How to Pay Taxes on Employee Stock Options

Through employee stock options, you may add several thousand dollars to your bottom line each year. Tax consequences on these transactions, of course, may stall the wealth-creation process. To coordinate strategy, it is therefore critical that you become familiar with basic tax law, as it relates to stock options. Stock options trigger unique tax consequences -- because they combine employee compensation alongside an investment component.

Employee Stock Option Structure

As part of your employee benefits' package, stock options grant you rights to purchase company stock at a set strike price for a certain period of time. You will exercise, or use, stock options when the market value for company shares exceeds your strike price. For example, you may be granted Acme Corporation stock options -- with a $55 strike price. You may opt to exercise options, if Acme were trading for $75 in the stock market. If Acme were to decline to $40, however, you would fare better economically to simply purchase shares at the market price through a stock broker.

Timing and Taxes

Employee stock options do not trigger tax consequences when they are initially granted. When you exercise stock options to buy shares, you are likely to owe ordinary income taxes. For the 2010 tax year, ordinary income is taxed at 10, 15, 25, 28, 33 and 35 percent rates. After buying company stock, you may ultimately sell shares for a profit. At that point, you would be responsible for paying taxes on realized capital gains. For tax purposes, capital gains are classified into short and long-term capital gains. Short-term capital gains are taxed as ordinary income, while long-term capital gains are either tax free or taxed at maximum 15 percent rates. For long-term capital gains, you must hold company stock for more than one year after exercising options to buy shares.

Ordinary Income Taxes

The difference between your employee stock options strike price and company stock market value is treated as compensation, and therefore taxed as ordinary income. Again, you may opt to exercise stock options to buy Acme Corporation shares for $55 -- when the stock actually trades for $75 in the market. For the tax year, you would then owe ordinary income taxes on $20 worth of employee compensation.

Capital Gains Taxes

For employee stock options, capital gains taxes and calculations only take market valuations into consideration. For Acme Corporation, you exercised $55 strike price options to buy a stock that actually traded for $75. In three years, Acme shares advance to $195, before you sell out your entire position. You would then owe long-term capital gains taxes on $125 worth of profits ($195 sales price - $75 original market price = $125).

How to Pay Taxes on Employee Stock Options, Source:

IRS: Stock Options

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