Employer stock options remain a potentially valuable asset for recipient employees, especially when they work for start-ups or fast-growing enterprises. For example, many Silicon Valley millionaires got rich (or at least semi-rich) from exercising their employer stock options.
However, complicated tax rules apply to folks who exercise company stock options. And when the market goes south, you can wind up owing income tax on paper gains that have vanished.
This column summarizes what you need to know about the federal income and employment tax rules for employer-issued nonqualified stock options (NQSOs).
Employer stock option tax planning objectives
You will eventually sell shares you acquire by exercising an employer stock option, hopefully for a healthy profit. Your tax planning objectives are to:
1. Have most or all of that profit taxed at lower long-term capital gain rates.
2. Postpone paying taxes for as long as possible.
Key Point: Don’t let these tax planning objectives override the more fundamental financial planning objective of making as much money as possible on the deal without taking on excessive risk.
Two kinds of employer stock option
Employer stock options come in two basic flavors.
First flavor: incentive stock options (ISOs)
ISOs are also sometimes called qualified options or statutory options. They are entitled to preferential federal income tax treatment. However, they are also subject to tax-law restrictions that make them unattractive for company big-wigs and unfavorable handling under the dreaded alternative minimum tax (AMT) system. The most important restriction is that an ISO cannot offer you an exercise price that is lower than the stock price on the date the option is granted. I’ll cover ISOs in a later column.
Second flavor: nonqualified stock options (NQSOs)
NQSOs are not subject to any tax-law restrictions, but they also confer no special tax advantages. That said, you can get good tax results with advance planning. Employer-issued stock options that are not ISOs are NQSOs by default.
Tax results when you acquire and sell NQSO shares
When you exercise an NQSO, the bargain element (difference between market value and exercise price at the time of exercise) is treated as ordinary compensation income, same as a bonus payment. That bargain element will be reported as additional taxable compensation income on the Form W-2 you get from your employer for the year of exercise. So, the IRS knows what happened.
Your tax basis in NQSO shares equals the market price on the exercise date. Any subsequent appreciation is capital gain taxed when you sell the shares. If the market price falls on the exercise date, you have a capital loss.
On March 1, 2018, you were granted an NQSO to buy 2,000 shares of company stock at $25. On Dec. 15, 2018, you exercised the option when the stock was trading at $34. On May 15, 2020, the shares are trading at $52, and you cash in your chips. You paid 2018 federal income tax on the $18,000 bargain element (2,000 shares x $9 bargain element) at your ordinary rate. Assume you paid $4,320 (24% x $18,000).
Your per-share tax basis in the option stock is $34, and your holding period began on December 16, 2018.
When you sell on May 15, 2020 for $52 per share, you trigger a $36,000 taxable gain (2,000 shares x $18 per-share difference between $52 sale price and $34 basis). Assume the gain gets taxed at the standard 15% federal rate, resulting in a $5,400 tax hit (15% x $36,000).
When all is said and done, you net an after-tax profit of $44,280. Not bad. Proof: Sales proceeds of $104,000 (2,000 shares x $52) minus exercise price of $50,000 (2,000 shares x $25) minus $5,400 capital gains tax on the sale of the option shares minus $4,320 tax upon exercise.
Key point: To keep things simple-ish, this example assumes you don’t owe the dreaded 3.8% net investment income tax (NIIT) on your stock sale gain. We also assume the current favorable capital gain tax rates will still be in place when you sell your option shares. Fingers crossed. Finally, we ignore any state income tax hit. The Social Security and Medicare tax hit is explained at the end of this column.
Conventional wisdom NQSO strategy: exercise early
The after-tax results in Example 1 are pretty good. But if you had exercised earlier in 2018 when the stock was worth less than $34, you could have cut your tax bill for that year and increased the amount taxed later at the lower long-term capital gain rates. In fact, that’s the conventional wisdom strategy for NQSOs: exercise early to minimize the current tax hit and maximize the amount treated as hopefully lower-taxed long-term capital gain when you eventually sell the option shares.
Double dip strategy: version 1
Here’s a strategy worth considering for NQSOs: Instead of spending the cash to exercise the option, use the same amount to buy shares of company stock at market. Hold those shares until you have a significant gain eligible for favorable long-term capital gain tax rates.
Then sell the shares and pay the resulting tax hit (usually at a 15% federal rate, ignoring the 3.8% NIIT). Use the after-tax proceeds to exercise your NQSO.
Then you can immediately sell the option shares if you wish. That will trigger tax at ordinary rates on the entire profit from selling the shares. But you can still come out well ahead because you have two gains instead of one: a double dip of profit. Consider the following example.
Same basic facts as Example 1, except this time you bought 1,470 shares of company stock at $34 on December 15, 2018 with the same $50,000 you would have otherwise spent to exercise your NQSO.
You sell the 1,470 shares at $52 on May 15, 2020 and net an after-tax profit of $22,470. Proof: Sales proceeds of $76,440 (1,470 x $52) minus $50,000 exercise price (1,470 x $34) minus $3,970 capital gains tax (15% x $26,440).
Next, you spend $50,000 on May 15, 2020 to exercise your NQSO for the 2,000 shares and immediately sell those shares for $104,000 (2,000 x $52). You owe tax at your regular marginal rate, which we assume is 24%, on the $54,000 profit ($104,000 sales proceeds – $50,000 cost). So, you owe $12,960 to the Feds (24% x $54,000). You net an after-tax profit of $41,040 ($54,000 – $12,960).
Your combined after-tax profit from the two sales is a cool $63,510 ($22,470 + $41,040). That’s better than the $44,280 after-tax profit you would have earned by spending the same $50,000 to exercise the NQSO in 2019 and then selling at $52 per share in 2020, as in Example 1.
Key point: In both Example 1 and Example 2, you have the same $50,000 amount at risk. But the strategy illustrated in Example 2 has double dip profit potential.
Double dip strategy: version 2
While the preceding double dip strategy can be quite profitable when things go well, a less-risky double dip strategy is to hold the option and spend the same amount on other attractive equity investments. You will have a more diversified portfolio and avoid the risk that the company stock may underperform compared to other equities. Eventually, you can sell the other equities and use the resulting after-tax proceeds to exercise your in-the-money company stock option before it expires. You can then turn around and sell the company shares immediately if you wish.
The risk-free strategy for company stock options is to simply hold them until the earlier of: (1) the date you want to sell the underlying shares for a profit or (2) the date the options will expire. If the latter date applies and the options are in-the-money on the expiration date, you can exercise and immediately sell. If the options are under water, you can simply allow the options to expire with no harm done.
The elephant in the room
When you follow either of the double dip strategies or the risk-free strategy, all of your NQSO profit will be taxed at whatever ordinary income rates are in effect for the exercise year. If ordinary income tax rates go up in future years (a distinct possibility), your tax bill for the exercise year will be that much higher.
On the other hand, if you follow the conventional wisdom strategy by exercising early when tax rates are still low, your tax bill in the exercise year will be lower. But you lose the risk-free opportunity and the chance for a double dip of profits.
Bottom line: Place your bets and act accordingly.
Payroll tax hit from exercising NQSOs
When you exercise an NQSO, the bargain element (difference between exercise price and market price on the exercise date) is treated as ordinary compensation income. The income is therefore subject to federal income tax withholding and Social Security tax and Medicare tax withholding. The Social Security and Medicare taxes are on top of the income tax hit.
The last word
Employer-issued nonqualified stock options (NQSOs) can be a valuable perk, and you may be able to benefit from lower long-term capital gain tax rates on part (maybe a big part) of your profit. And you can potentially compound your after-tax profit with the double dip strategies. But beware of the risk of higher tax rates in future years. If you have a potentially lucrative NQSO in hand or coming soon, I suggest huddling with your tax pro for a planning session. Money well-spent.