Stock Option Exercise Tax: How owning private company shares can affect your taxes

The following is not legal, tax or investment advice, and is intended neither to provide a full or exhaustive discussion of any topic discussed herein, nor to discuss all topics that may be pertinent to any individual situation. Any questions with regard to your own individual situation should be discussed with your own legal, tax or investment advisors, as the below speaks only in general terms and your own situation could lead to the application of different rules/principles and/or different results.

Tax season’s just around the corner, and if you own private company stock (or plan to), you might be wondering how these assets will affect your tax situation.

Of course, keep in mind that these are just general guidelines and are not tax advice. For definitive answers to any tax questions you may have, get in touch with a financial advisor or tax professional with expertise on these matters.

So without further ado, let’s dive in.

How do taxes differ for public and private stock?

In general, the IRS treats sales of private and public stock similarly. Buying or selling stock can trigger a tax liability depending on the circumstances. For instance, if you make a profit from selling your stock, you’re also responsible for paying taxes on that amount. Likewise buying or selling private company shares has tax implications.

The tax implications of exercising your stock options

An option grant allows you to buy company stock at a set price, typically called the strike price, exercise price, or award price. This exchange is known as “exercising your options.”

Option grants typically can’t be exercised until they vest and you receive full ownership of the options. Grants also expire — and once they do, the opportunity to buy company stock at the price specified in the grant ends as well.

First-time grant holders may jump at the prospect of buying stock at a low strike price in hopes of turning a profit years down the road. But many forget to consider the taxes and other costs involved with this kind of purchase.

If you buy Company XYZ stock at a $1 strike price, for instance, it may (understandably) sound like a great opportunity at first. But buying 50,000 shares at that price is still a $50,000 investment.

Depending on the grant you receive, you may also need to pay additional taxes when you exercise your options, as you’ll learn later. That’s why it’s important to look at the whole picture before locking yourself into a purchase.

Nonqualified stock options (NSOs)

What are nonqualified stock options?

Nonqualified stock options (NSOs), also known as non-statutory options, are one of two main types of options you might receive from your employer.

Although they’re often used to reward employees, companies also offer them to non-employees such as non-employee directors, consultants and other business partners. NSO’s are also often offered to foreign domiciled employees. As a result, you don’t need to be an employee at the company to receive NSOs.

How are NSOs taxed?

NSOs aren’t subject to taxes when they’re granted, and you don’t report them on your return until they’re exercised. At that time, the tax implication is based on the difference between the grant price and your exercise price at your standard income tax rate.

Say your grant price is $1 a share and the stock price at the time you exercise your options is $10 a share. Your tax liability is based on the $9 spread for every share you buy.

If you’re an employee at the issuing company, your employer is required to withhold taxes from your NSO exercise for you. You can pay the strike price plus the amount you owe in taxes upfront, or if your company allows it, surrender a portion of your total shares to offset your tax liability and the strike price.

However, if you’re a contractor or otherwise not employed by the company, you generally manage and pay the taxes on gains from the transaction yourself via a 1099-NEC form.

Incentive stock options (ISOs)

What are incentive stock options?

Incentive stock options (ISOs), which are also known as statutory or qualified stock options, are the other kind of stock option often offered by employers.

Where NSOs can be offered to virtually anyone inside or outside of a company, ISOs are only available to employees — meaning you can only exercise them while you’re still employed with the issuing company or within a certain period after you leave (which, for many companies, is 90 days). Employees who receive a grant must also wait until their options vest before they can exercise them.

How are ISOs taxed?

Different from NSOs, ISOs are taxed when you sell the resulting shares, instead of when you exercise them. And when you do sell them, subject to the below caveat, your gains are taxed at the capital gains tax rate instead of the higher ordinary income tax rate.

The caveat is that, to take advantage of this lower rate, you must hold the stock for:

• At least one year after exercising your options, and
• At least two years after receiving your grant

If you sell your stock before meeting these milestones, you’d trigger what’s called a disqualifying disposition. In that case, the gains from the sale will be recognized as regular compensation income equal to the lesser of the two following amounts:

• The gain at the time the option was exercised, calculated as the difference between the fair market value on the date of exercise and the amount paid to exercise the ISO.
• The actual gain on the sale, calculated as the difference between the gross sales price and the amount paid to exercise the ISO.

Alternative minimum tax

Another thing to keep in mind with ISOs is the alternative minimum tax (AMT), especially if you already have a sizable income or stand to make a large profit from selling ISOs.

AMT was designed to ensure wealthy individuals pay a certain share of taxes every year. By applying a different set of rules to those who meet certain criteria, AMT to an extent prevents them from using tax breaks to lower their tax bill.

To find out if you’ll owe AMT when you exercise your ISOs, fill out IRS Form 6251 and consult with your legal, tax or financial advisor.

Because this is usually done in conjunction with the rest of your taxes, many people don’t realize they owe the IRS a significant amount until they file their return.

Restricted stock and restricted stock units

What is restricted stock?

Restricted stock is often given to employees including executives, although for executives they often come with performance conditions that act as a double trigger to satisfy vesting. It is “restricted” in the sense that it’s subject to vesting and certain conditions apply before the stock vests, including but not limited to:

• Meeting specific corporate or personal performance goals
• Meeting regulations set by SEC Rule 144
• Forfeiting stock if employment is terminated

Recipients of restricted stock also generally can’t sell or transfer ownership of their shares until these restrictions are lifted and conditions satisfied and the shares fully vest.

But although they don’t fully become owners until then, the person who receives this type of stock often maintains the same voting rights as other shareholders.

What are restricted stock units?

Restricted stock units (or RSUs, for short) can be thought of as a promise made by a company to grant an employee a set number of shares once they fully vest. They carry some similarities to restricted stock, including restrictions the holder must follow to receive the shares.

How is restricted stock taxed?

RSUs are taxed as ordinary income at the fair market value of the price per unit (or share) on the date of vesting.

Section 83(b) election: One way to reduce taxes on the sale of restricted stock

Depending on your situation, taking a Section 83(b) election within 30 days of receiving a restricted stock grant can save you money.

Here’s how it works:

You may recall that employees are usually taxed on their stock once it vests. A Section 83(b) election allows you to pay taxes on the stock once it’s granted, even though it hasn’t vested yet. The more time you have before the vesting date, the greater the opportunity for your shares to increase in value. And by opting to pay taxes on these assets now instead of when they fully vest at a potentially higher price, you potentially avoid a much larger tax liability.

Plus, if you hold your shares for at least one year after receiving your grant, you unlock the long-term capital gains tax rate if and when you decide to sell after that time.

Of course, there are downsides to this strategy.

If you make the election but your stock loses value between the time of grant and the vesting date, you end up paying more than you needed to. Additionally, if you leave the company before the stock vests, you lose your shares along with the taxes you’ve already paid on them.

Depending on your situation, taking a Section 83(b) election within 30 days of receiving a restricted stock grant can save you money. And just like any other investment strategy, this approach comes with its fair share of risks, so you may want to consult a financial professional beforehand.

How are RSUs taxed?

Because you don’t own any of the stock you’re promised in an RSU grant until you actually receive it, you also don’t owe any taxes on it until that moment.

No need to whip out a calculator to determine its value either — it’s determined by the stock’s FMV on the date of vesting. The total value of the stock will then be reported as ordinary income on your tax return in the year of vesting, meaning that your exact tax rate will ultimately depend on your tax bracket for the year.

And if you decide to sell your shares, they receive the same tax treatment as ordinary shares. Shares you hold on to for less than a year before selling are taxed at the short-term capital gains rate, while those you’ve owned for a year or longer receive the long-term capital gains tax treatment.

The tax implications of selling private stock

When you exercise your options and sell the shares at a later point in time, you may pay taxes, just like you would with any other stock. Generally, though, you would only pay taxes on the gains (if there are any), not the entire transaction amount. Let’s look at an example where you sell stock for a profit.

So how do you calculate your profit?

First, you’d determine the total cost of the sale. Calculate the cost of buying the stock, and add any fees you paid to facilitate the transaction. That’s your cost basis. Take that sum and subtract it from the amount you received from the sale of your stock to calculate your profit.

Let’s look at a simple example. Say you buy 100 shares from your employer at $20 each, but you pay $10 in transaction fees to do so. Later on, you sell your stock for $25 each and pay another $10 fee to close the sale.

Calculate your total purchase price (100 shares x 20 = $2,000) and add the $10 fee incurred when you bought your shares to get your cost basis ($2,000 + $10 = $2,010).

Then you’d calculate your total proceeds from the sale (100 x $25 = $2,500 - $10 = $2,490) and subtract your cost basis from that number to get your profit ($2,490 - $2,010 = $480). In this example, you have a profit of $480. You’d only pay taxes on the $480, not the total $2,500.

Once you know your profit, you can calculate your tax liability from the sale too. But first you’ll need to take into consideration your total income for the year, how long you’ve owned the stock for, plus the following factors, as they all impact what the final number looks like.

Cost basis when selling stock

If you’re not an institutional investor, you may want to hire securities attorneys, financial advisors, and brokers to guide you through the processes of buying and selling private stock.

But if you’re hesitant about shelling out fees for such professional services, the IRS allows you to deduct your transaction-related expenses by including them in your cost basis. After all, the money you’re using to buy these assets has likely already been taxed — deducting these expenses from your profit ensures those funds don't get taxed again.

Fair market value of your stock

Because private stock transactions typically happen far less often than public ones, it may not make sense to use past sale prices as benchmarks for your current transaction.

If the last sale of Company XYZ stock took place two years ago, for example, you may not want to rely on that valuation because much may have changed since then.

For private companies, the Fair Market Value (or FMV) is generally defined by their most recent 409a valuation. For public companies, the FMV is based on the stock price and how it is calculated is generally specified in the company’s plan documents, i.e. current day's close, prior day's closing price etc.

Expenses

Similar to your cost basis, you can also deduct additional transaction-related expenses from your taxable profit.

Keep in mind that, in order to claim these expenses, they must be considered necessary for facilitating the transaction. So any fees paid to a private securities broker can often be deducted, while consultation fees for a financial advisor you met with for other reasons may not be able to be deducted.

Short-term and long-term capital gains tax rates

Selling stock typically results in a capital gain or capital loss, based on whether any profit was made from the transaction.

You can break down both capital gains and capital losses into short-term and long-term ones too, depending on how long you owned the stock for. This is important to know when it comes to capital gains, because long-term gains are taxed at a lower rate than their short-term counterparts.

Stocks held for less than a year before selling at a profit, if any, may trigger short-term capital gains taxes. Short-term capital gains are taxed at the marginal income tax rates.

Find your marginal tax rate for the 2022 tax year.

Source: IRS - https://www.irs.gov/pub/irs-drop/rp-21-45.pdf

Understanding how private stock transactions affect your taxes

Taxes can be difficult to navigate. And when you throw in the complexities of stock ownership and the taxes involved, it can seem downright impossible to figure out.

To make the most of your employee equity, it’s best to consult with a certified financial planner or other financial professional who can help you navigate securities and tax laws, maximize your returns, and minimize your costs.