The Impact of Stock Options on your Taxes

There are two main types of stock options that companies grant their employees:

  1. Non-qualified stock options

  2. Incentive stock options (ISOs)

The first kind, non-qualified stock options, are more common. They are called “non-qualified” because they don’t qualify for the special tax treatment that incentive stock options (ISOs) do. But that’s ok, because having non-qualified stock options is better than not having any stock options at all.

The first taxable transaction for non-qualified stock options occurs when you exercise your right to buy the stock. For example, suppose you exercise your right to purchase 100 shares of company stock at $20 per share. It costs you $2,000. On the day you purchase these shares, the company stock is selling at $30 per share. The difference between what you actually paid for the shares and the current price is included in your paycheck. So, in this case, $1,000 ($30 per share minus $20 per share, * 100 shares) would be included in your next paycheck.

The second taxable transaction for non-qualified stock options occurs when you sell the stock. For example, suppose you decide to sell those 100 shares of stock that you originally purchased at $20 per share 18 months later when the company stock is selling at $50 per share. Your “long-term capital gain”, which is taxed a lower rate than your regular income, would be $2,000. We arrived at this number by starting with the sale price of $5,000 ($50 per share * 100 shares) and subtracting what you originally paid ($2,000) plus the amount that was originally included in your paycheck ($1,000).

We generally recommend holding on to non-qualified stock options for more than a year after you exercise your right to purchase the shares. Holding for more than a year, then selling, results in a “long term capital gain”, which is taxed at a rate much lower than your normal income. Selling the shares on the day you exercise your option to purchase or within a year of purchase results in a “short term capital gain”, which is taxed at the same rate as your other income.

Incentive stock options (ISOs) are less common, but more advantageous than non-qualified stock options. There is no taxable transaction when you exercise your right to purchase the stock, as long as you hold onto it for at least a year. Then, when you eventually sell the stock, the entire amount is treated as a long-term capital gain. The only downside is that we have to make an adjustment for the Alternative Minimum Tax (AMT) when you exercise your right to purchase, but given the new tax laws it is unlikely the adjustment will have a major impact.

Rick McCutcheon