When Are You Subject to Tax on Employee Stock Options?

If you receive an employee stock option, you will be subject to federal income tax at some point. This could be when you receive the option, when you exercise the option to purchase stock, or when you sell or dispose of the option itself or the stock you purchase with the option. According to the IRS, this depends on whether the option you receive is a statutory or a non-statutory option.

Statutory options

Generally, if you receive an option under an employee stock purchase plan or an incentive stock option (ISO) plan, it would be considered a statutory stock option. As explained in CNN Money, a stock option gives you the right to purchase a certain number of shares of stock in the company at a certain price. The stock option gives you a certain period of time in which to exercise the option. And there may be a vesting schedule that determines when you can exercise the option.

If you receive a statutory stock option you are not subject to federal income tax when you receive the option or when you exercise it. When you eventually sell the stock you purchased with the option you would have a taxable gain or loss. Your gain or loss would be the difference between the option price at which you purchased the stock and the amount you received from the sale. This would be a capital gain that you would report on Schedule D if you meet the holding period requirement.

According to the IRS, you meet the holding period requirement if you do not sell the stock before the later of one year after the stock was transferred to you or two years after the option was granted. If you do not meet this requirement, and you had a gain on the sale of the stock, the gain would be considered ordinary income that you would have to report as wages on your tax return. If the sale resulted in a loss, it would be a capital loss.

If you are subject to the alternative minimum tax, the difference between the fair market value of the stock you acquired by exercising the option and the amount you paid for the stock is considered a preference item. This amount enters into the calculation of the alternative minimum tax, even though it is not subject to regular income tax.

Non-statutory options

In the case of non-statutory stock options you may be subject to federal income tax when you receive the option. If the fair market value of the option can be readily determined, for example when the options are traded on an exchange, and you are substantially vested in the option, you would include the fair market value of the option in your taxable income as wages.

If the option does not have a readily determinable fair market value, you would not be subject to income tax when you receive the option. Instead, when you exercise the option you would be subject to tax on the fair market value of the stock you receive, minus the amount you paid for the stock. Later, if you sell the stock, you would have a capital gain or loss.

Sources:
Employee stock options, CNN Money
Instructions for Form 6251, Alternative Minimum Tax, IRS
Publication 525, Taxable and Nontaxable Income, IRS
Schedule D, Capital Gains and Losses, IRS
Stock Options, IRS