When it comes to taxes, stock options can be a desirable benefit for employees, but it can also raise questions about capital gains. In this article, we'll dive into the details of capital gains and how they apply to stock options, so employees can better understand the tax implications of this popular employer perk.

Capital Gains

When it comes to capital gains and stock options, it's important to understand how they are taxed. A capital gain is the profit made from selling a capital asset such as stocks, bonds, or real estate for more than the original purchase price. How long the asset was held before selling it determines whether the gain is considered short-term or long-term.

Short-term capital gains are gains from selling assets held for one year or less and are taxed as ordinary income, which can be as high as 37% for the tax year 2022, depending on your tax bracket. On the other hand, long-term capital gains are gains from selling assets held for more than one year and are taxed at a lower rate than short-term gains.

The tax rate for long-term capital gains depends on the taxable income and ranges from 0% to 20%. The majority of individual taxpayers pay a tax rate on net capital gains of no more than 15%, according to the IRS.

Stock Options

Stock options are a popular form of compensation used by companies to attract and retain employees. Essentially, stock options are contracts that give the employee the right to buy a certain number of shares of the company's stock at a pre-determined price, known as the grant price. This grant price is typically lower than the current market price of the stock, which allows the employee to potentially make a profit if the stock price rises.

Stock options come in different forms, including non-qualified stock options (NSOs) and incentive stock options (ISOs). NSOs are more common and are typically offered to all employees, while ISOs are reserved for executives and other key employees. ISOs have more favorable tax treatment, but they also come with more restrictions and rules.

When a company offers stock options as compensation to its employees, it grants them a contract that allows the employee to purchase a set number of shares of the company's stock at a predetermined price, which is usually lower than the current market value. While holding the stock options, the employee does not have an ownership interest in the company, but exercising them to buy the stock provides them with the ownership interest.

There are two types of stock options: statutory and non-statutory. Statutory stock options are granted under either an employee stock purchase plan or an incentive stock option (ISO) plan, which both have specific rules and regulations that must be followed. Non-statutory stock options, also known as non-qualified stock options (NSOs), are granted without any type of plan and are typically more flexible in terms of their terms and conditions.

Capital Gains and Stock Options

When it comes to capital gains and stock options, the tax implications start when the options are exercised. At that point, the tax liability is based on the difference between the fair market value of the shares and the exercise price. This difference is known as the "spread". The spread is taxed as ordinary income, subject to income tax withholding and payroll taxes.

When an employee sells the shares acquired through exercising their stock options, any gain or loss is treated as a capital gain or loss. If the shares have been held for more than one year, any gain is subject to long-term capital gains tax rates, which are generally lower than ordinary income tax rates. However, if the shares have been held for one year or less, any gain is subject to short-term capital gains tax rates, which are the same as ordinary income tax rates.

The tax treatment of stock options also differs depending on whether they are statutory or non-statutory options. Statutory stock options, such as those granted under an employee stock purchase plan or incentive stock option (ISO) plan, have special tax treatment. When ISOs are exercised and the shares are sold, the gain or loss is generally taxed as a long-term capital gain or loss. However, there are certain holding period and other requirements that must be met for the special tax treatment to apply.

Non-statutory stock options, also known as non-qualified stock options (NSOs), do not receive the same special tax treatment as ISOs. Instead, the spread between the fair market value of the shares and the exercise price is taxed as ordinary income when the options are exercised. Any gain or loss on the sale of the shares is then taxed as a capital gain or loss.

It is crucial to hold stocks obtained through an employer's stock options program for at least a year, regardless of whether they are ISOs or NSOs, to take advantage of the lower tax rate for long-term capital gains.

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