs)
- Schedule D (if you sold ISOs or NSOs)
- Form 8949 (if you sold ISOs or NSOs)
Taxes are complicated enough without taking stock options into account. When you meet with a tax advisor, be sure to cover the following topics:
- What is the tax upside to exercising now versus the financial downside if my shares lose value? Is it worth exercising and selling shares simultaneously even though it’s not the most tax-efficient option?
- If I have the option to early exercise or make an 83(b) election, should I?
- When is the best time of the year to exercise my options?
- What should I do if I don’t have the money to exercise my options? Is option lending worth it?
- How many ISOs can I exercise before I owe AMT?
- If I exercise ISOs and owe AMT, how much of that AMT deposit can I expect to recover as a tax credit when I sell the shares?
- How does moving to a different state impact my tax obligations?
- I’m thinking of leaving my company—how long do I have to purchase my options? After a certain period, will the options convert to a different type of option or expire altogether?
- How do I integrate my equity holdings into an estate plan or in trust planning?
- Holloway: Taxes on equity compensation
- Wood LLP: Tax refresher on options and restricted stock
- IRS: Topic No. 427 Stock Options
Help your employees navigate tax decisions
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DISCLOSURE: This publication contains general information only and eShares, Inc. dba Carta, Inc. (“Carta”) is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.