Stock Options and Taxes: What You Don't Know Can Cost You

March 22, 2004

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

Stock options let you buy shares of your employer's stock at a strike price (exercise price) which is set in the grant agreement. You don't incur taxes when options are granted to you, but they come into play when you exercise the options. Understanding how stock options are taxed can help you maximize your potential return and minimize the tax bite.

ISOs receive special tax treatment

Incentive stock options (ISOs) receive special tax treatment as long as you exercise and hold the shares for more than two years from the grant date AND more than one year from the exercise date. In this case, the spread—the difference between the strike price and the market price on the date of exercise—is exempt from ordinary income tax.

What's more, when you sell the shares any gain is subject to the favorable long-term capital gains tax of 15% (at least through 2008—after that the rate goes back to 20%). However, exercising ISOs may trigger alternative minimum tax (AMT).

AMT rules are complicated. Exercising ISOs doesn't automatically mean you'll owe AMT since it can be triggered by many events. Before you exercise ISOs, you should discuss your overall AMT situation with your tax advisor. 

If you sell your ISO shares without meeting the holding period requirements—what's called a disqualifying disposition—and if the sale occurs in the same year as exercise, the spread becomes taxable as ordinary income. Any gain from the sale of the shares is not eligible for long-term capital gains tax treatment.

NQSOs are taxed as ordinary income

When you exercise nonqualified stock options, or NQSOs, the spread is taxed as ordinary income in the year of exercise and is subject to income and payroll tax withholding. If you hold the shares more than one year after you exercise, then sell the shares for a gain, you can receive favorable long-term capital gains tax treatment.

If you hold the shares one year or less after exercise, then sell for a gain, you can receive short-term capital gains treatment, which means the gain is taxed at your ordinary income tax rate.

How exercise methods affect taxes

  You have three ways to exercise stock options. Here's a brief summary of each and the tax treatment at the time of exercise.

Cash exercise. You buy shares of stock and hold the shares. You pay cash for the exercise costs, transaction fees and any taxes.

• If you exercise ISOs, no income taxes are due on the spread, but AMT may be triggered.
• If you exercise NQSOs, the spread is taxed as ordinary income, subject to withholding at the time of exercise.

Cashless exercise. You buy shares of stock and you simultaneously sell some or all of the shares.

• If you exercise ISOs, no income taxes are due on the spread for the shares you hold, but AMT may be triggered. The shares that you sell are "disqualified" and the spread is taxable as ordinary income. If you sell the shares for more than the exercise price, the gain is subject to capital gains tax.
• If you exercise NQSOs, the spread is taxed as ordinary income, subject to withholding at the time of exercise.

Swap. If your plan allows, you may use previously owned company stock to exercise your stock options.Swaps are complicated and taxation depends on many factors. You must keep careful records that document information such as the type of shares you're swapping, how and when you acquired them, their cost basis and what type of option you're exercising. You should talk to an investment advisor and/or tax advisor before doing a swap. 

The taxation of stock options is complex. Make sure you consult with a tax advisor before exercising in order to get the most from your options.