How to tax and report on stock options

Stock options are employee benefits that enable them to purchase employer stock at a price lower than the stock market price. Options do not convey ownership rights, but exercising them to acquire shares does. There are different types of options, and each option has its own tax result.

Key points

  • Stock options are divided into two different categories: statutory options granted under purchase plans or incentive stock option plans, and illegal fixed-term rights without plans.
  • Income is generated when you sell shares acquired by exercising statutory stock options, which generates an alternative minimum tax.
  • If you exercise a non-statutory option, you must include the fair market value of the stock at the time of purchase, minus any amount you paid for the stock.
  • When you sell stocks, you will report capital gains or losses on the difference between the tax base and the sale proceeds.

Two stock options

There are two types of stock options:

Tax rules for statutory stock options

Granting ISO or other statutory stock options will not generate any direct income subject to regular income tax. Similarly, as long as you hold stocks in the year you acquire the stocks, exercising the option to acquire stocks will not generate any direct income. When you later sell the stock obtained by exercising the option, you will generate income.

However, implementing ISO will result in an alternative minimum tax or AMT adjustment—a shadow tax system designed to ensure that those who reduce conventional taxes through deductions and other tax reliefs will pay at least some taxes. The adjustment is the difference between the fair market value of the stock obtained through the exercise of ISO and the amount paid for the stock, plus the amount paid for the ISO (if any). However, adjustments only need to be made if your rights in the stock are transferable and there is no significant risk of forfeiture in the ISO exercise year. When stock rights are transferable for the first time or the rights no longer face major risks of forfeiture, the fair market value of stocks used for adjustment purposes is determined without considering any invalidation restrictions.

Form 6251 will help you determine if you owe any AMTs after performing ISO.

If you sell shares in the same year that ISO is implemented, there is no need to adjust AMT. This is because the tax treatment has become the same for conventional taxation and AMT purposes.

If you must make AMT adjustments, please increase the basis in the stock through AMT adjustments. Doing so can ensure that the taxable income for AMT purposes is limited when you sell stocks in the future, which means that you will not pay taxes twice on the same amount.

How the report works

When you exercise your ISO qualifications, your employer will issue Form 3921-Incentive Exercise of Stock Option Plans under Section 422(b), It provides the information required for tax reporting.The following is an example of how to use the information in Form 3921 to report ISO implementation:

For example, if you exercised ISO to purchase 100 shares this year, the rights can be transferred immediately and you will not face significant risk of forfeiture. You paid $10 per share (strike price), reported in box 3 of Form 3921. At the exercise date, the fair market value of the shares was $25 per share, reported in Box 4 of the table. The number of shares acquired is listed in box 5. AMT adjusted to $1,500 ($2,500 [box 4 multiplied by box 5] Minus $1,000 [box 3 multiplied by box 5]).

When you sell stocks acquired through the implementation of ISO or employee stock purchase plans, you will report the sales gains or losses.When purchasing shares at a discounted price under the employee stock option plan, you will receive Form 3922-Transfer of shares obtained through the employee stock purchase plan Transfer agent from your employer or company. The information on this form can help you determine the amount of gain or loss, and whether it is capital income or ordinary income.

Tax rules for non-statutory stock options

For this type of stock option, there are three events, each of which has its own tax consequences: the grant of the option, the exercise of the option, and the sale of the stock obtained through the exercise of the option. Only when their fair market value can be easily ascertained (for example, options are actively traded on an exchange) can taxes be immediately imposed on these options received.However, in most cases, there is no easily ascertainable value, so the granting of options does not incur any tax.

When you exercise an option, you will receive the fair market value of the stock minus any amount you paid for the stock as income. This is your ordinary salary income reported on W2, so it adds to your stock tax base.

Later, when you sell stocks acquired by exercising options, you will report capital gains or losses on the difference between your tax base and the sale proceeds.

Bottom line

Stock options can be a valuable employee benefit. However, the tax rules are complicated. If you receive stock options, you should consult a tax advisor to determine how these tax rules affect you.


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