Probably one of the most confusing things surrounding stock options are the tax implications and rules which apply differently to NSOs and ISOs. Here’s a breakdown of how taxes work.
Tax Implications of RSUs
When you earn income, typically you expect some amount of tax to be paid to the government. Since RSUs are a form of compensation through equity, they are treated similarly as your salary or wages for tax purposes.
When RSUs become vested, an amount equal to the fair market of these newly unrestricted shares will be added to your taxable income for that year. RSUs are subject to ordinary income taxes at the Federal, and State level. Even if you don’t sell your shares, you must pay taxes based upon the fair market value at the time when your shares vest.
This same fair market value at the time shares vest is your cost basis. If you decide to hold the shares and they increase in value, when you eventually sell shares, the difference between the cost basis and the amount you sold the shares for will be subject to capital gains tax. There are three options to pay taxes once the stock vests:
Same-day sale of all stock = All unrestricted shares are sold, you receive the cash left over after subtracting tax withholdings.
Sell to cover = Just enough unrestricted shares are sold to cover the tax withholding. You keep the remaining shares and can sell them whenever you want. This is often the default action by an employer.
Cash transfer = The employee covers the required tax withholding amount with cash. If you pay the amount in cash to cover withholding, then all of the shares belong to you.
Risk and Reward of 83(b) Election
If you made an IRC section 83(b) election, you will be taxed on the fair market value at the time of granting and will have withholding at the time the stock is transferred to you. Making an 83(b) election is a big risk, but it can pay off. With an 83(b) election you pay taxes on the value of the RSUs at the time they are granted.
If the stock price is lower on the vesting date or when you sell shares, you’ve already paid taxes on the higher amount from when the RSUs were originally granted. An 83(b) election can be beneficial in the event the value of the stock goes up considerably between the time your RSUs were granted, vested, and sold.
Tax Implications of Exercising Your Stock Options
One important similarity is that you are not taxed on stock options when they become vested, but rather when you exercise or sell stock. When exercising NSOs you are taxed on the bargain element, which is the difference between the exercise price and fair market value price of the stock when you exercise.
This amount is subject to ordinary income tax. With NSOs your cost basis is the total fair market value of stock received after exercising the option. With ISOs it’s possible you may not owe any taxes at the time of exercising, unless you decide to sell some of the stock, this includes a cashless exercise. ISO stock options are subject to capital gains tax on the difference between the exercise price and the fair market value share price of the stock when you sell it.
With ISOs your cost basis is the total cost of exercising the option. There is a capital gain if the total proceeds from selling stock is higher than the cost basis. Long term capital gains tax rates apply if you hold the stock for at least one year before selling it.
Short term capital gains tax rates apply if held less than one year. Tax considerations for NSOs and ISOs are drastically different, and your employer may be required to withhold some amount of estimated taxes when you exercise your options.
One More Thing to Consider
One more thing to consider is that ISOs are subject to an alternative minimum tax, or AMT. This makes the potential taxation of ISOs even more complex. AMT is a minimum tax rate to ensure that high earners pay at least a minimum amount of tax, regardless of deductions. Consider consulting with a tax professional and financial planner to fully understand how NSOs, ISOs, and if AMT factors into your tax and financial situation.
Tax Reporting for Restricted Stock and Stock Options
When RSUs vest or you exercise NSO and ISO stock options, your employer is responsible for certain types of tax reporting. Your employer or the financial company transacting the shares may also be required to withhold for taxes.
Compensation from RSUs are reported on your W2 and IRS form 1099-B. Stock options are reported on IRS form 3921 and 3922. These forms can help you determine cost basis, gains or losses and if any amount is subject to ordinary income tax.
Do You Have Employer Stock Options or Restricted Stock? Here’s What to do Next
Everyone has a unique financial situation that requires a tailored strategy to exercise stock options. If you need help creating a plan to exercise yours, we’re here to help. Schedule a complimentary consultation today, so we can help you put the pieces of your financial plan together.