2.16 Stock Options
Employees receiving statutory stock options do not incur regular income tax liability either at the time the option is granted or when the option is exercised. However, the option spread is generally subject to AMT (23.2). Statutory options include incentive stock options (ISOs) and options under an employee stock purchase plan (ESPP). Employees receiving nonstatutory (nonqualified) stock options generally must include the option spread in income for the year the option is exercised unless the stock does not become vested until a later year.
Incentive stock options (ISOs).
A corporation may provide its employees with incentive stock options to acquire its stock (or the stock of its parent or subsidiaries). For regular income tax purposes, ISOs meeting tax law tests are not taxed when granted or exercised. Income or loss is not reported until you sell the stock acquired from exercising the ISO. The option must be exercisable within 10 years of the date it is granted and the option price must be at least equal to the fair market value of the stock when the option is granted. If the fair market value of stock for which ISOs may first be exercised in a particular year by an employee exceeds $100,000 (valued at date of grant), the excess is not considered a qualifying ISO. An ISO may be exercised by a former employee within three months of the termination of employment; if exercised after three months, income is realized under the rules for nonqualified options, discussed later in this section.
AMT consequences of exercising ISO.
Although you do not realize taxable income for regular tax purposes when you exercise an ISO, you may incur a substantial liability for alternative minimum tax (AMT) (23.2). See the Caution on this page.
Caution
Gain or loss on sale of ISO stock.
If the stock acquired by the exercise of the ISO is held for more than one year after acquisition and more than two years after the ISO was granted, you have long-term capital gain or loss (5.3) on the sale, equal to the difference between the selling price of the stock and the option price you paid when you exercised the ISO. If you sell to comply with conflict-of-interest requirements, the holding period rules are considered satisfied.
If you sell before meeting the one-year and two-year holding period tests, a gain on the sale is generally treated as ordinary wage income to the extent of the option spread (bargain element)—the excess of the value of the stock when you exercised the ISO over the option price. Any gain in excess of the spread is reported as capital gain. In figuring the capital gain, cost basis for the stock is increased by the amount treated as wages. If the fair market value of the stock declines between the date the option was exercised and the date the stock is sold, the amount that must be treated as wages is generally reduced. The ordinary income (wages) is limited to the actual gain on the stock sale where the gain is less than the option spread at exercise. However, the reduction to ordinary income does not apply on a sale of the stock to a related person or if replacement shares are purchased within the wash-sale period (30.6) because the reduction applies only if a loss “would be” recognized if sustained (actual loss is not required for limitation to apply so long as a loss “would be” recognized).
If you have a loss on the sale of stock acquired by exercising an ISO, it is a capital loss and there is no ordinary wage income to report.
| Selling price ($20 × 1,000 shares) | $20,000 |
| Less: Cost of stock ($10 exercise price × 1,000 shares) | 10,000 |
| Gain | 10,000 |
| Less: Ordinary wage income | $5,000 |
| ($15,000 value − $10,000 option price) | |
| Capital gain ($20,000 sales price − basis of $15,000 | $5,000 |
| ($10,000 cost + $5,000 treated as wages)) |
Employee stock purchase plans (ESPPs).
These plans allow employees to buy their company’s stock, usually at a discount. The plan must be nondiscriminatory and meet tax law tests on option terms. Options granted under qualified plans are not taxed until you sell the shares acquired from exercising the option.
If you sell the stock more than one year after exercising the option and also more than two years after the option was granted, gain on the sale is capital gain unless the option was granted at a discount. If at the time the option was granted the fair market value of the stock exceeded the option price, then when you sell the stock, gain is ordinary wage income to the extent of that discount. Any excess gain is long-term capital gain. A loss on the sale is long-term capital loss.
If you sell the acquired stock before meeting the one-year and two-year holding period tests, you must report as ordinary wage income the option spread—the excess of the value of the stock when you exercised the option over the option price. This amount must be reported as ordinary income even if it exceeds the gain on the sale (which would occur if the sale price were lower than the exercise price). Add the ordinary income amount to your cost basis for the stock. If the increased basis is less than the selling price, the difference is capital gain. You have a capital loss if the increased basis exceeds the selling price.
| Selling price ($30 × 1,000 shares) | $30,000 |
| Less: Cost of stock ($20 × 1,000 shares) | 20,000 |
| Gain | 10,000 |
| Less: Ordinary wage income | 2,000 |
| ($22,000 value at grant − $20,000 option price) | |
| Capital gain ($30,000 sales price − basis of $22,000 | $8,000 |
| ($20,000 cost + $2,000 treated as wages)) |
Nonstatutory (nonqualified) stock options.
A nonstatutory stock option (also called a nonqualified option) can in some cases be considered nonqualified deferred compensation subject to the requirements of Code Section 409A (2.7). Under IRS regulations, the Section 409A rules apply if the exercise price can be less than the value of the underlying stock when the option is granted or the option permits any other deferral feature.
Caution
If the Section 409A rules do not apply, the amount of income to include and the time to include it depends on whether the option has a readily ascertainable fair market value when the option is granted. It is very rare for a nonstatutory option to be actively traded on an established securities market or to meet the other tests in IRS regulations for having a readily ascertainable fair market value.
In the usual case where there is no readily ascertainable fair market value for the option at the time it is granted, no income is realized on the receipt of the option. Income will not be realized until the year the option is exercised, assuming you are vested in the stock in the year you receive it. If the stock is not vested when you exercise the option, income is deferred until the vesting year under the restricted property rules (2.17). In the year that you become vested in the stock, you must report as ordinary wage income the value of the stock (as of the vesting date), minus the amount you paid. If you receive vested stock when the option is exercised, you are taxed on the difference between the fair market value of the stock when you exercise the option and the option price. For example, in 2012, you exercise a nonstatutory stock option to buy 1,000 shares of your employer’s stock at $10 a share when the stock has a value of $30 a share. Your rights to the stock are vested when you buy it. When you exercise the option you are treated as receiving wages of $20,000, equal to the option spread ($30,000 value − $10,000 cost). This income is subject to withholding taxes that you will have to pay out-of-pocket at the time of exercise unless the withholding can be taken from regular cash wages. The taxable spread will be reported as wages on Form W-2 and will be separately identified in Box 12, using Code V. Your cost basis for the shares is increased by the ordinary income reported for exercising the option. If you hold the shares for more than one year after exercising the option and then sell them for $35,000 ($35 a share × 1,000 shares), you will have a $5,000 long-term capital gain ($35,000 − $30,000 basis ($10,000 cost plus $20,000 taxed as wages at exercise)).
If in a rare case a nonstatutory stock option has an ascertainable fair market value, the value of the option less any amount you paid is taxable under the restricted property rules (2.17) as ordinary wage income in the first year that your right to the option is freely transferable or not subject to a substantial risk of forfeiture. However, a Section 83(b) election (2.17) may not be made for the nonstatutory option. For other details and requirements, see IRS Regulation Section 1.83-7.
Nonstatutory stock options may be granted in addition to or in place of incentive stock options. There are no restrictions on the amount of nonstatutory stock options that may be granted.