Tax Treatments of Incentive Stock Options

As an employee, you may receive incentive stock options as part of your benefits package. Over time, these incentive stock options can improve your net worth by tens of thousands of dollars. Wealth creation through incentive stock options, however, does introduce important tax ramifications that affect your bottom line. To plan accordingly, you must first familiarize yourself with the basic structure of incentive stock options.

Identification

• Incentive stock options grant rights for employees to purchase stock at a set strike price. You exercise incentive stock options to buy company stock at the strike price. Incentive stock options only have value when the strike price is lower than the company's current market share price. For example, you may be granted Corporation Z incentive stock options that carry a $50 strike price. You would not exercise these options if you could simply purchase Corporation Z shares in the stock market for $30.

Misconceptions

• Incentive stock options combine compensation and investment components, which complicates their tax treatment. You are generally not responsible for paying taxes when the options are granted, or even exercised. Selling shares that were bought through incentive stock options may increase your tax bill.

Features

• Incentive stock options qualify for special tax treatment. With non-qualified options, you would be responsible for paying ordinary income taxes on the difference between your strike price and actual market value for the stock. For example, you may exercise non-qualified options to buy Corporation Y stock for $40 when it is trading for $60 in the market. With non-qualified options, the $20 difference would be treated as income.

  Incentive stock options, however, bypass these ordinary income taxes if you meet special holding period restrictions. To qualify for special tax treatment, you must sell company stock more than two years after your incentive option grant date and more than one year after exercising your options.

Considerations

• You will be responsible for paying taxes on realized capital gains through your incentive stock options. Capital gains are realized when you sell shares for a profit. In terms of incentive stock options, you will use your strike price as the cost basis for capital gains. For example, you may exercise incentive stock options to buy Corporation Z stock at $50 per share, while it actually trades for $65 in the market. Two years later, you sell Corporation Z shares for $80. You would then owe taxes on $30 worth ($80 - $50) of long-term capital gains. As of 2010, 15 percent is the maximum long-term capital gains tax rate.

Warning

• Your ultimate goal is to make money and maximize returns, which does not necessarily translate into the lowest tax bill. In terms of incentive stock options, you should avoid the temptation to hold onto losing stock simply to meet the one year holding period for special tax treatment. For diversification purposes, you may even consider selling company stock immediately to purchase mutual fund shares. If your company fails, you will be laid off while you also hold onto worthless stock.