How Stock Options Are Taxed and Reported

Lea Uradu, J.D. is a Maryland State Registered Tax Preparer, State Certified Notary Public, Certified VITA Tax Preparer, IRS Annual Filing Season Program Participant, and Tax Writer.

Vikki Velasquez is a researcher and writer who has managed, coordinated, and directed various community and nonprofit organizations. She has conducted in-depth research on social and economic issues and has also revised and edited educational materials for the Greater Richmond area.

Stock options are employee benefits that enable an employee to buy their employer’s stock at a discount to the stock’s market price. The options do not convey an ownership interest, but exercising them and acquiring the stock does.

There are different types of options, each with its own tax implications.

Key Takeaways

• Stock options fall into two different categories: statutory and nonstatutory.
• Statutory options are granted under purchase plans or incentive stock options plans; nonstatutory options are not granted by a plan.
• Income derived from selling stocks acquired by exercising statutory options is subject to the alternative minimum tax.
• If you exercise the nonstatutory option, you must include the fair market value of the stock when you acquired it, less any amount you paid for the stock.
• When you sell the stock, you report capital gains or losses for the difference between your tax basis and what you received on the sale.

Types of Stock Options

Stock options fall into two categories:

• Statutory stock options, which are granted under an employee stock purchase plan or an incentive stock option (ISO) plan
• Nonstatutory stock options, also known as non-qualified stock options, which are granted without any type of plan

Tax Rules for Statutory Stock Options

The grant of an ISO or other statutory stock option does not produce any immediate income subject to regular income taxes. Nor does the exercise of the option to obtain the stock, as long as you hold the stock in the year you acquire it. Income results when you later sell the stock acquired by exercising the option.

Alternative Minimum Tax Rules

However, exercising an ISO requires an adjustment for purposes of the alternative minimum tax, or AMT. The AMT is a shadow tax system designed to ensure that those who reduce their regular tax liability through deductions and other tax breaks will pay at least some tax.

The adjustment is the difference between the fair market value of the stock acquired through the exercise of the ISO and the amount paid for the stock, plus the amount paid for the ISO, if any.

Importantly, the adjustment is required only if your rights in the stock are transferable and not subject to a substantial risk of forfeiture in the year the ISO is exercised.

Furthermore, the fair market value of the stock for purposes of the adjustment is determined without regard to any restriction lapse when rights in the stock first become transferable or when the rights are no longer subject to a substantial risk of forfeiture.

If you sell the stock in the same year you exercised the ISO, no AMT adjustment is required. This is because the tax treatment becomes the same for regular tax and AMT purposes.

If you have to make an AMT adjustment, increase the stock's cost basis by that amount. Doing this ensures that when the stock is sold in the future, the taxable gain for AMT purposes is limited, which means you don’t pay tax twice on the same amount.

Form 6251 will help you figure out if you owe any AMT after you exercise an ISO.

How Reporting Works

When you exercise an ISO, your employer issues Form 3921—Exercise of an Incentive Stock Option Plan under Section 422(b), which provides the information needed for tax-reporting purposes.

How to use information on Form 3921 to report the exercise of an ISO:

Say that this year you exercised an ISO to acquire 100 shares of stock, the rights of which became immediately transferable and not subject to a substantial risk of forfeiture. You paid $10 per share (the exercise price), which is reported in box 3 of Form 3921.

On the date of exercise, the fair market value of the stock was $25 per share, which is reported in box 4 of the form. The number of shares acquired is listed in box 5.

The AMT adjustment is $1,500 ($2,500 [$25 x 100 shares] minus $1,000 [$10 x 100 shares]).

How to use information on Form 3922 to report the sale of ISO-exercised stock:

When you sell the stock acquired through the exercise of an ISO or an employee stock purchase plan, you report a gain or loss on the sale. If the stock was acquired at a discount under an employee stock option plan, you’ll receive Form 3922—Transfer of Stock Acquired Through an Employee Stock Purchase Plan from your employer or the corporation’s transfer agent.

The information on this form helps you determine the amount of gain or loss, and whether it is capital or ordinary income.

Tax Rules for Nonstatutory Stock Options

For the nonstatutory type of stock option, there are three events, each with its own tax results:

1. The grant of the option
2. The exercise of the option
3. The sale of stock acquired through the exercise of the option

1. The receipt of these options is immediately taxable only if their fair market value can be readily determined (e.g., the option is actively traded on an exchange). In most cases, however, there is no readily ascertainable value, so the granting of the options does not result in any tax.

2. When you exercise the option, you include, in income, the fair market value of the stock at the time you acquired it, less any amount you paid for the stock. This is ordinary wage income reported on your W2, therefore increasing your tax basis in the stock.

3. Later, when you sell the stock acquired through the exercise of the options, you report a capital gain or loss for the difference between your tax basis and what you receive on the sale.

How Does a Stock Option Work?

A stock option gives an employee the right (though no obligation) to buy a pre-determined number of shares of a company's stock at a pre-determined price. There is usually a vesting period before you are able to purchase the stock.

Is a Stock Option a Good Benefit?

Yes, a stock option can be a good benefit. If employees receive stock options, they potentially can gain a personal interest in the company. If the company does well, its share price goes up, and the employees see a financial benefit if they own shares. If the company is private, stock options can also be a good benefit if the company eventually goes public, which delivers a financial gain to employees with stock options.

How Are Stock Options Taxed?

Stock options are taxed or the loss is deducted when the holder of a company's stock sells the stock they bought when they exercised their stock options. The gain will usually be taxed at a capital gains tax rate.

The Bottom Line

Stock options can be a valuable employee benefit because they convey the opportunity to buy a company's shares at a discounted price. However, the tax rules that concern stock options are complicated. Therefore, if you receive stock options, you should talk to a tax advisor to determine how these tax rules may affect you.

1. Internal Revenue Service. "Topic No. 427, Stock Options."
2. Internal Revenue Service. "Publication 525, Taxable and Non-Taxable Income," Page 12.
3. Internal Revenue Service. “Instructions for Form 6251, Alternative Minimum Tax—Individuals,” Page 4.
4. Internal Revenue Service. "About Form 6251, Alternative Minimum Tax - Individuals."
5. Internal Revenue Service. "Form 3921, Exercise of an Incentive Stock Option Under Section 422(b)," Page 4.
6. Internal Revenue Service. "Form 3922, Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423(c)," Page 3.
7. Internal Revenue Service. "Publication 525, Taxable and Non-Taxable Income," Pages 11-12.

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