by Jason Pryor
If you have access to employer-granted stock options, you may already understand that a stock option is the right to purchase a company’s stock in the future at a fixed price. And you also may know that in order to exercise an option, you must purchase shares of the company’s stock directly from the company at the grant price – a price set by the company at the time the stock option grant is made. In the best-case scenario, the price of the stock would appreciate beyond the grant price you will pay, which would allow the value of your option to also appreciate.
In order to become well versed in this unique benefit, you should also understand the various types of options. Below, we will explore the different types of stock options that may be available to you.
Stock options come in one of two forms: incentive stock options (ISOs) or nonqualified stock options (NSOs). The primary difference between the two types is how you will be taxed upon exercising the option.
Incentive Stock Options (ISOs): ISOs are not taxed at exercise but rather when the shares are sold. When you are granted incentive stock options there are no immediate tax consequences. The notable exception is that the exercise may cause you to be subject to the alternative minimum tax or AMT. When you eventually sell these shares, the difference between the selling price of the stock when sold and the cost basis (grant price) is the income you must consider for tax purposes. As long as you have held the stock for the required holding period, which is at least one year from the date of exercise and two years from the grant date, the entire difference between the selling price for the stock and your cost basis will be taxed as long-term capital gains. It is important to note that the rates for long-term capital gains are very favorable when compared to the tax rates for ordinary income.
Nonqualified Stock Options (NSOs): As the most common type of options granted by companies, you will probably become more familiar with NSOs. Like ISOs, there is no taxable event created when NSOs are granted, however, a taxable event does occur when you exercise NSOs. And unlike the ISO, this taxation occurs whether you sell the resulting shares immediately or continue to hold them following exercise. When an NSO is exercised, you must recognize that the taxable spread – which is the stock price on date of exercise minus grant price – will be taxed as ordinary income. So, this income will be considered as part of your total compensation and will be included in your W-2.
Once shares are exercised, your cost basis for the NSO shares will be equal to the stock price on the date of exercise. If you elect to hold the shares following exercise, this cost basis will be critical to computing your future gains or losses when you eventually sell the stock. At the time of a sale, you will recognize a capital gain or loss equal to the difference between your cost basis and the price at which you sell the shares. If you sell within one year of the date of exercise, the capital gain or loss will be considered short-term. But, if you sell the shares more than one year after the exercise date, a long term capital gain or loss will result.
Your employer-granted stock options can be a valuable benefit if you put together a well thought out plan for exercising them. Just remember the ins and outs of your company’s plan so you may continue to enhance your portfolio in the future.
Our firm does not give tax or legal advice.
This article was provided courtesy of K. Jason Pryor, Registered Representative with Dominion Capital Partners in Norfolk & Richmond at 804-986-1121. Securities offered through Prospera Financial Services, Inc., Member FINRA/SIPC. Accounts carried through First Clearing, LLC, Member NYSE / SIPC.