If you have received a stock option from your employer, you may wonder whether you have taxable income. Whether you need to report income at the time you receive the stock option, when you exercise the option, or when you eventually sell the stock in the future, depends on the type of stock option you've received.
Stock options give you the right, but do not obligate you, to purchase company stock at a discount to the fair market value (FMV). The stock option is for a predetermined price, and it can only be exercised for a set period of time.
There are two types of stock options, statutory stock options and nonstatutory stock options. If you need help determining what type of stock option you've been granted, you can refer to IRS Publication 525, Taxable and Nontaxable Income.
Statutory stock options
Employers issue statutory stock options, also known as incentive stock options (ISOs), through an employee stock purchase plan or an ISO plan.
Taxation of incentive stock options
Statutory stock options are generally not taxable when you receive or exercise the option. Instead, you will typically have a capital gain or loss—the difference between your tax basis and what you receive from the sale—when you eventually sell the stock that you received through exercising the stock option. However, if you don't meet certain holding period requirements, you may have ordinary income at the time of your sale.
The holding period requirements are the later of:
- The 1-year period after you received the stock, or
- The 2-year period after you received the statutory stock option
Important forms from your employer
You will receive a form from your employer with important dates and values you can use to determine your capital or ordinary income for tax purposes. When you initially exercise a stock option under an ISO, you will receive Form 3921, Exercise of an Incentive Stock Option Under Section 422(b). When you sell stock acquired from exercising an option under a employee stock purchase plan, you will receive Form 3922, Transfer of Stock Acquired Through an Employee Stock Purchase Plan Under Section 423(c).
Alternative minimum tax
Although you do not have a taxable event upon receiving or exercising a statutory stock option, you may be subject to the alternative minimum tax (AMT) in the year you exercise the option. The AMT is designed to ensure that taxpayers—who otherwise benefit from significant tax deductions and credits—pay at least a minimum determined tax rate. The AMT recalculates the taxpayer's income by adding back certain items.
When you exercise a statutory stock option, you will add back the FMV of the stock received minus what you paid for it at the time you exercised the option. You can use Form 6251, Alternative Minimum Tax—Individuals, to determine if you owe the AMT.
Nonstatutory stock options
Nonstatutory stock options, or nonqualified stock options, are not issued through an employee stock purchase plan or ISO plan.
Taxation of nonstatutory stock options
If you can readily determine the FMV of the nonstatutory stock option— if it's actively traded on an established market, for example—you should report income when you receive the option. You will treat it like property received as a form of compensation. Additionally, you will have a capital gain or loss when you sell the stock in the future. You calculate the gain or loss based on the difference between your tax basis and what you receive from the sale.
If you cannot readily determine the FMV of the nonstatutory stock option at the time you receive the option, you do not have a taxable event when you receive the option. Most nonstatutory stock options fall into this category. However, you must include the FMV of the stock received minus what you paid for it at the time you exercise the option. Additionally, you will have a capital gain or loss when you sell the stock in the future.