One strategy companies have used in recent years is to reward employees with
options to purchase a certain amount of the company's stock for a fixed
price after a defined period of time. Usually (and hopefully), by the time the
employee's options vest (become eligible for exercising), the market price of
the stock has gone up, and they get to buy the stock for a lower price than
what it's going for in the current market.
Unless you're an executive, the options you receive from your employer are
probably nonqualified stock options. Nonqualified stock options are stock
options that do not meet specific requirements in the Internal Revenue
Code for special tax treatment. In this article, we're going to discuss the
tax implications of exercising nonqualified stock options.
For our purposes, let's assume that you receive options for stock
that is actively traded on an established market such as NASDAQ, but that the
options themselves aren't traded. The tax catch with this type of option is
that you must recognize taxable income equal to what's called the compensation
element when you exercise the stock options and purchase the stock.
Compensation element defined
Your compensation element is basically the amount of discount that you
get when you buy the stock using your options. It's calculated as (market value
- stock grant price) x # of shares you buy
- The market value of the stock is the stock value on the date you
exercise the options (i.e., the date you buy the stock under your option agreement).
- The stock grant price is the amount that you can buy the stock for
per your option agreement.
And here's the kicker: you have to report the compensation element on your
Form W-2 for the year you exercise the options.
When you start paying taxes on your options
First things first: You DON'T have to pay any tax on any income when you're
granted those options! If your boss just walked in and gave you an option
agreement that allows you to purchase 1,000 shares of company stock, you have
been granted the option to purchase stock. This grant by itself isn't
a taxable transaction. It's only when you actually exercise those options
or sell stock that you purchased originally with stock options that you have
a taxable transaction.
Types of stock option transactions
How you report your stock option transactions depends on the type of transaction
it is. Usually, taxable nonqualified stock option transactions fall into four
possible categories:
- You exercise your option to purchase the shares and you hold on to the
shares.
- You exercise your option to purchase the shares, and then you sell the shares
the same day.
- You exercise the option to purchase the shares, and the date that you sell
them is a year or less after the day you purchased them.
- You exercise the option to purchase the shares, and the date you sell them
is more than a year after the day you purchased them.
We discuss the tax implications of each category below.
Category 1: You exercise your option to purchase the shares and you
hold on to those shares.
- Exercise date: 6/30/2001
- Exercise price: $25.00
- Market price on 6/30/2001: $45.00
- Number of shares: 100
Your compensation element is the difference between the exercise price ($25.00)
and the market price ($45.00) on the day you exercised the option and purchased
the stock, times the number of shares you purchased.
$45.00 - $25.00 = $20.00 x 100 shares
= $2,000.00,
Your employer includes the compensation element amount ($2,000) in box 1 (wages)
of your Form W-2. Why is it reported on your W-2? Because it's considered "compensation"
to you -- just like your salary. Because it's included in your W-2 wages, it will
be reported on your tax return as usual.
Category 2: You exercise your option to purchase the shares, and then
you sell the shares the same day.
- Exercise date: 6/30/2001
- Exercise price: $25.00
- Market price on 6/30/2001: $45.00
- Sales Price on 6/30/2001: $45.00
- Commission paid at sale: $10.00
- Number of shares: 100
Like the previous example, the compensation element is $2,000, and your employer
will include $2,000.00 in income on your Form W-2. What if for some reason the
compensation element is not included in box 1 of your W-2? It's still considered
wages, so you must add it to Form 1040, line 7 when you fill out your tax return.
Next, you have to report the actual sale of the stock on Schedule D, Capital
Gains and Losses, Part I. Because you sold the stock right after you bought
it, the sale counts as short-term (i.e., you owned the stock for a year or less -- less
than an hour in this case). In this example, the date acquired is 6/30/2001,
the date sold is 6/30/2001, the sales price is $4,490.00, and the cost basis
is $4,500.00. The net loss is the difference of $10.00 (the commission), which
is your short-term capital loss.
Let's talk about how we determined these amounts. The sales price is the market
price at the date of sale ($45.00) times the number of shares sold (100); this
equals $4,500.00. Then you subtract any commissions paid for the sale ($10.00
in this example) to arrive at $4,490.00.
Because you sold stock, you'll probably receive a Form 1099-B, Gross Proceeds,
from the broker that handled your option purchase and sale. That form should
show $4,490.00 as your gross proceeds from the sale.
How did we come up with the cost? The cost is the actual price paid per share
times the number of shares ($25.00 x 100 = $2,500.00) PLUS any amounts
you were already taxed on, meaning the $2,000.00 calculated above and reported
on your Form W-2. Therefore, the total cost of your stock is $4,500.00.
Category 3: You exercise the option to purchase the shares, and the
date that you sell them is a year or less after the day you purchased them.
- Exercise date: 6/30/2001
- Exercise price: $25.00
- Market price on 6/30/2001: $45.00
- Sales date: 12/15/2001
- Sales Price: $50.00
- Commission paid at sale $10.00
- Number of shares: 100
Again, the compensation element of $2,000.00 (calculated the same as in the
previous examples) is considered income and will normally be included in box
1 of your Form W-2. Because you sold the stock, report the sale on Schedule
D, and in this example, a short-term capital gain will result.
As with the second example, if the $2,000.00 compensation element is not
included in Box 1 of Form W-2, then you must add it to Form 1040, line 7.
The stock sale is considered short-term because you actually owned the stock
less than a year. In this example, the date acquired is 6/30/2001, the date
sold is 12/15/2001, the sales price is $4,990.00, and the cost basis is $4,500.00.
The net gain is the difference of $490.00.
How did we get these figures?
The sales price ($4,990.00) is the market price at the date of sale
($50.00) times the number of shares sold (100), or $5,000.00, less any commissions
you paid when you sold it ($10.00). Form 1099-B from the broker handling your
sale should report $4,990.00 as the gross proceeds from your sale.
The cost is the actual price you paid per share times the number of
shares ($25.00 x 100 = $2,500.00) PLUS the compensation element of $2,000.00
already included in your W-2 for a total of $4,500.00.
Category 4: You exercise the option to purchase the shares, and the
date you sell them is more than a year after the day you purchased them.
- Exercise date: 06/30/2000
- Exercise price: $25.00
- Market price on 6/30/2000: $45.00
- Sales date: 12/15/2001
- Sales Price: $50.00
- Commission paid at sale: $10.00
- Number of shares 100
The compensation element is the same as in the preceding examples and should
have been included in box 1 of your W-2 in the year in which you originally
exercised the options to purchase the stock. Because this occurred in a previous
year, you don't have to pay tax on the compensation element again; it's now
considered part of your purchase price for the stock.
This time, you must report the sale of the stock on Schedule D, Part II because
it's long-term -- you owned the stock for almost 18 months. As in the preceding
example, the amount of gain is $490.00, calculated in the same manner.
Hopefully, these examples help clear up some of the mysteries of reporting
transactions involving nonqualified stock options. When you're granted stock
options, get a copy of the Option Plan or Prospectus from your employer and
read it carefully.
Your employer is required to withhold payroll taxes from that compensation
element we mentioned, but occasionally that doesn't happen correctly. In one
case we know of, an employee's payroll department did NOT withhold federal or
state income taxes from the employee's compensation element. He exercised his
options and sold the stock on the same day, then took his proceeds and bought
an $80,000 car, leaving very little cash in hand. Come April 15th,
he was extremely distressed to learn that his tax liability was huge (he had
to include a good portion of that $80,000 in income), and he had no ready cash
to pay his taxes. Don't let this happen to you!
An additional note: the IRS has added optional reporting requirements to the
2001 version of Form W-2 with regard to nonqualified stock options. This optional
reporting requirement also extends to the 2002 version of Form W-2. Employers
can report the income from a 2001 exercise of nonqualified stock options in
box 12 of the 2001 Form W-2 using a code of "V." The compensation element is
currently already included in boxes 1, 3 (if applicable) and 5, but now can
be also be reported separately in box 12 to clearly indicate the amount of compensation
arising from an exercise. For 2001 and 2002, employers aren't required to conform
to this reporting requirement, but after 2002, reporting in box 12 will be required. |
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