STOCK OPTIONS: REPORTING AND TAXATION

A stock option pertains to a contract between two parties where the owner (buyer) obtains the right, not the obligation, to buy or sell 100 shares of an underlying stock at a preset price from or to the writer (seller) within a certain time period.

Companies award these options to employees, allowing them to purchase their stock at a discount. Such options hold no ownership interest, but they can exercise those to buy the stock. There are two types of stock options:

• Statutory stock options - Awarded under an employee stock purchase plan or incentive stock option.
• Nonstatutory - Non-qualified options that do not meet some IRS requirements for a special tax treatment, which is granted without any plan.

Statutory Stock Options

Any immediate income from an ISO or other statutory stock option is not subject to standard income taxes. Also, exercising the option to obtain the stock does not generate any earning swiftly as long as the person holds the stocks in the year it is acquired. Income will be accrued when that stock is sold by exercising the option.

Executing an ISO induces an adjustment for alternative minimum tax. Adjustment refers to the difference between the stock’s fair market value by exercising the ISO over the amount to be paid for that ISO, if any. But, any adjustment is needed only if the stock’s rights are deemed transferable and not subject to substantial risk of forfeiture in the year it is applied. The stock’s fair market value for adjustment is identified without accounting any lapse restriction, granted the rights in the stock first becomes transferable or are no longer under a substantial risk of forfeiture.

No AMT adjustment must be done if an individual sells the stock in the similar year the ISO is executed because the tax treatment becomes the same for the standard tax and AMT. If it is necessary to make an AMT adjustment, escalate the basis in the stock by the AMT adjustment to ensure the gain to be taxed for AMT is constricted when the stock is sold.

Nonstatutory Stock Options

This stock option encompasses three events: grant, exercise, and the sale of stock obtained through executing the option. In most instances, the option is not taxed immediately since its value cannot be ascertained right away. But the receipt of these options is taxed directly only on the premise the fair market value can be assessed instantly.

When exercising the option, the stock’s fair market value at the time it is bought is integrated in income, minus any amount to be paid for the stock. It is the ordinary wage income indicated in Form W-2. It increases the tax basis in the stock.

When the stock bought through exercising the options, the holder denotes capital gain or loss for the difference between the tax basis and proceeds of the sale.

When executing an ISO, the employer provides Form 3921, Exercise of an Incentive Stock Option Plan under Section 432(c). The form outlines the details required for tax reporting. When a stock, purchased through the execution of an ISO or employee stock purchase plan, an option holder reports earnings or loss on the sale.