Stock Option Taxation Considerations for Employees

The previous article discussed the basics of employee stock options, focusing mainly from the company’s perspective. However, employee stock options can also have significant tax consequences and impacts to the employees who receive them. Companies and founders need to understand these so that they can explain them to employees and design a compensation structure that achieves the desired goals. Employees should also understand how the options they receive are taxed so they can make choices to help them plan for and reduce taxes. This article discusses how stock options are treated for tax purposes for employees.

IMPORTANT NOTE: Since tax laws change and everyone’s situation is different, employees with stock options should consult with their own tax advisor to confirm the impact on them.

There are two categories of stock options:

• Incentive Stock Options (ISOs): These are usually granted to founders and key management employees. Incentive stock options enjoy preferential tax treatment if certain conditions are met.
• Non-Qualified Stock Options (NSOs): Non-qualified options are more commonly used than ISOs. Unlike ISOs, NSOs can be granted to anyone, including non-employees such as consultants, advisors, and board members. They lack the preferential tax treatment of ISOs, but they offer more flexibility in granting and are simpler to administer, making them significantly more common than ISOs.

There are no immediate tax consequences to employees when stock options are granted or vested for either type of option. Taxation occurs at two key junctures: when the options are exercised, and when the shares obtained through exercise are sold. The tax treatment varies between ISOs and NSOs.

It should be noted that stock options are usually granted at fair market value (FMV). If options are granted with an exercise price below FMV, then immediate tax implications are triggered. For this reason, options are rarely granted below FMV. For the rest of this article, it will be assumed that options are granted at an exercise price of FMV.

Although ISOs provide preferential tax treatment, they come with several limitations which make them less attractive to use. Some of these key limitations include:

• Eligibility: ISOs can only be granted to employees.
• Annual Limit: There is an annual $100,000 cap on the value of ISOs that can vest to any employee in a single year. Any ISOs in excess of the $100,000 limit automatically convert to NSOs and are subject to immediate withholding tax. (As a side note, employers should be careful how they design their vesting schedules for ISOs in order to avoid exceeding the $100,000 limit.)
• Expiration: ISOs must be exercised within 90 days following termination of employment. There is no similar limitation on NSOs.
• Company Tax Deductions: Employers cannot claim tax deductions when employees exercise ISOs, unlike NSOs.

The complexities of ISO holding periods as well as alternative minimum tax consequences (discussed further below) also make them more challenging to explain to employees.

In combination, all of the above factors limit the more widespread use of ISOs.

Understanding the tax treatment of stock options is critical in order to understand the potential tax consequences as well as to avoid an untimely and large tax bill. The income and gains from employee stock options are taxed in one of two ways: either as ordinary income, or as capital gains, depending on the circumstances of the share transactions.

Ordinary income is taxed at the employee’s marginal tax rate. The marginal tax rate is the tax rate of the top bracket in which the employee’s cumulative annual earnings fall. Outside of stock options, salary is typically the largest component of earnings and ordinary income.

The following table summarizes the U.S. federal tax brackets for 2024 and 2025 for a single filer. 

For example, the U.S. federal tax liability for someone earning $200,000 in 2024, before consideration of any tax credits or deductions, is computed as follows:

Capital gains apply to the sale of securities and property acquired and sold for a profit, and include the gains from the sale of shares acquired via employee stock options. Capital gains are classified as short-term or long-term depending on how long the shares were held.

• Short-Term Capital Gains: If the shares were bought and held for less than a year before being sold, then the gains are taxed as ordinary income.
• Long-Term Capital Gains: If the shares were held for a year or more before being sold, then the associated gains are eligible for a reduced tax rate. 

For 2024, the long-term capital gains tax rate is 15 percent for individuals with income between $47,026 and $518,900. If total income is above $518,900, then the long-term capital gains tax rate increases to 20 percent.

The gains on incentive stock options enjoy preferential long-term capital gains tax treatment if certain holding requirements are met. These conditions are:

• The shares must be sold at least two years after the grant date.
• The shares must be held for at least one year after the exercise date.

If the above conditions are met, the sale of the shares is referred to as a qualifying disposition. If the conditions are not met, then the sale is referred to as a disqualifying disposition.

On the exercise of an option to acquire shares, there is no immediate income or tax liability recognized on the spread between the FMV and the exercise price. However, the spread is input into the alternative minimum tax (AMT) calculation. AMT is designed to prevent individuals from avoiding or shifting tax liabilities out of the current tax year. If the AMT is greater than the regular income tax, the AMT must be paid instead; however, AMT is reduced when the shares are sold.

As long as the holding period criteria are met, then all of the gains between when the option was exercised and when the shares are sold are treated as long-term capital gains with the preferential long-term capital gains tax rate.

If the shares are sold before the holding periods for a qualifying disposition are met, then the preferential capital gains treatment does not apply and the entire gain is treated as ordinary income upon sale.

The taxation of NSOs is more complicated than for ISOs, with impacts at both the time of exercise and at the time of sale of the shares, requiring careful consideration by employees.

When an NSO is exercised, the spread between the FMV and exercise price is treated as ordinary income, taxed at the employee’s marginal tax rate.

Employers must report the spread as ordinary income of the employee, often as a component of W-2 wages. Employers are also required to withhold taxes on this component, just as they do with salary or wages. However, companies may not withhold the full amount required to cover the tax liability at the employee’s marginal tax rate, which can result in a tax withholding shortfall for the employee. This can create an unwelcome surprise when the employee is preparing their tax filing and discovers they have a substantial tax liability they need to fund.

At the time of an option exercise, the FMV of the shares forms the new tax basis for those shares going forward.

The subsequent sale of NSO-acquired shares triggers additional taxes based on the holding period after the original exercise of the option. If the shares were held for less than a year, then the gains on the shares are short-term capital gains and are taxed at ordinary income tax rates. If the shares were held for a year or more, then the gains qualify for long-term capital gains tax rates.

As noted above, the exercise of an NSO could create a significant tax liability for the employee if the spread between the FMV and exercise price is high. This tax liability is in addition to any cash the employee may have fronted in order to exercise the options.

Due to the high cash requirements to exercise options and pay the associated tax liability, many employees choose to exercise their options only after a company has gone public, allowing them to easily sell part of their shares and use the proceeds to offset the associated costs. However, doing so increases the employee’s tax burden for two reasons. First, waiting until the company is public is also likely to mean the company’s valuation is much higher at this point, resulting in a higher spread taxed as ordinary income. Second, acquiring and selling the shares immediately foregoes any potential capital gains treatment.

Employees can exercise their options sooner rather than later to take advantage of a smaller spread between the FMV and exercise price, as well as to give themselves more time to hold the shares before selling them, increasing the chance that future gains will be treated as long-term capital gains. However, this strategy assumes that a company is successful and that its value will continue to increase, which is not always assured. Exercising options before the company goes public could also result in locking up funds in an investment that cannot be easily liquidated in the event funds are needed, or even simply to realize losses for tax purposes.

Some companies may permit for a cashless exercise of options even before the company’s shares are liquid, whereby a number of options are effectively retained by the company in order to help cover the exercise price and taxes. This helps the employee avoid the upfront cash outlay outlined and could enable them to exercise their options sooner. Employees should review their company’s stock option plan to determine if the plan offers cashless exercise.

To quickly summarize, the decision on when to exercise NSO options is a balancing act between minimizing current and future tax liabilities and current cash outflows against the probabilities that the company’s shares will be worth more in the future and can be sold.

This section illustrates the tax impact of various scenarios using some simplified examples based on an option with an exercise price of $5, plus the assumptions that the marginal tax rate for ordinary income is 32 percent, the tax rate for long-term capital gains is 15 percent, and the employee is able to sell the shares when he or she wishes. Also assume the following valuations for the company:

Scenario A vs. Scenario B: Holding Period Impact

The first two scenarios demonstrate the impact of selling the shares after being held for less than or more than one year, to show the impact of long-term capital gains tax:

• Scenario A: The option is exercised in 2025, and the share is then sold in 2026 after being held for less than one year.
• Scenario B: The option is exercised in 2025, and the share is then sold in 2026 after being held for more than one year.

As the above table shows, holding the shares for more than a year after exercising the option results in a significantly lower tax liability, thanks to the lower tax rate for long-term capital gains treatment.

Scenario C vs. Scenario D: Timing of Exercise

The next two scenarios demonstrate the impact of being able to exercise options and hold the shares for more than a year to obtain long-term capital gains treatment, versus exercising the options and selling the shares at the same time.

• Scenario C: The option is exercised in 2026, and the share is then sold in 2027 after being held for more than one year.
• Scenario D: The option is exercised and the share is sold at the same time in 2027.

The table above shows that by being able to exercise early and hold the shares for more than a year results in higher net cash for the employee or option holder, thanks to part of the gain being taxed at the lower long-term capital gains rate. However, exercising early requires the employee to front a significant portion of the cash for not only the exercise of the options themselves but also to pay for the tax liability.

Both ISOs and NSOs present opportunities and challenges regarding taxation. For ISOs, meeting the criteria for a qualifying disposition can offer significant tax benefits. For NSOs, the timing of exercise and sale can significantly dictate the resulting tax implications, but this must be weighed against the risks and expectations of the company’s future valuation.

Employees are encouraged to consult their stock option plan documents and tax advisors to navigate these complexities. By assessing the advantages and disadvantages tied to exercising and holding periods, employees can optimize their tax strategies around stock options.

Understanding the nuances of stock option taxation is crucial not only for employees aiming to maximize their compensation but also for companies that seek to foster informed decision-making among their workforce.