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Understanding Taxes on Qualified & Non-Qualified Stock Options

Stock options that are granted neither under an employee stock purchase plan nor an ISO plan are nonstatutory stock options. Renew an Existing Membership. We are all scratching our heads about how this will effect our personal taxes as some of us are US citizens living in Europe and some are European citizens also living in Europe. Tax rules and strategies for people who buy, own and sell stocks, mutual funds and stock options. Email this page Printer-friendly version.

Stock Options and the Alternative Minimum Tax (AMT) Incentive stock options (ISOs) can be an attractive way to reward employees and other service providers. Unlike non-qualified options (NSOs), where the spread on an option is taxed on exercise at ordinary income tax rates, even if the shares are not yet sold, ISOs, if they meet the.

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How much you can claim depends on how much extra you paid by paying the AMT in a prior year. That provides a credit that can be used in future years. The amount you would claim would be the difference between the regular tax amount and the AMT calculation. If the regular amount is greater, you can claim that as a credit, and carry forward any unused credits for future years. This explanation is, of course, the simplified version of a potentially complex matter.

Anyone potentially subject to the AMT should use a tax advisor to make sure everything is done appropriately. One way to deal with the AMT trap would be for the employee to sell some of the shares right away to generate enough cash to buy the options in the first place. So an employee would buy and sell enough shares to cover the purchase price, plus any taxes that would be due, then keeps the remaining shares as ISOs.

For instance, an employee might buy 5, shares on which he or she has options and keep 5, But the employee will have more than enough cash left over to deal with this. Another good strategy is to exercise incentive options early in the year. That's because the employee can avoid the AMT if shares are sold prior to the end of the calendar year in which the options are exercised.

John holds on to the shares, but watches the price closely. John is a higher-income taxpayer. If, however, John sells before December 31, he can protect his gains. The rule here is that is the sale price is less than the fair market value at exercise but more than the grant price, then ordinary income tax is due on the spread. On the other hand, if in December the stock price still looks strong, John can hold on for another month and qualify for capital gains treatment.

By exercising early in the year, he has minimized the period after December 31 he must hold the shares before making a decision to sell. The later in the year he exercises, the greater the risk that in the following tax year the price of the stock will fall precipitously. If John waits until after December 31 to sell his shares, but sells them before a one-year holding period is up, then things are really bleak.

He is still subject to the AMT and has to pay ordinary income tax on the spread as well. Fortunately, almost in every case, this will push his ordinary income tax above the AMT calculation and he won't have to pay taxes twice.

Finally, if John has a lot of non-qualified options available, he could exercise a lot of those in a year in which he is also exercising his ISOs. This will raise the amount of ordinary income tax he pays and could push his total ordinary tax bill high enough so that it exceeds his AMT calculation.

That would mean he would have no AMT next year to pay. It is worth remembering that ISOs provide a tax benefit to employees who willingly take the risk of holding on to their shares. Sometimes this risk does not pan out for employees. Moreover, the real cost of the AMT is not the total amount paid on this tax but the amount by which it exceeds ordinary taxes. The real tragedy is not those who take a risk knowingly and lose, but those employees who hold onto their shares without really knowing the consequences, as the AMT is still something many employees know little or nothing about and are surprised too late to learn they have to pay.

Email this page Printer-friendly version. You might be interested in our publications on this topic area; see, for example: Model Equity Compensation Plans Sample plan documents and brief explanations for employee stock option and stock purchase plans includes CD. What you need to know when you exercise nonqualified stock options. Your nonqualified stock option gives you the right to buy stock at a specified price.

You exercise that right when you notify your employer of your purchase in accordance with the terms of the option agreement. The precise tax consequences of exercising a nonqualified stock option depend on the manner of exercising the option. But in general you'll report compensation income equal to the bargain element at the time of exercise. The rules described here apply if the stock is vested when you receive it. Generally, stock is vested if you have an unrestricted right to sell it, or you can quit your job without giving up any of the value of the stock.

See When Stock Is Vested. If the stock isn't vested when you exercise the option, apply the rules for restricted stock described in Buying Employer Stock and Section 83b Election. The bargain element in the exercise of an option is the difference between the value of the stock on the exercise date and the amount paid for the stock.

The value of the stock should be determined as of the date of exercise. For publicly traded stock the value is usually determined as the average between the high and low reported sales for that date.

For privately held companies the value must be determined by other means, perhaps by reference to recent private transactions in the company's stock or an overall appraisal of the company.

Fair Market Value of Stock Bargain element as income The bargain element in the exercise of an option received for services is considered compensation income. You're not allowed to treat this amount as capital gain. The amount of tax you'll pay depends on your tax bracket. If you exercise a large option, it's likely that some of the income will push up into a higher tax bracket than your usual one.

The important thing to focus on — ahead of time if possible — is that you have to report this income, and pay the tax, even if you don't sell the stock.

You haven't received any cash; in fact, you paid cash to exercise the option, but you still have to come up with additional cash to pay the IRS. This is one reason advance planning is important in dealing with options. If you're an employee or were an employee when you received the option , the company is required to withhold when you exercise your option. Of course the withholding obligation must be satisfied in cash.

The IRS won't accept shares of stock! There are various ways the company can handle the withholding requirement. The most common one is simply to require you to pay the withholding amount in cash at the time you exercise the option. The amount paid must cover federal and state income tax withholding, and the employee share of employment taxes as well.

The amount paid as income tax withholding will be a credit against the tax you owe when you report the income at the end of the year.

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Unlike non-qualified stock options, gain on incentive stock options is not subject to payroll taxes. However it is, of course, subject to tax, and it is a preference item . Incentive Stock Options and The Alternative Minimum Tax January 16, By Daniel Zajac, CFP®, AIF®, CLU® Leave a Comment The alternative minimum tax is a supplemental tax that may be due, in addition to regular income tax, for calendar years during which a taxpayer has a special circumstance that causes the tax to be due. Jan 31,  · Stock options that are granted neither under an employee stock purchase plan nor an ISO plan are nonstatutory stock options. Refer to Publication , Taxable and Nontaxable Income, for assistance in determining whether you've been granted a statutory or a nonstatutory stock option.