01 Jun Got stock options? Don’t wait until tax time to seek guidance
Start-ups are to California as blades of grass are to a lawn. Chances are this analogy wasn’t on your SAT exam, but if it were, most people would probably answer correctly. When you live in California, you know someone who works (or worked) for a start-up. Chances are that some within that group were offered stock options. Maybe that person is you. If it is you, you best wise-up to the tax implications of these options lest you opt to pay Uncle Sam vast sums of money. Does your employer offer incentive stock options (ISOs), nonqualified stock options (NSOs), Restricted Stock Units (RSUs), stock appreciation rights (SARs), phantom stock, or an Employee Stock Purchase Program (ESPP)?
Clearly, the goal with stock options is to make money. Beyond that, the goal is to make sure as much of the money made is taxed at the lowest rates possible. The key here is achieving long-term capital gains tax treatment as opposed to ordinary income tax (think Mitt Romney here).
If you are offered NSOs, the implications are straightforward. When you exercise the option to buy the stock, you are taxed on the difference between the price you pay and the market value of the stock on the day you buy it. You can’t avoid it; your employer is required to include it on your W-2. Your choice point is essentially this: what year do I want to pay the taxes in and do I think the stock price is going to increase over time. If you answered yes to the second part, then you would be smart to exercise the option as soon as possible. The reason is that the appreciation of the stock subsequent to the exercise will qualify as a capital gain, instead of ordinary income.
If you are offered ISOs, then you have a few more things to consider. Unlike NSOs, when you receive ISOs, you aren’t taxed when you exercise the option. Rather, you are taxed once you sell the stock. How you are taxed depends on a two-pronged test:
- Did you hold the stock for at least a year after you exercised it?
- Did you sell the stock 2 or more years after the grant date of the option?
If the answer is yes to both, then you only have to pay long-term capital gain (which is taxed at a favorable rate) on the difference between the purchase price and the sales price. If you said no to either, then you will find yourself subject to NSO tax treatment.
How about RSUs? The complication ratchets up a bit. You can actually elect to be taxed on an RSU before you vest in the equity. Why would you do that? If the stock isn’t worth much now and you think it will be worth more in the future, you may as well take the tax hit for the difference between the purchase price and the market value at the time. Beware though, you only have 30 days after the grant date to make this election with the IRS.
These are just some of the high notes on the tax planning considerations for stock options. I’ll save the other options for another post. The main takeaway is that it’s in your best interests to seek advice on the front end so you aren’t stuck with lousy tax treatment on the back end.