How Are Employee Stock Options Taxed?

Employee stock options are a popular benefit. These options allow eligible employees to purchase shares of their employer's stock at a discounted rate within a specified window. However, there are tax implications when employees earn a profit from their shares. Moreover, administering an employee stock purchase plan effectively requires an employer to follow specific reporting and disclosure guidelines that can be complex. If you are an employer considering offering this benefit to your employees, or an employee thinking about exercising their options, here's what you need to know.

What are Employee Stock Options?

An employee stock option is a benefit that, when exercised, lets an employee purchase their employer's stock at a discount to their market value. Typically, this discount rate is between 5 percent and 15 percent (the maximum discount rate allowable as per the IRS) of the stock's market value. Receiving a stock option from one's employer does not usually trigger any tax consequences. However, if the stock option an employee receives is itself also a publicly-traded security, an employee may face tax consequences upon receipt.

Stock options are usually exercisable only after a stock has attained a certain market value. For example, an employee may be awarded an option to buy up to 1,000 shares at a 10 percent discount to the market rate when the stock's market value reaches $100 per share. By structuring the benefit in this manner, employers can use the options to motivate employees to perform at high levels and hit the corporate goals necessary to increase the market value of the company's stock.

Employers usually allow employees to purchase stock through Employee Stock Purchase Programs (ESPPs) over time through payroll deduction. Payroll deduction options help spur participation in these and other similar employee benefits (such as retirement plans) as employees are more likely to spend small amounts over time than large amounts all at once. Employers typically aggregate an employee's deductions over a three-to-six month period until they are sufficient to exercise the option they have been granted.

The lucrative nature of the benefit can also help employers retain top-performing employees for the long haul. In some circumstances, buying and holding the stock option for some time can help employees maximize capital gains while minimizing their resulting tax liability. Further, the employee now has a direct financial interest in the company's long-term performance, which can keep them from jumping ship. You can also boost employee retention by clearly communicating their total compensations (including stock options). With a tool like Welcome's Total Rewards, employees can visualize career paths, equity and your compensation philosophy. 

What Happens When You Exercise Your Stock Options?

When you, as an employee, exercise your stock options, you purchase a specific amount of shares at a specific discount rate. Depending on the type of stock options you're issued, your employer may issue you certain IRS documents so that you may document any gain or loss appropriately. Also, depending on the type of option, the difference between the exercise and market price, when you exercised the option, and several other factors, you are subject to different tax rules which determine your tax liability and reporting requirements.

Employers must also complete different forms to comply with IRS reporting requirements and provide employees with the information they need to complete the return. Further, an employer may be required to withhold a portion of the employee's purchase for tax purposes in certain cases. 

Understanding Tax Rules for Employee Stock Options

To understand the tax implications of exercised employee stock options, it's important to understand the two types of options an employer can offer. The first is a non-qualified stock option (or a nonstatutory option), and the second is an incentive stock option (also known as a statutory option). The IRS treats each type quite differently.

Non-qualified stock options

A non-qualified option is immediately taxable when it is exercised. If an employee purchases the stock, the difference between its discounted purchase price and its fair market value is subject to tax. Because of this, employees typically sell their stock to realize the gain since it is taxable.

An employee may also choose to hold the stock, in which case they would be liable for the difference between the discounted price and the stock value at the time the option was exercised, as well as applicable FICA taxes. Even if the stock declines before the employee sells, the employee would owe taxes on the difference between the discounted purchase price and the exercise price. A loss could be offset in full, or in part, by the annual limit of $3,000 in capital losses an individual may claim in a given year.

Incentive stock option gains

In the case of incentive, or statutory, options, the employee is not liable for income tax upon receipt. Further, exercising the option does not trigger tax consequences as long as the employee holds the stock. And when the employee holds the stock for at least one year after the option was exercised and at least two years after receiving the option, all gains will be taxed at the long-term capital gains rate rather than at the normal income rate.

Waiting to exercise stock options and holding onto stock can be quite lucrative. An employee whose tax rate is 35 percent would pay that percentage of their profit in taxes if they exercise and sell their incentive stock option immediately. However, an employee in the 35 percent tax bracket would pay a long-term capital gains rate of 15 or 20 percent on any profit they earned.  

It's also important to understand that if the difference (or spread) between the option price and the market price is high enough, it may trigger an Alternative Minimum Tax (AMT) liability or add to an employee's AMT liability the year the option is exercised. The AMT is a tax rate designed for high earners who reduce their taxable income completely or substantially through deductions. It was designed to ensure that these earners paid at least some taxes.

Given that a high spread may put an individual over the threshold for an AMT liability or result in a higher tax basis for an employee in the year they choose to sell their shares, they need to understand the tax rules for statutory options.

Tax Rules for Statutory Stock Options

Beyond an employee's tax liability, each option type necessitates different employer reporting requirements that, if performed incorrectly, can create headaches for the employer and employee.

How Reporting Works 

For statutory stock options, employers complete IRS Form 3921 (Exercise of an Incentive Stock Option Under Section 422(b)) when an employee has exercised the option. The form will list the exercise price, the market value per share on the exercise date and the number of shares acquired. Selling the shares will trigger the completion of IRS Form 3922 (Transfer of Stock Acquired Through an Employee Stock Purchase Plan) by the employer, which will detail the employee's gain or loss from the sale and whether it is considered ordinary income or capital income. 

If an employee earns above a certain income, they must calculate their AMT tax liability and tax liability under regular tax rules to determine which method yields a higher tax. Given the complexity of AMT, employees should consult with tax professionals before doing so. They, or their tax agent, will need to complete IRS Form 6251 (Alternative Minimum Tax, individuals) to do so and report it appropriately.  

If an employee with statutory options:

  • Has transferable rights;
  • Their rights are unlikely to be forfeited the year they exercise them, and
  • They do not sell their stock during the same year they exercised the option.

They will likely need to make an adjustment to their AMT. However, they can potentially avoid the AMT if the market value of the exercised options drops and they sell those shares before the end of the year.

Tax Rules for Nonstatutory Stock Options

When an employee is awarded a statutory stock option, they will only face a tax liability if the option's market value can be readily ascertained (such as if the granted option is also publicly available on an exchange). However, in most cases, the market value of an option cannot be ascertained, so there is nothing to report.

For most employees, reporting starts when they exercise the option, at which point they are subject to income tax and payroll (FICA) tax. They then must report their profit as income (minus any commission costs) on their return. The employee will complete Form 8949 to show the transfer, though the gross profit will show on their W-2 as ordinary wage income. The employer will report that profit on Form 1099-B - a sum which should also be reflected on the employee's return. And when they sell the stock, they report the capital gain or loss on their return. 

How to Communicate Stock Options 

Employee stock options and ESPPs are excellent financial benefits, popular among employers and employees alike. But these plans have complex tax implications for both employees and employers that can be difficult to understand and comply with. At Welcome, we provide companies with the right tools to help their employees understand challenging concepts such as stock options and equip them so they can easily illustrate what employee stock options would be worth as the companies’ valuations change. .

If you're growing your workforce or working to retain top performers, offering stock options presents an excellent opportunity. However, given their complexity, these options can also be a burden to administer without the right tools.

Using Welcome's "Total Rewards" application, your team can manage your stock options plans more effectively for your employees. Capable of seamless integration with leading benefits platforms, "Total Rewards" gives employees an accurate look at the current and potential value of their options, as well as the impact their options have on their total compensation.

If you're interested in learning more or accessing a demo of "Total Rewards," please sign up to learn more.