In this blog post, we will explore the taxation of stock options and provide an overview of how it works.

Stock options are a common form of compensation for employees, particularly in startup companies. They give employees the option to purchase company stock at a predetermined price, allowing them to share in the company’s success as its value increases over time. However, stock options can also be a source of confusion when it comes to taxation. 

When an employee is granted stock options, they are not immediately taxed on the value of those options. Instead, taxation occurs when the employee exercises the options and purchases the underlying stock. At that point, the difference between the exercise price (the price at which the employee can buy the stock) and the fair market value of the stock is considered taxable income.

For example, let’s say an employee is granted stock options to purchase 1,000 shares of company stock at $10 per share, and the fair market value of the stock at the time of exercise is $20 per share. If the employee exercises the options and buys the stock, they will have taxable income of $10,000 (the difference between the exercise price of $10,000 and the fair market value of $20,000).

The timing of taxation is important when it comes to stock options. If the employee holds onto the stock after exercising the options, any future appreciation in the stock’s value will be subject to capital gains tax when the stock is eventually sold. However, if the employee sells the stock within a year of exercising the options, any gain on the sale will be subject to ordinary income tax rates, rather than the lower capital gains tax rates.

In addition to federal taxes, stock options may also be subject to state and local taxes. The rules and rates for state and local taxes vary by jurisdiction, so it is important for employees to consult with a tax professional to understand their specific tax obligations.

Employers are also subject to tax obligations when it comes to stock options. If an employer grants stock options to employees, they are required to report the grant to the IRS and withhold taxes on the income when the options are exercised. Failure to do so can result in penalties and interest charges.

Stock options can be a valuable form of compensation for employees, but it is important to understand the tax implications. Employees should be aware of when taxation occurs, the potential for different tax rates depending on the timing of sales, and the possibility of state and local taxes. Employers should also be aware of their tax obligations when granting stock options. Consulting with a tax professional can help ensure that everyone involved understands their tax obligations and can make informed decisions about their stock options.

You should always consult a financial, tax, or legal professional familiar about your unique circumstances before making any financial decisions. This material is intended for educational purposes only. Nothing in this material constitutes a solicitation for the sale or purchase of any securities. Any mentioned rates of return are historical or hypothetical in nature and are not a guarantee of future returns. Past performance does not guarantee future performance. Future returns may be lower or higher. Investments involve risk. Investment values will fluctuate with market conditions, and security positions, when sold, may be worth less or more than their original cost.

Jonathan Jordan,

Financial Advisor, CFP®, CEPA