Stock options give you the right to buy shares of your employer's stock at a specific price -- the "strike price" -- at some point in the future. When you first receive a stock option, there's usually nothing to report on your tax return. That's because the company typically sets the strike price equal to the market price on the day it issues the option. At that point, the option gives you no price advantage, so it has no intrinsic value and thus doesn't count as taxable compensation. However, as time passes and, you hope, the market price rises, the option gains value. That value becomes taxable when you exercise the option -- meaning you actually buy the shares.
Options Reported on W-2
Obtain your W-2 form from your employer at the end of the year. This form lists all compensation provided to you by your employer.
Look at Box 12 of your W-2 form. If you exercised stock options, you should see a code "V" printed in Box 12. Next to it will be the "compensation element" of your option. This is the difference between the strike price and the market price on the day you exercised the option -- the taxable "profit" you got from the option.
Fill out your tax return the same way you would even if you didn't exercise any options. When an employer reports Code V in Box 12, that means it has included the compensation element in Box 1 of your W-2, "Wages, tips and other compensation." The amount from Box 1 goes on Line 7 of your tax return, either Form 1040 or Form 1040A. At that point, you've reported your gain from exercising options.
If Options Aren't Reported on W-2
Calculate the compensation element manually if, for some reason, your employer did not report your options on form W-2. Start by looking up the market price of the shares on the day you exercised the option. Historical charts of the closing prices for stocks are readily available at financial news websites.
Subtract the strike price from the market price of each share.
Multiply the result by the number of shares you purchased when you exercised the option. This gives you your total compensation element.
Fill out your taxes as usual, including the compensation element on Line 7 of your Form 1040 or Form 1040A tax return.
- You must pay taxes on the compensation element of the options you exercise -- even if you buy and hold the shares and thus don't convert that profit into cash. Check with your employer to make sure you have enough money withheld from your pay to cover these taxes.
- The instructions in this article apply to "nonqualified stock options," the most common type issued to employees. A different kind of option, an "incentive stock option," has no tax-reporting requirements when you receive or when you exercise the option. Taxes on your profits apply only when you sell the shares later on.
- If you received stock options, you cannot use Form 1040EZ to file your taxes. You must use either the 1040 or 1040A.
- If you sell the shares after exercising the option, a separate capital gains tax will apply to any profit. Since you've already paid taxes on the compensation element, "profit" in this case is defined as the difference between your selling price and the market price on the day you exercised the option.
Items you will need
- W-2 form