How to Pay Less Taxes on Stock Options

Imagine this: you're in the top tax bracket, your ordinary income is taxed at a staggering 37%, and your capital gains carry a 20% burden, plus an additional 3.8% net investment income tax. Suddenly, your take-home pay doesn't feel quite as substantial as it once did.

Now, let's consider another scenario. Your employer has been generous, granting you stock options and restricted stock units (RSUs). You're thrilled, but then comes the question: how are these taxed, and can you do anything to lighten this tax load?

While it's impossible to completely erase the taxes linked to your stock options, there are clever tactics you can employ to soften the blow. Your personal tax scenario, and the kind of grant you've received, will ultimately determine which strategies are most effective for you

Types of Stock and Associated Taxes

In general, there are four federal taxes that impact employee stock grants.

Ordinary Income Tax

Depending on your tax bracket, this tax is charged on basic earned income, such as wages, consulting fees, interest income, ordinary dividends, and net rental income.

Capital Gains Tax

A capital asset sale triggers this tax, which can apply to either public or private stocks. Those who hold the stock for more than one year will get preferential long-term capital gains treatment, which is 20% at the top tax rate. Stocks held for less than one year are considered short-term gains and subject to the 37% ordinary tax rate.

Alternative Minimum Tax (AMT)

This tax mainly affects taxpayers with high incentive stock options (ISOs), and is calculated by first modifying your taxable income - including adding back deductions such as for state taxes, as well as incorporating spread income from the exercise of incentive stock options. As a result, these taxpayers might have a higher taxable income using the AMT calculation, which is subject to the 28% flat tax.

Each year you’re required to pay your regular tax or your AMT—whichever amount is higher—so exercising ISOs can create a tax liability even if you haven’t received any income. For this reason, AMT is often called a phantom tax.

Net Investment Income Tax

You will be subject to a 3.8% tax on passive income, including investment income, if your income exceeds certain thresholds $200,000 for an individual, $250,000 for a couple.

State & Local Taxes

These taxes vary from location to location.

It is best to consult a tax accountant about these taxes as they can be very specific to your work location and residency.

Type of Stock Compensation

• Incentive Stock Option (ISO):

  • Taxed as a long-term capital gain if held for at least two years from the date of grant and one year from the date of exercise; otherwise taxed as ordinary income.

  • The spread is included in the Alternative Minimum Tax (AMT) at the time of exercise.

  • There are no withholdings on exercise.

• Nonqualified Stock Option (NQSO or NSO):

  • Taxed as ordinary income upon exercise. Withholdings apply on exercise.

  • When sold, the appreciation after exercise is taxed as a long-term capital gain if held more than one year from exercise, or taxed as a short-term capital gain if held less than one year from exercise.

• Restricted Stock Unit (RSU):

  • Taxed as ordinary income at vesting. Withholdings apply on vesting.

  • When sold, the appreciation after vesting is taxed as a long-term capital gain if held more than one year from vesting, or taxed as a short-term capital gain if held less than one year from vesting.

How do I reduce my tax impact of my stock options and RSUs?

1. Exercise ISOs Early: A common tax strategy is to exercise ISOs before a spread occurs between the grant price and the fair market value. Although this requires an upfront cash investment, it prevents an increase in taxable income for AMT purposes.

2. Make the 83(b) Election for Early Exercise: Most stock options come with vesting restrictions. However, many companies offer early exercise, which accelerates tax consequences, starting the capital gains clock early. To do this, you need to file the 83(b) election form within 30 days of purchasing unvested options.

3. Exercise ISOs to AMT Crossover Point: Here, you would exercise ISOs only up to the point where you would enter AMT, effectively exercising them tax-free. Any further exercise will trigger the AMT.

4. Raise Your Ordinary Income with Same-Day Sales: If you're already in AMT, a same-day sale strategy might help. By immediately selling stocks after exercising options, you increase your ordinary income, possibly surpassing your AMT.

5. Exercise ISOs Early in the Year: Not holding ISOs long enough triggers a disqualifying disposition, making gains taxable as ordinary income. However, you can use this to your advantage by timing your sales right.

6. Take Deductions in Years with High RSU Vesting Income: Unlike other stock grants, RSUs become taxable as ordinary income upon vesting. In years when large blocks of RSUs vest, you can use state income tax and property tax deductions to reduce your tax liability.

Whether these strategies will be effective ways to reduce the tax impact of your stock options or RSUs will depend largely on your particular compensation package and your personal tax situation. To learn if one of these strategies or others may work for you and for help applying it effectively, your financial planning & tax professional. If you don’t have one, feel free to set-up a complementary intro meeting with me.