Stock Options: A Quick Tax Guide
by Byrne Hobart
Whether you’re sitting on an employee options grant or day-trading puts and calls, taxes play an important part in determining how much money you keep from every trade. Here are some quick tips to get you started:
When you are granted employee stock options, you won’t pay taxes on the initial grant. This is one of the reasons options have been so popular. They’re a great way to show someone that their work is recognized, but to give them an incentive to stick around for the long term. Since they’re valuable from day one, they provide a nice incentive, but unlike other forms of incentive, they don’t burden anyone with a cash outlay.
When you do cash in your options, tax liability may become a problem. The size of the problem depends on how you structure things: if you exercise and then sell right away, you’re hit with normal taxes. It’s often a better idea to exercise and then hold for a year, so you get long-term capital gains treatment. The problem here is holding on: for many people, the shares from a stock option exercise are by far the largest position in the account, and it’s often difficult to exercise these options without borrowing money to finance the purchase. Even if you borrow far less than the value of the options, market fluctuations can mean that you lose more from losses than you save in taxes. This was a more common problem right after the bubble, but it’s still a factor.
If you buy options as a trade, beware — you’re going to pay regular income taxes on the profits you make from trading or exercising them. If you sell options however, you won’t pay taxes until you either cancel out the trade, the options expire, or they’re exercised. The tax implications are minimal, but if you’re a short-term trader with a holding period that extends past the end of the taxable year, you might consider selling options, knowing that you won’t pay taxes on the gains until the next year.
Keep in mind that with options, unlike almost everything else, procrastination can be a virtue. The value of an option is always higher than the value of exercising it (the simplest proof: the date of the exercise doesn’t change your gains from the stock price movements — but if you just put the money you were going to spend on the option exercise in a CD, you’ll end up with the same amount, plus the CD’s interest. This ignores dividends, of course).
Stock options are a great way to incentivize employees, and they’re an easy way to get financial leverage without the risk of a total loss. With some basic tax knowledge beforehand, you can make sure the profits on your options end up with you, not with the IRS.