Tax Implications of Employee Stock Options

Since employer stock options are so common these days across the public and private sector, here's a short primer to help you avoid a nasty tax bill.

Elijah Keaton


Elijah is a CPA based out of California. After spending four years in public accounting preparing high-net-worth individual, partnership, trust, and corporation tax returns he shifted his career to a payroll tax start-up, Zeal. His role at Zeal includes filing payroll tax returns, researching payroll tax topics in all 50 states, and working with engineers to turn real world data into a software product used by hundreds of employers.

What are Employee Stock Options?

When an employer gives its employees stock options, they essentially give employees an option to buy their stock at an agreed-upon price (exercise price) and date. The employee is under no obligation to purchase these shares, but in many instances, employee stock options (ESOs) are used in addition to salary to compensate employees. ESOs are similar to standard call options, with the exception that if the market value of the stock rises above the exercise price, ESOs cannot be traded prior to the exercise date. Typically, ESOs come with vesting schedules that limit when the options can be exercised.

What are the tax implications when an employee gets paid in stock options? He pays only capital gains.

What Are The Types of Employee Stock Options?

Generally, there are two types of employee stock options, incentive stock options (ISOs) and non-qualified stock options (NSOs). In both cases, the holder has a right to purchase stock at a specified price. ISOs are typically only offered to key employees at a company (CEO, upper management, etc.) and are eligible for preferential tax treatment. NSOs are usually given to all employees and potentially those outside of the company (such as board members, contractors, etc.) and are not eligible for preferential tax treatment.

When Should I Exercise My Employee Stock Options?

Financially, it would make sense for an employee to exercise their stock options If the fair market value is greater than the exercise price.

For example, Jim was granted employee stock options to purchase 100 shares of company XYZ, Inc. at $50 per share after working one year at the company. After his one-year anniversary at the company, the market value of XYZ, Inc. stock on the open market is $100 per share. Jim would purchase 100 shares at $50 per share and turn around and sell the shares for a $50 profit per share.

How are Employee Stock Options Taxed?

To begin with, both ISOs and NSOs are not taxable when initially granted so long as the FMV of the stock is equal to the exercise price of the stock as of the grant date. If the FMV is greater than the exercise price, the difference in value is subject to ordinary income tax rates.

Incentive stock options are taxed when you finally sell after purchasing at the exercise price. These gains will be taxed as capital gains. Your holding period for these shares begins at the exercise date, so you must hold for at least one year to receive the favorable long-term capital gains rate. Using our example with Jim above, Jim would not pay any taxes when he exercises shares of XYZ, Inc. for $50. His basis in XYZ, Inc. would be $50 per share and would pay capital gain rates after he sells.

Non-qualified stock options are taxed when exercised. Those who exercise the options must pay ordinary income tax rates on the difference between the FMV of the shares and the exercise price. After you exercise the shares, your basis in the shares becomes the FMV at the exercise date. Any future gains or losses are subject to capital gain rates, with the preferential long-term capital gain rate coming after holding the shares one year or more from the exercise date. In our example with Jim, at the exercise date, Jim would pay ordinary income tax on $50 per share ($100 FMV - $50 exercise price). Jim’s basis in XYZ, Inc. would be $100 per share, and any future gains or losses would be subject to capital gain rates.

It is important to keep in mind that these types of transactions tend to have significant details in the small text and the smartest approach is to work with a tax professional.

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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult your tax professional. If you're looking to work with an accountant and need help finding someone, leave your information here, and we'll connect you.

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