Tax Consequences of Stock Options

Tax Consequences of Stock Options

How are employee stock options taxed?

Employee Stock Options are not taxable when granted (Except for RSUs which are taxed differently). ESO taxation begins when the options are exercised, and taxes are calculated based on the spread between the current Fair Market Value (FMV) and the exercise price.

Your options are taxed differently at exercise depending on what type of options you own, however the way taxes are calculated, and the cost of exercising remains the same:

Type of Stock Option How are they taxed?
ISO When paying taxes on ISOs you are exempt from paying ordinary income tax. However, ISOs are subject to Alternative Minimum Tax (AMT) at exercise. AMT will only be a factor for wealthier tax payers or when the spread between the current FMV and the strike price is large (the AMT exemption recently changed due to 2018 Tax Reform). AMT tax won't be assessed until you pay your taxes the following Spring.
NSO NSOs are subject to ordinary income taxes based on the spread between the current FMV and the strike price of the option. As opposed to ISOs, NSO taxes are withheld when exercised.
RSU RSUs will always be taxed at the high ordinary income tax rates. An IPO triggers taxes for RSUs even if you aren't ready to sell the shares.

What does this all mean?

Let’s say you are granted 1,000 options with an exercise price of $1.

If the current FMV is $2 your taxable income will be $2 - $1 = $1 per share, thus your taxes will be based on $1,000 of income (then adjusted depending on the applicable tax rate). It is easy to see how exercising of options can charge a hefty price, thus why it often makes sense to exercise your options with The Employee Stock Option Fund to preserve your cash and avoid unnecessary personal risk.

Employee stock options are also taxed upon sale. If the sale occurs within 1 year of exercise, they are taxed as short-term capital gains (ISOs sold within a year of exercise will not be subject to AMT). Any sale taking place beyond one year of exercise is subject to the lower long-term capital gains rate.