How Stock Grants Are Taxed
Rose Orrico will receive favorable, long-term federal capital gains tax treatment of any profits she makes by selling her stock, because the shares were purchased more than a year ago and given to her as a gift.
But tax treatment of other stock grants can vary widely.
The two main types of grants are stock options--non-qualified and incentive--but each have vastly different tax consequences that influence how they should be exercised and when they should be sold.
Incentive stock options, which get special tax treatment, are granted only to employees and must meet other strict criteria. Non-qualified options have looser criteria, less-favorable tax treatment and are granted to both employees and contractors.
The holder of either type of option must first purchase the shares at a price determined by the company that granted the option. This price is known as the exercise or strike price and usually becomes the taxpayer’s basis for determining taxable profit.
If the stock options are non-qualified, income and Social Security taxes must be paid on the difference between the strike price and the stock’s fair market value--the average price other investors paid on the day the shares were purchased. If the stocks are subsequently sold, any further gain is either taxed at regular income tax rates (if the stocks are sold within one year of purchase) or at more favorable capital gain rates (if sold at least one year after purchase). Federal income tax rates range from 15% to 39.6%, whereas long-term capital gains are taxed at 10% or 20%. California income tax rates top out at 9.3%.
Incentive stock options, on the other hand, escape regular income tax when the shares are purchased. Buying the stock triggers alternative minimum tax rules, however. These rules, originally designed to ensure that the wealthy did not escape taxes, have in recent years nabbed some middle-income people--in large part because of the growth in incentive stock options. Affected taxpayers must figure their taxes under both rules, regular and AMT, and pay whichever bill is higher.
Under AMT, income is taxed at one of two rates--26% and 28%. Once again, the tax is owed on the difference between the strike price and the fair market value of the stock. The bad news is that AMT affects other areas of a tax return, as well. For example, many common deductions, such as state income taxes and the interest on some home equity loans, are not deductible under AMT rules. Most financial planners recommend consulting a professional tax preparer to determine the tax consequences before exercising incentive stock options.
To qualify for long-term capital gains treatment of subsequent growth, the taxpayer with incentive stock options generally must wait 12 months to exercise the option and then wait another 12 months to sell the shares.
The difference in tax treatment means that many people choose to hold on to their incentive stock options shares to qualify for favorable capital gains rates if they have enough cash on hand to buy the shares, said certified financial planner Scott Leonard. Meanwhile, many people with non-qualified options choose to buy and immediately sell their shares in a cashless transaction rather than wait for future growth, because there is no immediate tax advantage to holding on to the shares once they have been exercised.
In addition, owning non-qualified stock often means that both the holders’ portfolios and their jobs are substantially tied up in the fortunes of one company. Most people would be better off selling at least some shares and diversifying their risk by buying shares of other companies or mutual funds, he said.
