How Are Stock Options Taxed?

Taxes

What you need to know about how stock options are taxed

Aug 6, 2022
4-min read

Steve Ching

Stock options can get you Elon Musk rich if your startup becomes the next Google. But you might be asking: How are stock options taxed?

Overlapping corporate tax documents — Tupungato / Getty Images

Although stock options may not be as appealing as, say, ergonomic chairs and free office beer taps, they give employees the right to purchase company stock at a set price (usually a reduced price). The hope is that your startup becomes the next Tesla, and you can become Elon Musk-rich by pocketing the difference between your shares’ market value and the set price at which you purchased them.

In the same moment you learn you can buy the restaurant you had takeout from last night, the IRS will want a cut of your success as well. Therefore, it is critical to understand how stock options are taxed at the onset to avoid a hefty tax bill on the backend.

The 2 types of stock options

At the heart of it, stock options allow you to share in the upside of the company by purchasing your company’s stock at a reduced price. For the typical startup, stock options are a good way to recruit the geniuses who will take the company to unicorn status. After all, how else are you going to motivate people who may be forgoing bigger salaries to work at a startup and paying $5,000 a month to live in a closet in the Bay Area?

Once recruited, companies want the geniuses to stick around. This is where “vesting” comes into play, to specify when these options are available for you to purchase.

Stock options generally come in two flavors: statutory options and non-statutory options. The biggest difference between the options is how they are taxed.

Tax implications of statutory stock options

Statutory stock options are generally not taxable when you’re exercising them (although the exercise may trigger AMT, which is a can o’ worms we won’t get into here).

Any gain you recognize on the sale of the stock (exercise price—sale price) is generally subject to the more preferential long-term capital gains rate (23.8% versus 37% at the highest individual bracket).

Tax implications of non-statutory stock options

Non-statutory stock options are generally subject to higher taxes than statutory stock options. That’s because the options are potentially taxable on the date of exercise. The tax is applied on the difference between the FMV of the vested shares and the exercise price. Worse yet, this difference is usually taxed as ordinary income.

You will get hit second round of taxes when you decide to sell your exercised shares. Like statutory options, any gain you recognize on the sale of the shares is subject to short- or long-term capital gain rates, depending on whether you held the shares for more (or less) than a year.

What you need to know about reporting stock options

When do you need to report stock options as income?

For statutory options, you will only need to report long- or-short term gains when you sell the shares. For nonstatutory options, you will potentially need to report income separately on the date of exercise and when you sell the shares.
What tax form do you fill out to report income from stock options?

Thankfully, the IRS has made it relatively painless to report income from stock options (well, as painless as filing taxes can be). If you have statutory stock options, you are only required to report long- or-short term capital gains from the sale of the shares on Schedule D and Form 8949.

Your employer will report any gain from the exercise of your non-statutory options as on your W-2. As discussed above, you’ll need to report this gain as ordinary income on Line 1 of your Form 1040. Any subsequent sale of the shares will also be reported on Schedule D and Form 8949.
Can I use TurboTax to report my income from stock options?

Sure, you can use TurboTax to report income from stock options (or even the most complicated return). But is it advisable?

In the opinion of this tax geek, you’ll want a trusted tax advisor to at least review your work before hitting that submit button.

That’s because this is complicated stuff. For example, stock options must meet certain criteria to be considered statutory options, and you’ll want someone to vet which bucket your options fall into. A trusted advisor can also double check that you’re properly characterizing and calculating your gains. And remember that AMT stuff I mentioned before? Yeah.

The takeaway

Stock options are potentially a great way for employees to invest in a company early and accumulate long-term wealth. However, taxes on stock options can rain on your parade, so it’s important to understand the tax implications around options from the outset. Remember, a lower tax bill means more money in your pocket to devote to other ventures, like investing in the next r/WallStreetBets mania.