Employee Stock Options Are a Mixed Blessing When Tax Time Arrives

It’s a classic good news, bad news situation. Like millions of American workers, Lynn Bettinger has employee stock options. Thanks to a great market that helped lift the price of her company’s stock, the Idaho-based accountant exercised a chunk of those options at a gain last year. But now, as she contemplates filing her 1999 tax returns, the bad news is sinking in: She’s likely to owe a bundle in taxes.

Lynn has plenty of company. In recent years, companies have awarded stock options to a growing number of workers. Roughly 1 in 5 American workers is now eligible to get stock options, up from 12% just a year ago, according to a recent study of more than 1,300 employers by Wilson Wyatt Worldwide, a Bethesda, Md.-based benefit consulting firm.

Yet when it comes to taxes, stock options--particularly so-called non-qualified options, which are the most common--are a decidedly mixed bag. They can land you a tax bill--often at relatively high income tax rates--even on a paper profit. Stock options can subject you to the onerous alternative minimum tax. And, of course, they can further complicate the task of filing your annual tax returns.

What tax issues do stock options pose, and how can you best manage them? Here are some answers.

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Question: What are employee stock options?

Answer: They are agreements that give you the right, but not the obligation, to buy stock in your company at a set price in the future. For instance, say you work for XYZ Co. Your company grants you an option to buy 1,000 shares of its stock five years from now at the current market price of $10 per share. The only proviso: You must remain continuously employed with the company in the interim.

While this option would have little market value today, if XYZ’s stock price appreciates, it would be valuable in the future. Assuming the company’s stock price gained about 10% a year, its shares would sell for $16 in 2005. By exercising your right to buy the stock at $10, you would earn a paper profit of $6 a share, or $6,000. (You won’t realize a real profit until and unless you sell that stock in the open market for more than the $10 a share that you paid.) You may have a multiyear window for exercising the option.

It is important to note that there are two types of employee stock options, so-called incentive stock options and non-qualified stock options. The big difference between the two is how they are taxed.

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Q: How are the two types of options taxed differently?

A: Non-qualified stock options, the most common type issued to workers, are taxed faster and at higher rates than incentive stock options, which are limited by law in number and mainly go to executives.

Specifically, you must pay tax (at your ordinary income tax rates) on the paper profit you earn when you exercise a non-qualified stock option, even if you don’t sell the stock. If you hold the stock for a year and it appreciates more, you’ll pay tax on the additional gain at long-term capital gains rates. If the stock declines in value during that year, you can claim a capital loss.

With incentive stock options, generally no tax is due until you sell the shares purchased with the option. If you hold the stock for a year after exercise (and at least two years from the date of grant), the gain from an eventual sale is taxed at capital gains rates.

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Q: How does the alternative minimum tax come into play?

A: Although you don’t pay tax on your paper profit when you exercise an incentive stock option, this profit is a so-called preference item for purposes of computing the alternative minimum tax. If you have a large paper profit from incentive stock options, you are likely to get hit with the AMT--a parallel tax system that kicks in for relatively high-income taxpayers who have substantial deductions--which is sure to make you pay more tax.

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Q: Is there a way to avoid that?

A: Possibly. For tax purposes, the best way to handle incentive stock options is to exercise them early--before you realize too much of a paper profit, says Philip J. Holthouse, partner in the Los Angeles tax accounting firm Holthouse Carlin & Van Trigt.

Additionally, if you have a lot of stock options, exercise only a portion each year. That reduces your chance of getting hit with the AMT. Meanwhile, it allows you to start the holding period for capital gains tax purposes. Ideally, you want to hold the stock at least a year before selling it, so you can generate profit at long-term capital gains rates rather than at ordinary income tax rates, which are always higher.

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Q: What’s the best way to deal with non-qualified stock options?

A: Because there is no way to avoid paying tax on non-qualified stock options at your ordinary income tax rates, the wisest idea is to engage in a so-called cashless exercise, Holthouse says. That means when you exercise the option to buy the stock, you sell it nearly immediately through a broker. That ensures you at least realize the gain on which you are paying taxes.

If you instead exercised the option but held on to the stock, you’d have to pay taxes on your paper profit. If you later suffered a market loss when you sold the stock, you would get a capital loss that you could use to offset gains. But that capital loss probably would wipe out profit that would otherwise be taxed at relatively low capital gains rates--even though you paid taxes on the phantom profit at your higher ordinary income tax rates.