Employee stock options have become quite popular in the recent times, owing to the strategies adopted by a large number of venture-backed companies and startups. The companies do this to attract quality talent, and for employees, it gives them a chance to gain a specific number of shares of the company, a great potential for increased financial worth in the future.
But there is a lot that employees need to understand, including employee stock options tax, and the terminologies. Below listed are some of the key terms associated with Employee Stock Options (ESOs):
- Exercise Price / Grant Price / Strike Price: The specific price set the by the company at which the employee can purchase the share.
- Grant Date – The agreement date when the stock is given to the employee by the employer.
- Market Price – The current value of the stock.
- Vesting Period – The period between the issue date and exercising the stock option.
- Vesting Date – The date when the employee can exercise the option according to the terms.
- Exercise Date – The date when one exercises the option.
- Exercise Price – The price at which one exercises the option.
- Exercise Period – The period after the stocks have vested when one has the right to buy the shares.
- Expiration Date – The date up to which one must exercise the option, post which the option expires.
Employee Stock Options Taxation
Before understanding the ESOs tax, one has to know that there are two different kinds of employee stock options – non-qualified stock options (NSOs) and incentive stock options (ISOs), and both are taxed differently:
Taxation of NSOs:
- When one exercises the NSO, the difference between grant price and market price is termed as ordinary income, irrespective of whether you are holding the stock. This earned income is subjected to payroll taxes and the ordinary income taxes. If you hold the stock after exercising, up to a certain period, then additional gain will be subjected as capital gain.
- You'll pay more payroll taxes if you are exercising NSO in a year when you have no other earned income in comparison to the year when you have income from other sources too.
Taxation of ISOs:
- Gain on Incentive Stock Options is not subjected to payroll taxes, however, it becomes a factor for the Alternative Minimum Tax (AMT).
- When you exercise the ISO and sell the share within the same calendar year, then the difference between grant price and market price is subjected to tax at ordinary income tax rate.
- But in case when you hold the stock after exercising the option, then the difference between grant price and market price is subjected to the AMT calculation. If you hold the stock for a minimum period of two years after the grant date, and minimum one year after exercise date, then the difference between market price and grant price is calculated towards tax as a long-term gain.
Understanding ESO terminologies, Exercise stock options tax, and key tax factors are vital to calculate stock options tax and make a better, informed choice for getting maximized returns on your shares.