Lesson 2: Income Taxes

Before we begin the discussion about income taxes (ugh!), a general disclaimer and a couple of words of warning:

The Disclaimer

This lesson is meant only to give you a basic understanding of how options are taxed. This area of tax law is complicated and confusing enough that there are professional books and journal articles written solely about how options are taxed (the kind of books and articles with all kinds of legal citations and technical jargon). Finally, we will only be discussing how options are taxed in the United States (if your options are subject to tax in another country, we recommend that you consult with a tax professional familiar with that country's tax system). So,

Warning 1: Get professional help!

The taxation of options can be one of the most complicated areas of tax law. While we will give you the basics in this lesson and your situation may be very basic, we want to encourage you to engage the services of a qualified tax professional before making any decisions. The money will be well spent. But when you do,

Warning 2: Beware of the Tax Tail
(wagging the proverbial dog - achieving your financial goals!)

Yes, paying taxes is a drag. Yes, it would be nice to avoid them. And, yes, there are strategies to minimize the taxes on your options. But focusing first or only on taxes can lead to making serious mistakes. Taxes should be considered only after you have clarified your financial goals, quantified your goals and analyzed your options (see the Five Steps to a Successful Exercise Strategy).

Okay, now on to the lesson itself . . .

Types of Taxable Income

To understand how your options are taxed, it is important to distinguish between the three basic types of income you might have:

1. Compensation - This is income you receive for the work you do, typically wages or salary. Often called "W-2 income" (referring to the form used for reporting to the IRS), this income is subject to Social Security and Medicare Taxes as well as to Federal and State Income Taxes. Whenever compensation is paid, your company is required to withhold these taxes from your paycheck and send the funds directly to the government.
2. Ordinary Income - This is income that comes from other sources such as interest or dividends. It is not subject to Social Security or Medicare Taxes, and it is not subject to withholding. It is taxed at your regular tax bracket and it may result in your needing to file and pay "estimated taxes." So anytime you receive a significant amount of ordinary income, make sure you check with your accountant or tax preparer to see if you also need to make an estimated tax payment.
   
3. Capital Gains - This income generally comes from the sale of an asset. You have a "capital gain" if you sell an asset at a profit and a "capital loss" if you sell it at a loss. There are two kinds of capital gains and losses:
   • Short Term Capital Gain or Loss - results from the sale of an asset you have owned (or "held") for 12 months or less. Short term capital gains are taxed like ordinary income.
   • Long Term Capital Gain or Loss - results from the sale of an asset you have owned for more than 12. Long term capital gains are taxed at a lower tax rate of 10-20%, depending upon how much other income you have.

   If you have capital losses, there are some tricky rules about how you can use those losses to offset capital gains and, in some situations, ordinary income as well.

The More You Make, The More They Take

Compensation and Ordinary Income are taxed in what is called a "marginal, bracketed system" at progressively higher rates. This means that as you earn income, the first dollars you earn are taxed at the lowest rate in the lowest "tax bracket". As you earn more, your additional earning are taxed at progressively higher rates (as you move into higher tax brackets). So, while you may only pay $0.15 in Federal Tax on the first dollar you earn (15%), you can pay as much as $0.40 (39.6%*) on the last dollar you earn, and state taxes are added on top of this!

The important thing to remember is that exercising options and selling stock usually result in income being added on top of all the other income you earn. So, option income is often taxed at much higher rates than your regular income.

Alternative Minimum Tax: The Other Tax System

Finally, before we look at how options are taxed, especially if you have ISOs (see Lesson 1), you also need to know that we have two tax systems, the regular tax system, that's what we've been describing above, and the Alternative Minimum Tax (AMT). In the 70's congress, reacting to evidence that many people were able to avoid paying any income tax through the use of shelters and other devices, passed legislation to make sure a "minimum tax" would be paid.

Basically, AMT is calculated by adding what are called "tax preference items" to your regular "taxable" income, subtracting a standard deduction (different from the regular tax system's standard deduction) and then applying a 26 or 28% tax rate (depending on the amount AMT income). If your AMT is larger than your regular tax, you must pay the AMT. If not, you pay your regular tax. Technically, every taxpayer is required to calculate both taxes and then pay the greater of the two.

This is especially important if you have ISO's, because the exercise of your ISO's usually creates a tax preference item and often will trigger the AMT.

Now, with all that in mind, let's talk about how your options are taxed . . .

Non-Qualified Stock Options (NQSOs)

• Exercising your options. When you exercise your NQSOs, the difference or "spread" between your exercise cost and the market value of the stock you receive is considered compensation income. As such, it is subject to Federal and State Income Taxes, Social Security and Medicare Taxes, and is subject to full withholding. For example, if you exercise 1,000 options at $5 a share and the market value of the stock at the time you exercise is $10, the spread or "bargain element" ($5 per share or $5,000 for the 1,000 shares) is compensation. If you were in a 30% tax bracket, you would have to pay 30% or $1,500 in Federal Taxes (remember, you would also have to pay Social Security and Medicare Taxes and State Taxes as well).
• Selling the stock. The stock you receive is then taxed just like stock you would otherwise buy if you were making an investment, except that your "basis" (a technical word for "cost") would be the value of the stock on the date you exercised your options (the amount you've paid taxes on), not your exercise cost. The difference between your basis and what you sell the stock for would be considered a capital gain (or loss). So, to continue the example, if you sold the 1,000 shares of stock you received in the paragraph above for $20 a share, you would have a capital gain of $10 per share ($20 sales price minus $10 value on the date of exercise). If you sold it for $5 a share, you would have a capital loss of $5 per share.

Incentive Stock Options (ISOs)

The tax advantage (incentive) that ISOs have over NQSOs is that:

• There is no compensation income created when you exercise an ISO. So, there is no regular tax to pay when you exercise an ISO, and
• If you meet the requirements, the entire gain on the sale of the stock is taxed as a capital gain, rather than as compensation or ordinary income. This means if you have ISOs, rather than paying taxes on your option profits at a higher rate (because it's added on top of your regular income), you can pay taxes at a lower rate, the long term capital gains tax rate. For many people, this difference can be tens of thousands or even hundreds of thousands of dollars!

So, what are the requirements? You must hold the stock you receive from the exercise of your ISOs for:

• At least one year from the date of exercise, and
• More than two years from the date the options were granted.

For example, if you had 1,000 ISOs to purchase stock at $5 per share and you exercise those ISOs when the stock is at $10 per share, unlike the example above with the NQSOs, you would have no compensation income when you exercise your options. Then, if you later sold the stock for $20 a share, holding it long enough to meet the requirements, you would pay tax on the entire gain of $15 per share at long term capital gain rates. So, rather than paying tax on compensation income when you exercise and on a capital gain when you sell the stock, with ISOs you can pay NO regular tax on exercise and pay tax only when you sell the stock, and then at long term capital gain rates!

Now, the bad news: The profit on your options on the date of exercise, is considered a tax preference item for AMT purposes and may result in your needing to pay AMT. This is especially bad news if you don't have the personal funds to pay the AMT, because if you have to sell stock to pay the tax, that stock will no longer qualify for the special ISO tax treatment!

If you don't hold the stock long enough to meet the requirements, the sale of the stock is considered a "disqualifying disposition." This would mean that the "bargain element" or profit on the date of exercise would be taxed as ordinary income and any gain from that point forward would be a capital gain. If you sold the stock for less than it was worth on the date of exercise, the amount of ordinary income would be reduced to the difference between the sales price and your exercise cost (you would have no capital gain).

And that's just the beginning!

A little confused? We warned you at the beginning of this lesson that this is a complicated area! And what we've covered here is just the "tip of the iceberg." There are lots of other rules and regulations which will affect how your options are taxed and how much tax you'll pay. So our closing recommendations to you are:

1. Get professional help! At the very least, we'd recommend that you consult the books or other websites.
2. Keep good records. Keep copies of all documentation you receive and all forms you complete, and carefully record the closing stock price on the day you exercise your options and the day you sell the stock. (Note that if you sell the stock on the same day you exercise your options, the sales price you receive for your stock may not be the same as the closing stock price for that day.) If you keep good records, you'll make your job and your tax preparer's job much easier when it comes time to file your tax returns!

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