How Employee Stock Options Are Taxed and Reported…and How to Get the Most Out of Yours

Stock options, and other forms of equity, have remained a popular and sought-after part of employee compensation packages ever since the rise of technology stocks in the 1990s. They can be a clever way for employees to share in the company’s success. 

They can create a strong incentive for the employee to help ensure the company does well. 

Furthermore, stock options can also provide a substantial long-term return on your investment while also providing some protection against volatility in the market. In some cases, your stock options may even end up being more valuable than your salary—especially when you become part of a young startup that takes off. 

That’s why many companies, especially in the tech sector, continue using stock options as a way to attract and retain top-tier employees. 

But for every “Microsoft millionaire,” there are plenty of employees who purchase shares, find themselves saddled with “underwater options,” and end up owing more in taxes than their stock is even worth. 

If you consider accepting employee stock options as part of your compensation, you’ll need to consider the matter from all sides. For instance, it’s essential to understand how the IRS will treat your stock options for tax purposes and whether and how you should report them on your personal income taxes (given that they are a form of compensation). 

In this post, I’ll outline the basics of employee stock options and provide an overview of what you need to know about reporting and taxation. I’ll also show you how to make sure you get the most out of your stock options and avoid costly mistakes.

What are stock options?

A stock option gives an investor the contractual right (but not the obligation) to buy or sell a stock at an agreed-upon price and within an agreed-upon timeframe. 

An important distinction: an option is not itself a share of stock. An option is a derivative, meaning that its value derives from the value of an underlying security or asset (in this case, the company’s stock). 

When two parties agree that they have the option to sell or buy a stock at a specified price, regardless of that stock’s actual share price, within a set period, they have entered an “option contract.”

How do employee stock options work? 

Let’s use an example. Suppose you start working at a tech startup. In that case, the company may supplement your compensation with an agreement to sell you 2,000 shares of the company’s stock at $10 per share, at any time over the next ten years, with your right to exercise your options beginning after a one year waiting (or “vesting”) period. 

(This is just a hypothetical; actual details may vary depending on the company.)

If the stock’s share price falls below the fixed price agreed upon in your option, you are still bound by that original price if you wish to exercise your options. You are not obligated to do so, but if you took a lower salary because of that stock option’s potential for growth, you could end up losing out.  

Likewise, if you leave the company before you become vested or do not exercise your options within ten years, they reabsorb into the company. This would come at no cost to you, but you wouldn’t get rich, either.  

On the other hand, if it turns out you are working for the next Microsoft or Apple, and the share price of the stock soars, you can exercise your option to purchase at the predetermined lower price and collect your fortune. 

If your option price is fixed at $10 per share, for example, but the market share price is now $100, you can exercise your option, then turn around and sell for shares for a $90 profit. 

There are, however, tax implications. 

How are stock options taxed?

There are two basic categories of employee stock options (ESOs):

  • Statutory (qualified) stock options are granted as part of an employee stock purchase plan or incentive stock option (ISO) plan. 
  • Nonstatutory (nonqualified) stock options are granted without any plan.

The employer determines the type of option offered to an employee, and the main difference between these two categories is the way the IRS treats them for tax purposes. 

The good news is that you are unlikely to incur any taxes when you receive the option in both cases. 

Statutory (qualified) stock options

Qualified stock option plans offer tax advantages and must comply with specific IRS rules. Most statutory stock options do not produce any immediate taxable income until you sell the stock. 

Therefore, most qualified stock option plans require you to purchase shares and hold them for at least one year before selling. After that year, any gain on the sale is subject to favorable capital gain tax rates. 

Nonstatutory (nonqualified) stock options

Nonqualified stock options have fewer restrictions than qualified stock option plans. But they come with different tax consequences.  

If you purchase stock at a discount under a nonqualified plan, the difference between purchase and market prices is taxable as income. So if you buy the stock at $10 and the market price is $100, you will have $90 of taxable income.  

The option grant may also be taxable, but only if you can easily assess the fair market value of the option if, for example, it is already trading on an exchange. 

Another critical point: the term “nonqualified stock option” is a technical term describing certain types of stock options granted to employees. The term refers to how the IRS taxes the gain, not to the legitimacy of the transaction.

Where do I report my stock options?

Exercising your statutory or qualified stock option is generally not a taxable event in the usual sense. However, it can result in an Alternative Minimum Tax (AMT) adjustment. 

The AMT exists to ensure that filers who earn above a certain income level are still liable for a minimum tax payment regardless of how many deductions or loopholes they may apply. 

The best way to determine whether you owe anything towards the AMT is to fill out Form 6251. If the tax calculated on the form is higher than that on your return, you will need to pay the difference as Alternative Minimum Tax, in addition to your regular income tax. 

On the other hand, Nonstatutory or nonqualified options do generate income tax on the difference between the current fair market value of the stock and the price you paid for it. 

So if your $10 stock is now worth $100, you will pay tax on the $90 you made if your option was nonstatutory. 

In that case, your employer will usually report your profits as income on your W-2, and it will already be part of your taxable wages, with no additional action needed from you. 

How do I get the most out of employee stock options?

Much of getting the most out of your employee stock options comes down to timing. 

Remember, your vesting schedule won’t last forever, so be sure to act before your options expire.   

Before you exercise your options, make sure you fully understand the cost, including how it will impact your tax bill. Small mistakes can lead to much higher taxes, so the time to be proactive about your financial planning is now. 

Another best practice to keep in mind is that more diverse portfolios are generally considered lower risk. General advice is not to concentrate your investments on a narrow portfolio. Many advisors suggest that stock in a single company should not comprise more than 10-15% of your portfolio. 

You can also spread out the sale of your stocks over time to cushion their value against market fluctuations and decrease the percentage of your portfolio. 

Finally, the best advice is to work closely with a tax professional to make sure you understand your financial situation, know your options, and have the support you need to feel confident in your decisions. 

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Jeff Coyle, CPA

Jeff Coyle, CPA, Partner of Rosenberg Chesnov, has been with the firm since 2015. He joined the firm after 20 years of business and accounting experience where he learned the value of accurate reporting, using financial information as a basis for good business decisions and the importance of accounting for management.

He is a diligent financial professional, able to manage the details and turn them into relevant business leading information. He has a strong financial background in construction, technology, consulting services and risk management. He also knows what it takes to create organizations having built teams, grown companies and designed processes for financial analysis and reporting.

His business experience includes:

Creating and preparing financial reporting, budgeting and forecasting.
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Providing insight on financial results and providing advice based on those results.

Jeff also has a long history of helping individuals manage their taxes and plan their finances including:

Income tax planning and strategy.
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Prior to joining the firm in 2015, Jeff was in the private sector where he held senior financial and management positions including Controller and Chief Financial Officer. He has experience across industries, including construction, technology and professional services which gives him a deep understanding of business.

Jeff graduated from Montclair State University, he is a CPA and member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and New Jersey State Society of Public Accountants.

Jody H. Chesnov, CPA

Jody H. Chesnov, CPA, Managing Partner of Rosenberg Chesnov, has been with the firm since 2004.  After a career of public accounting and general management, Jody knows the value of good financials.  Clarity, decision making, and strategy all start with the facts – Jody has been revealing the facts and turning them into good business results for more than three decades.

He takes a pragmatic approach to accounting, finance and business. His work has supported many companies on their path to growth, including helping them find investors, manage scaling and overcome hurdles.  His experience and passion for business reach beyond accounting and he helps businesses focus on what the numbers mean organizationally, operationally and financially.

He has a particular expertise in early-stage growth companies.  His strengths lie in cutting through the noise to come up with useful, out of the box, solutions that support clients in building their businesses and realizing their larger visions.

Prior to joining the firm in 2004, Jody was in the private sector where he held senior financial and management positions including General Manager, Chief Financial Officer and Controller.  He has experience across industries, which gives him a deep understanding of business.

Jody graduated with a BBA in Accounting from Baruch College, he is a CPA and member of the American Institute of Certified Public Accountants and New York State Society of Certified Public Accountants.

In addition to delivering above and beyond accounting results, Jody is a member of the NYSCPA’s Emerging Tech Entrepreneurial Committee (ETEC), Private Equity and Venture Capital Committee and Family Office Committee.  

He is an angel investor through the Westchester Angels, and has served as an advisor for many startup companies and as a mentor through the Founders Institute.

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