Stock options are one of the most attractive rewards for employees working in American companies. But how are these options taxed and what is the basic knowledge for optimal tax planning? In this article, we will discuss US Stock Options and related taxes.
What are Stock Options?
A stock option is a plan that gives an employee the right to purchase stock in a company at a future date at a certain price. This gives employees the opportunity to participate in the company’s success and enjoy future benefits.
When are Stop Options taxed? What is the difference between ISO and NSO?
There are two main types of Stock Options. Incentive Stock Options (ISO) and Non-Qualified Stock Options (NSO). ISOs are subject to special tax regimes and may be subject to long-term capital gains tax rates.
Stock Option involves the process of (1) the company granting the Stock Option, (2) the employee exercising (purchasing) the Stock Option, and (3) the employee selling the stock.
There is no taxation at the time the Stock Option is granted.
Stock options are generally taxed at two points: when they are exercised (purchased) and when they are sold. Understanding the difference between ISO and NSO can provide tax benefits.
Incentive Stock Option (ISO)
・When exercised (purchased): Not taxed as income but may be included in the calculation of Alternative Minimum Tax (AMT) and pay Alternative Minimum Tax.
・When sold: Taxed as ordinary income or capital gains.
Non-Qualified Stock Option (NSO)
・When exercised (purchased)：Taxed as ordinary income.
・When sold: Taxed as a capital gain.
ISO and NSO case studies
＜Case Study＞
Your employer granted you a Stock Option and you exercised 1,000 shares for $1 at a fair market value of $6 per share.
After holding shares for a period of time, you sell 1,000 shares at $10 each.
Let’s see what kind of taxation difference there is between ISO and NSO in the above case.
ISO
When exercised (purchased)
$5,000 (1,000 shares x <$6 – $1>) of gains due to the fair market value being greater than the amount granted is not taxed as income and is not included in the Alternative Minimum Tax (AMT) calculation. included. This Alternative Minimum Tax (AMT) calculation applies only if you purchased an ISO and did not sell it in the same tax year. You pay the higher of the regular income tax and the Alternative Minimum Tax (AMT). We recommend that you set aside funds for your obligation to pay the Alternative Minimum Tax (AMT).
When sold
When you sell shares affects the tax rate on the gain.
You can take advantage of ISO tax savings if you meet the following retention requirements: This results in a lower long-term capital gains tax rate on all taxable earnings.
Shareholding requirements
・2 years after being granted ISO, and
・One year after exercising ISO
The holding period of the shares acquired upon exercising the Stock Option begins the day after the Stock Option is exercised.
<1> If you meet the shareholding requirements
Gains and losses on the sale of shares are subject to the long-term capital gains tax rate.
For our case study, $9,000 (1,000 shares x <$10 – $1>) is the long-term capital gain. Long-term capital gains tax rates may be lower than regular income tax rates.
<2> If you do not meet the shareholding requirements
If there is a profit on sale, the amount exceeding the amount given to the fair market value of the stock at the time of exercising the stock option will be ordinary income, and the excess profit will be capital gain. If there is a loss on sale, it will be a capital loss. For ordinary income, your employer or former employer must include it in Box 1 of Form W-2 as wages.
For our case study, $5,000 (1,000 shares x <$6 – $1>) is normal income and $4,000 (1,000 shares x <$10 – $6>) is capital gain. Capital gains are long-term capital gains if the stock has been held for more than one year, and short-term capital gains if the stock has been held for less than one year.
NSO
When exercised (purchased)
The gain of $5,000 (1,000 shares x <$6 – $1>) due to fair market value exceeding the amount granted is generally taxable as ordinary income.
When sold
The difference between the selling price and the post-exercise acquisition price of $4,000 (1,000 shares x <$10 – $6>) is taxable as a capital gain. If the stock is held for more than one year, it is a long-term capital gain, and if it is held for less than one year, it is a short-term capital gain.
As mentioned above, NSOs are taxed twice as income at the time of exercise and at the time of sale, so the tax burden is generally higher for NSOs than for ISOs.
Ordinary income tax rate and long-term capital gains tax rate
Long-term capital gains tax rates range from 0% to 20%. The ordinary income tax rate is a progressive tax with a top rate of 37% in 2023. Depending on the amount of taxable income, long-term capital gains tax rates can be more favorable than regular income tax rates.
Summary
Stock Options provide employees with the right to purchase shares of a company at a certain price at a future date, giving employees the opportunity to participate in the company’s success and enjoy future profits.
There are two main types of Stock Options, Incentive Stock Options (ISO) and Non-Qualified Stock Options (NSO), each with their own taxation rules. Through case studies of ISO and NSO, we have shown the difference in taxation at the time of exercise and at the time of sale, and also explained the difference in tax rate depending on the holding period of the shares.
Finally, we touched on the benefits of long-term capital gains tax rates and highlighted points employees should consider when making the best tax plans. This basic knowledge of Stock Options and Taxes will be important for your employees and will be part of a wise financial plan.
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