I’d like to cover some basics on a topic that I often discuss with my clients when it comes to their retirement planning, particularly those who work for large companies… and that’s Employee Stock Options and Ownership.
The tax treatment upon the sale of a stock option depends on whether its classified as an Incentive Stock Option (ISO), which can be granted only to employees, or a Nonqualified Stock Option (NSO), which can be granted to mostly anyone, including employees, consultants, and directors. Since ISOs are a lot less popular today, let’s just focus on the NSO, which, if you have stock options, that’s most likely the type of option you’re dealing with. In addition, I will briefly touch on how the taxation on an ESOP differs from that of an NSO.
As an example, let’s assume you are an executive at a company that has decided to reward you by granting you NSOs at a price of $50 per share. At the grant of the NSO, there is absolutely no tax event to you. Now, fast-forward, let’s say two years, the NSOs are now at $75 per share, and you decide you would like to exercise your shares. Not sell… exercise. At this point, the difference between the grant price ($50) and the exercise price ($75) is going to be taxed at your ordinary income tax rate… so, your tax is $25 times the number of shares you exercised. Once this occurs, your new cost basis in those NSO shares is $75 per share instead of the initially granted $50 per share.
Fast-forward six months… the price just shot up to $100 per share, and you decide you want to sell your NSOs. Here’s how you are going to be taxed… when you sell your non-qualified stock options, you are going to incur, in this case, $25 per share of short-term capital gains tax. Depending on how long you decide to hold on to your NSOs from the day you exercise… that is going to determine whether your next tax is short-term capital gains or long-term capital gains. How long do you have to hold an NSO for it to be considered a long-term capital gain? Exactly one year from the date of exercise. So, in this example, if you would have sold your stock one year from the date of exercise instead of six months from the date of exercise, you would have had a long-term capital gain of $25 per share instead of a short-term capital gain of $25 per share. What’s the difference in tax rates between a short-term capital gain and long-term capital gain? The short-term capital gain is going to equal your ordinary income tax rate… so, if you are in the highest tax bracket, you will pay 39.6% in taxes if the gain is short-term. If it is long-term and you are in the highest tax bracket, you will pay a maximum of 20% in taxes.
Now, if you have an Employee Stock Ownership Plan (ESOP) or company stock in any other ERISA qualified plan, the stock can qualify for net unrealized appreciation (NUA). NUA is the difference between the employer’s cost basis at contribution and the market value at the lump-sum distribution to the employee.
Let’s use another example. Assume an employee has ESOP shares that were contributed to a qualified plan by an employer at $50 per share. Over the years the stock has grown to $75 per share. Now, at age 60 it’s time to retire, so the employee takes a distribution and sells the ESOP shares right away. At that time, the employee will incur an ordinary income tax of $50 per share, which is the cost basis, and a long-term capital gain of $25 per share gain ($75-$50). The appreciated value of the ESOP shares at the time of distribution will be taxed at long-term capital gains rates no matter when the shares are sold.
Now, here’s where it can get a bit tricky. Let’s assume that, at the distribution of shares at the employee’s retirement, the stock is $75 per share, but the employee waits six months after retirement to sell the ESOP shares when they are valued at $80 per share. The employee will still be taxed at the ordinary income rate for the $50 per share cost basis, that doesn’t change. Since the appreciated value of the ESOP shares were $75 at the time of distribution, $25 per share will be taxed at long-term capital gains rates regardless of the time held. However, since distribution, there has been further appreciation $5 per share. Upon the sale of shares, the $5 per share will be taxed at short-term capital gains rates (which is the same as the ordinary income tax rate), because the time horizon from the time of distribution to the time of sale was six months. So, the taxes are $50 per share at the ordinary income tax rate when distributed, then $25 per share at the long-term capital gains rate and $5 per share at the short-term capital gains rate when the ESOP shares are sold. If the time horizon from distribution to sale was one year or longer, the $5 per share would be taxed at the long-term capital gains rate.
One last thing I will mention about net unrealized appreciation is that if you decide to take substantially equal periodic payments through what’s called a 72t distribution, or if you rollover your ESOP or qualified plan shares into an IRA, the NUA tax benefits will be lost.
I hope this helps you understand your stock options a little better.
If you have questions about stock options or anything else regarding your own specific situation, I can provide a financial plan that will highlight potential solutions to the issues you are most concerned with.