Updated for Tax Year 2014

OVERVIEW

Exercising options to buy company stock at below-market price triggers a tax bill. How much tax you pay when you sell the stock depends on when you sell it.

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One way to reward employees

One strategy companies use to reward employees is to give them options to purchase a certain amount of the companys stock for a fixed price after a defined period of time. The hope is that by the time the employees options vestthat is, at the time the employee can actually exercise the options to buy stock at the set pricethat the market price of the stock will have risen, so the employee gets the stock for less than the current market price.

If youre an executive, some of the options you receive from your employer may be Nonqualified Stock Options. These are options that dont qualify for the more-favorable tax treatment given to Incentive Stock Options. In this article, youll learn the tax implications of exercising nonqualified stock options.

Lets assume that you receive options on stock that is actively traded on an established market such as the NASDAQ, but that the options themselves arent traded. The tax catch is that when you exercise the options to purchase stock (but not before), you have taxable income equal to the difference between the stock price set by the option and the market price of the stock. In tax lingo, that’s called the compensation element .

Compensation element

The compensation element is basically the amount of discount you get when you buy the stock at the option exercise price instead of at the current market price. You calculate the compensation element by subtracting the exercise price from the market value.

The market value of the stock is the stock price on the day you exercise your options to buy the stock. You can use the average of the high and low prices that the stock trades for on that day.

The exercise price is the amount that you can buy the stock for according to your option agreement.

And heres the kicker: Your company must report the compensation element as an addition to your wages on your Form W-2 in the year you exercise the options. This means the IRS knows all about your windfall, and treats it as, compensation income, just like your salary. You will owe income tax and Social Security and Medicare taxes on the compensation element.

When do I have to pay taxes on my options?

First things first: You dont have to pay any tax when youre granted those options. If you are given 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 isnt taxable. Its only when you actually exercise those options and when you later sell the stock that you purchased that you have taxable transactions.

How you report your stock option transactions depends on the type of transaction. Usually, taxable Nonqualified Stock Option transactions fall into four possible categories:

1. You exercise your option to purchase the shares and you hold onto the shares.
2. You exercise your option to purchase the shares, and then you sell the shares the same day.
3. You exercise the option to purchase the shares, then you sell them within a year or less after the day you purchased them.
4. You exercise the option to purchase the shares, then you sell them more than a year after the day you purchased them.

Each of these four scenarios has its own tax issues as the following four tax examples show.