Tax Increases and Stock Options. What Does This Mean for You?
With possible tax increases coming soon, what does that mean for your stock options? A new bill could be passed at the 11th hour, and with year-end approaching, now is the time to analyze how this may impact you.
Stock Options – A Brief Overview
Stock options give employees the right to buy company stock at a set price over a certain period, usually ten years.
There is generally no tax when options are granted. But before taxes come into play, two things must happen:
1) The stock price has to go up after it’s granted. The difference between the exercise and grant price (which we’ll call the spread) is what is subject to tax. But if the exercise price doesn’t exceed the grant price, the options are worth nothing.
2) The options must be exercised before they expire. If you do nothing, they expire worthlessly.
The tax on worthless options? You guessed it: zero. Higher tax rates won’t have an impact unless the options have value.
Assuming everything goes right, however, the tax implications depend on the type of option:
- With non-qualified options (NQOs), the spread is taxed as ordinary income at exercise. Therefore, the employee has some control over their tax situation.
- Incentive Stock Options (ISOs) provide more favorable tax treatment. There is no tax at exercise, only when you sell the stock. If you wait at least two years from the grant date and one year from the exercise date before selling, the spread is taxed at lower long-term capital gains rates.
Important point: The spread on ISOs may trigger alternative minimum tax (AMT) in the year of exercise, which could be more than your ordinary tax bill. Have your CPA run the numbers to avoid unexpected pitfalls.
Strategies to Consider
Tax increases will certainly impact stock options. A few considerations include:
- NQOs: President Biden has expressed a desire to raise the top ordinary tax rate from 37% to 39.6%. If you expect to be in the top tax bracket this year and next and have options approaching expiration, you may want to exercise those in 2021 to pay 37% vs. 39.6%.
- Should you hold the stock after you exercise? The tax on exercised NQO’s is the same if you hold or sell the stock, so this really doesn’t matter.
- Those further from expiration may not make sense to exercise early. Stock options have substantial upside due to leverage, which you may miss out on.
- ISOs: While capital gains rates may also increase, you will probably still want to try for capital gains treatment by meeting the holding requirements. Capital gains rates are still likely to remain lower than ordinary rates for most taxpayers. There are a few exceptions:
- If AMT is triggered, you can avoid it by selling the shares in the same calendar year you exercise. This is called a disqualifying disposition, and the ISOs are treated as non-qualified and taxed at ordinary rates. It makes sense to exercise ISOs early in the year to give as much time as possible to see if this is an issue. Therefore, you may want to hold off exercising ISOs close to expiration until January, if you can, that is. Don’t let them expire!
- If the stock suffers a big drop post-exercise AND triggers AMT, consider selling within the same calendar year. This allows you to pay ordinary tax on your actual gain.
- Biden has proposed a 39.6% capital gains rate on incomes over $1 million. While this looks less likely to come to fruition, if it happens, those impacted may be better off exercising and selling ISO shares in 2021 to pay 37% ordinary tax on the spread instead.
Stock options are a complex area. Every situation is unique, so please don’t hesitate to contact us if you have questions or for a complimentary review. We would love to hear from you.
Gary is a Wealth Manager at BDF and member of the Firm’s Investment Committee. He specializes in executive and stock-based compensation plans, including stock options, restricted stock and deferred compensation. He combines his tax knowledge, executive compensation experience and capital markets expertise to help clients reduce their tax burdens and achieve each of their unique goals.