In this lesson, you will learn some of the basics about the taxes that apply to employee stock options.
This chapter is a general discussion about taxes and employee stock options. Please don't consider it expert advice on tax matters.
I will cover the general principles that apply in most cases. However, as I am sure you are aware, the tax code is very complicated. You should always consult a tax professional with specific questions about your particular tax situation.
This chapter also deals strictly with stock options and unrestricted stock. If you receive stock through an employee stock option plan that has any restrictions on it, please consult a tax professional. The tax rules for restricted stock can be very different from the rules for options.
Caution
Special rules cover restricted stock and they are quite different from the rules governing stock options.
It is possible, for instance, to use vested stock options to acquire unvested stock. I discuss stock plans in Lesson 13, "Employee Stock Purchase Plans," and Lesson 14, "Employee Stock Ownership Plans."
For most people covered by employee stock options plans, the tax rules are relatively straightforward and easy to understand. In Lesson 10, "Taxes and Your Options," I relate them directly to options.
Not only are the tax rules complicated, they use a language that only an accountant could love. Fortunately, it's not hard to learn the few terms that are required to deal with stock options.
The tax code generally recognizes two types of income for individual taxpayers: ordinary income and capital gains.
The simplest way to understand ordinary income is that it is everything except capital gains. Your salary, dividends, interest, and so on are all considered ordinary income.
Obviously this definition doesn't address items like Roth IRA distributions, gifts, and so on. Since this book is not a tax guide, I'll pass right on by those complications and stick with how the tax code impacts options.
Capital gains (and losses) refer to the sale for a profit or a loss of a capital asset. For our purposes, this specifically refers to the stock you acquired through an employee stock option plan.
There are two types of capital gains or losses: long-term and short-term. The calendar decides which is which.
If you hold stock for more than one year (at least a year and one day) and sell it for a profit, that is a long-term gain. Any stock sold before the year and one-day limit is a short-term gain.
Tip
You should keep careful records on all your employee stock option transactions. Timing is crucial.
Why is this important to know? The long-term capital gains tax rate is 20 percent (10 percent if you are in the 15 percent tax bracket). The short-term capital gains tax rate is the same as ordinary income. For a person in the top tax brackets this can be significant, as we see later in this chapter. However, even persons of modest means can benefit by taking advantage of capital gains treatment.
You can generally use long- and short-term capital losses (in other words, selling your stock at a loss) to offset capital gains. See your tax professional for specific advice.
Tax brackets and how they relate to what you actually pay in taxes is a misunderstood topic. I'll try to make sense of it for you.
Individual taxpayers are assessed taxes on the amount of taxable ordinary income they have in the tax year using tax brackets. The more you make, the higher your tax bracket.
Here are the current tax brackets:
|
Married Filing Jointly |
Single | |
|---|---|---|
|
15% |
Less than $43,050 |
Less than $25,750 |
|
28% |
$43,050–$104,050 |
$25,750–$62,450 |
|
31% |
$104,050–$158,550 |
$62,450–$130,250 |
|
36% |
$158,550–$283,150 |
$130,250–$283,150 |
|
39.6% |
More than $283,150 |
More than $283,150 |
The income figures in this chart are your taxable income, that is after adjustments for deductions, and so on. The figures are not your gross income.
For example, you and your spouse had taxable income of $40,000 for the year. You would be in the 15 percent bracket. You pay 15 percent of $40,000, or $6,000 in taxes.
Plain English
Taxable income is what remains after you have claimed your deductions and credits. Two taxpayers with the same annual income can be in different tax brackets thanks to deductions and credits.
Now suppose you got a big bonus at the end of the year and it pushed your income to $45,000. That moves you into the 28 percent bracket. Is your tax bill now $12,600 ($45,000 × 28% = $12,600)?
No. Here is where the concept of brackets becomes apparent. Here is how you would figure your taxes:
First, you would pay 15 percent on the first $43,050 of income:
$43,050 × 15% = $6,457.50
Second, you would pay 28 percent on the remaining $1,950:
$1,950 × 28% = $546
Total taxes: $7,003.50
Fortunately, moving into the next higher tax bracket doesn't mean all your taxable income is subject to the higher rate. The higher rate only applies to the amount over the bracket limit.
However, you are in that higher bracket. Using the example above, you and your spouse are in the 28 percent bracket. This means that you pay the 28 percent rate on any additional income.
Although you are in the 28 percent bracket, you are not paying that on all your income. Your actual rate is a blend of the two brackets. For example, your total taxes are $7,003.50 on taxable income of $45,000. Your actual tax rate is 15.56 percent ($7,003.50 ÷ $45,000 = 0.1556).
It is important to know your tax bracket because it tells you the rate for any increase in income. Continuing our preceding example, say you had the opportunity to exercise and immediately sell stock through nonqualified stock options for a $10,000 profit; you know $2,800 will go to taxes.
Basis is the starting point for figuring out capital gains tax. For example, if you paid $5,000 for stock bought through a broker, the purchase price plus broker's fees ($20) establishes your basis ($5,020).
Tip
Your stockbroker will provide you with a 1099 form showing the amount you received when you sell stock. You need the supporting documentation to show what you paid for the stock. This establishes your basis.
Later, if you sell the stock for $6,000, your tax liability is for the difference between your basis and what you received for the stock, minus brokerage fees ($20). Here are the numbers:
How long you held the stock before you sold determines whether it is a short-term gain or a long-term gain. Either way your basis remains $5,020.
The alternative minimum tax (AMT) was designed to make sure people with high incomes didn't escape paying income tax through various credits and deductions not easily available to regular taxpayers. Unfortunately, its net is quite large and people of even fairly modest means may have to deal with AMT. Basically, AMT requires you to recalculate your income tax using a different set of rules.
Caution
The alternative minimum tax rules are complicated. Unless you are comfortable with the tax code, you should consult experts for the correct interpretation of the law in your case.
The AMT rules eliminate or reduce many of the deductions available under regular income tax rules. If your tax bill is higher under regular income tax rules, you do not have to pay AMT. However, if your tax bill is higher under AMT rules, you must pay your regular income tax plus the difference between AMT tax and regular income tax.
For example, suppose you compute your income tax under regular rules and find you must pay $28,000 in taxes. When you compute your tax under AMT rules, the tax bill is $34,000. What is your tax liability?
|
$28,000 | |
|
Tax under AMT rules: |
$34,000 |
|
Your tax liability is: |
$28,000 regular income tax |
|
|
$6,000 AMT tax |
|
|
$34,000 total tax |
Unlike regular income tax brackets, the AMT only has two rates: 26 percent and 28 percent.
Many situations can trigger AMT, so there is no way to know exactly when AMT comes into play on your return. One item or the combination of several items may trigger the tax.
Since this is not a guide to taxes, I won't explore every one of them. Broadly stated, if you have significant deductions and credits on your regular tax return, you may be a candidate for AMT.
Two items relating to employee stock options in particular on your return may trigger the AMT: long-term capital gains and incentive stock options.
AMT doesn't target long-term gains specifically. However, a large long-term gain may push you into AMT. This is because the tax rate for long-term gains is 20 percent, much lower than all but the bottom income tax bracket as we saw earlier.
For example, a person with a long-term gain of $100,000 in the 31 percent tax bracket would only pay $20,000 in tax instead of $31,000 under ordinary income tax rules.
AMT rules tax long-term capital gains at 20 percent also, but they can still pose a problem. There is an AMT exemption designed to protect lower income taxpayers.
Tip
The alternative minimum tax exemption or deduction can protect you from paying AMT; however, you have to know how to apply it.
A large long-term capital gain can wipe out this exemption. When that happens, other factors may push you into the AMT rules. The exemption is fairly large (it changes periodically, so check with your tax expert or the IRS) and does offer some protection.
If you are fortunate enough to hold a large block of stock with a large long-term capital gain, you should consult a tax expert before you sell the stock and generate the long-term gain.
A tax expert can help you determine if you will have any AMT liability and suggest ways to deal with the tax. With professional help, you may be able to time your long-term capital gains to minimize the AMT.
I explain in Lesson 5, "Incentive Stock Options," that incentive stock options incur no tax liability at exercise. For the most part, that is true. However, you do face an AMT "adjustment" at exercise and that may push you into paying AMT.
This adjustment is equal to the difference between the exercise price and the fair market value of the stock or the spread. You would report this amount as ordinary income if you were exercising nonqualified stock options.
It is impossible to tell just from the spread whether you will have to pay AMT, but the larger the spread, the more likely you will face an AMT bill.
Caution
Alternative minimum tax rules make it hard to know when it will apply. Some tax preparation software will alert you to the possibility, but professional help is usually the best course of action.
It is not possible to cover alternative minimum tax in detail within the scope of this book. However, it is important to be aware of several factors regarding AMT:
A combination of several items on your return can trigger AMT.
Taxpayers have an AMT exemption depending on their income.
Exercising incentive stock options triggers an AMT adjustment that can consume your exemption.
The only way to know for sure whether you owe AMT is to calculate your income taxes under the ordinary rules and under the AMT rules. If the tax is lower under ordinary income tax rules, you owe AMT.
Ordinary income is everything that is not a capital gain, such as salary, dividends, interest, and so on.
When you sell a capital asset (stock) for a profit (or loss), the result is a capital gain (or loss).
Profit from a stock held for more than one year is long-term capital gain. The tax on long-term capital gains is 20 percent.
Your taxable income determines your tax bracket.
A large long-term capital gain or exercising incentive stock options may trigger the alternative minimum tax.