Tax Day. While some people embrace the fact that it comes every year like clockwork, others dread it. Bidding adieu to another year’s filing deadline, for many, means an opportunity to breathe a sigh of relief and to not have to think about it again for another year. As an executive financial advisor, however, the topic of taxes is never far from my mind. When I’m consulting my clients, a top priority is always how the decisions we make will affect their tax situation.
This was the case with one of my executive clients I met with around the first of the year. After our usual small talk covering the latest on our kids and grandkids, we dove into his equity compensation strategy and decided now was the time to finally exercise some of his non-qualified stock options. We covered all the bases—how much stock to exercise and when, and when to sell the stock. I then turned the discussion to the tax impact of this transaction.
My client hadn’t realized that, by exercising these stock options, he would be adjusting his income and would need to report it on his tax return. As an executive, how the potential income from exercising non-qualified stock options can affect your taxes is important to consider. Here’s a closer look at how this income is calculated and how to report the exercise of non-qualified stock options on your tax return.
How Income Is Calculated When You Exercise Your Non-Qualified Stock Options
One of the biggest factors you need to consider when exercising your non-qualified stock options is the compensation element. This is the difference between the exercise price and the current market value of the stock when you exercise the options. The exercise price is given to you by your employer when you receive the stock options. When you exercise your options, this is the price at which you can purchase company stock, regardless of its current market value. The market value of the stock is the price at which it is trading when you decide to exercise your options.
The hope is that your company will continue to grow (in part due to your management and production) and the stock will be worth more when you decide to exercise than when you were granted the options. Your company will take the market value and subtract the exercise price to determine the compensation element. This amount will be reported as income for the year in which you exercise your options and therefore taxed at your federal income tax level.
Four Ways to Report the Exercise of Non-Qualified Stock Options on Your Tax Return
How you report this income will depend on the way in which you exercised your non-qualified stock options. The following scenarios represent the four ways to do this and report it on your tax return:
You exercise your stock options and hold on to the shares for at least the current year. This is a scenario in which the only taxable incident you need to consider is the compensation element. As previously mentioned, the compensation element is found by taking the exercise price and subtracting it from the market value of the stock at the time in which you exercise your options and purchase the company stock.
Your employer will have a record of this transaction and provide this information on your W2 at the end of the year. There is no real reporting needed on your end outside of submitting your W2 to your tax professional of choice just like every other year.
You exercise your stock options and sell off those shares immediately. In this scenario, the first taxable incident is the exercise of the non-qualified stock options. This involves the compensation element, just like the scenario above.
The other taxable incident in this case is the immediate sale of the stock. Because you sell the stock the same day, you don’t have much time, if any, for the market price to fluctuate, but you may still incur a minor short-term capital gain or loss after you account for broker fees and commissions. A short-term capital gain is taxed at the same rate as ordinary income tax.
You exercise your stock options and sell those shares within a year. In this scenario, the first taxable incident is still the compensation element. The second is the sale of your shares within a year of purchasing them. If you sell the stock for more than the combined exercise price and compensation element, you would incur a short-term capital gain. The opposite results in a short-term capital loss. Either one of those would need to be reported to your tax professional, and you can expect to pay short-term capital gains tax if the sale resulted in a profit.
You exercise your stock options and sell off those shares a year or longer after you exercise the option to purchase them. The compensation element again is the first taxable incident to consider here. The second taxable incident is slightly different due to the fact that you have held your stock longer than a year before selling it, which triggers a long-term capital gain or loss as opposed to a short-term one. A long-term capital gain has a maximum tax rate of 20%. A gain or loss amount should be given to your tax professional, who will report it on your Schedule D, part 2. Schedule D is a form used to report transactions such as the sale of a home or exchange of capital assets.
As you consider each of these potential methods for exercising your non-qualified stock options, remember that reporting them on your tax return should be the last piece of your equity compensation strategy. You should already be working with an executive financial advisor to help you answer the questions of how much stock you should exercise, when you should exercise your options, when you should sell your company stock, and how each action could affect your personal tax situation. All of these and more should be considered before making a decision regarding your non-qualified stock options.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for integrated asset allocation and equity compensation management. He can help you navigate how to report the exercise of stock options on your tax return. For more information on how Wade and the Carpenter Team can advise you on equity compensation strategies, reach out today for a complimentary consultation.
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