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If you work for a public company in an executive position, a small start-up that you keep telling your parents is a "rocket ship," or one of the big tech companies where you can make "day in the life" Tik Tok's, then you're probably familiar with stock options. An employee stock option plan (ESOs) are a popular form of compensation offered by companies to their employees as part of their compensation income, essentially as a cheap way for a company to pay an employee lots and lots of money.
ESOs (sometimes called "employee stock purchase plan") give employees the right to purchase a specified number of shares of company stock at a predetermined price (known as the “exercise price” or “strike price”). ESOs can be a valuable form of compensation, especially when the price of company shares increase, as employees can realize a substantial profit by selling their stock.
However, it is important to understand the tax implications of ESOs, as the taxes owed on ESOs can be significant. In this article, we will examine the taxation of ESOs in the United States and provide an overview of the tax rules that apply to different types of ESOs, including nonqualified stock options (NSOs), incentive stock options (ISOs), and restricted stock units (RSUs). Please keep in mind that every individual's tax return is different, and tax consequences of these different options can be very unique. Please seek a licensed tax professional for your own personal situation, or for any specific tax purposes. Now, let's jump into the type of stock option that you might encounter in your day-to-day as a San Francisco-based coding genius.
Non-Qualified Stock Options (NSOs)
Non-qualified stock options (NSOs) are the most common type of ESO and are generally not eligible for any favorable tax treatment. When an employee exercises an NSO, the difference between the exercise price and the fair market value of the stock on the date of exercise is considered at the ordinary income tax rate. This ordinary income is usually taxed at the employee’s marginal tax rate, which can be as high as 37%.
In addition to the ordinary income taxes, employees may also owe alternative minimum tax (AMT) on the spread between the exercise price and the fair market value of the stock. The AMT is a separate tax system that was created to ensure that high-income taxpayers pay at least a minimum amount of tax, regardless of their deductions and credits. The AMT calculation takes into account the spread between the exercise price and the fair market value of the stock and adds it to the employee’s taxable income, adjusting the tax basis the employee is working from, and therefore their tax liability.
It is important to note that the spread between the exercise price and the fair market value of the stock is considered taxable income even if the employee does not sell the stock. That's right! There are downsides to being a coding genius, and that includes "everything is a taxable event for you." If the employee holds onto the stock, the spread between the exercise price and the fair market value on the date of exercise becomes the employee’s cost basis in the stock for purposes of calculating the gain or loss when the stock is eventually sold.
Incentive Stock Options (ISOs)
Incentive stock options (ISOs) are a type of ESO that is eligible for special tax treatment under the Internal Revenue Code. When an employee exercises an ISO, the spread between the exercise price and the fair market value of the stock is not taxed as ordinary income. Instead, the spread is taxed as a capital gain when the stock is sold.
In the exercise of an ISO, there are two types of capital gains: short-term capital gains, which apply to assets held for one year or less, and long-term capital gains, which apply to assets held for more than one year. Long-term capital gains are taxed at a lower rate than short-term capital gains and ordinary income. For example, in 2023, the long-term capital gain tax rate ranges from 0% to 20%, depending on the taxpayer’s income, while the short-term capital gain tax rate ranges from 10% to 37%.
In order for the special tax treatment for ISOs to apply, the employee must hold the stock for at least one year from the date of exercise and two years from the date the option was granted. If the employee sells the stock before these holding periods have been met, the spread between the exercise price and the fair market value of the stock will be taxed as ordinary income, and the employee may also owe AMT on the spread.
In addition, there are limits on the amount of ISOs that an employee can exercise in a single year without triggering the alternative minimum tax. For 2023, the ISO exercise limit is $100,000. If an employee exercises more than $100,000 worth of ISOs in a single year, they may owe AMT on the excess amount.
Restricted Stock Units (RSUs)
Restricted stock units (RSUs) are a form of equity compensation in which an employee is granted a certain number of shares of the company’s stock, subject to certain conditions. RSUs are taxed differently than NSOs and ISOs, as they are taxed as ordinary income at the time they vest, rather than at the time they are exercised.
At the time of vesting, the employee’s taxable income is equal to the fair market value of the stock, which is then taxed as ordinary income at the employee’s marginal tax rate. The employee’s cost basis in the stock for purposes of calculating the gain or loss when the stock is eventually sold is equal to the fair market value of the stock at the time of vesting.
While the above sounds like a financial hellscape of doom, gloom and social security tax payments, there is good news to remember here: you're still making money! Taxation of employee stock options only happen when you...have employee stock options, and that's the new-age way to build a LOT of wealth!
However, it is important to understand the tax implications of employee stock options before exercising or selling any options. The type of ESO and the timing of the exercise or sale can have a significant impact on the taxes owed. There are also other important factors to consider, such as: your tax year versus calendar year, your employee stock vesting schedule, what state you live in and what your state income tax is, what the sale price is, if you have any AMT adjustments and so on. This is why tax preparers get paid so much fucking money: because they have to deal with this nonsense every single tax year. Please do not do this yourself if you have a complicated tax situation. Please find a certified tax professional, or get ready for the hammer that is the federal government.