When you exercise a stock option, the IRS considers profits to be a capital gain in most cases. This is true for traded stock options as well as employee stock options. Once you know this, it takes much of the confusion out of determining the tax rates that apply. However, there can be complications, depending on the type of stock option you exercise.
Options Tax Rates
When you buy an option or are awarded options by your employer, you don’t own actual shares. If you exercise the option, profits are considered a capital gain, except in the case of non-qualified employee options. Because the shares are normally sold quickly, you usually have a short-term capital gain. Your profit will therefore be taxed at the same rate as ordinary income. Should you choose to hold the shares for more than a year after purchasing them, this becomes a long-term capital gain, and is subject to a tax rate of 15 percent. The important thing to remember is that the length of time you own the shares determines which tax rates apply, not how long you held the options prior to being exercised.
When you exercise non-qualified employee stock options, your profit at the time of exercise is considered compensation instead of a capital gain, and is listed as such on your W-2 form. You pay taxes at the rates applicable to wages. If you choose to hold the shares instead of selling them immediately, any further appreciation of the stock is a capital gain. Assume, for example, you have non-qualified options with an exercise price of $15 per share, and you exercise the option at $25 per share. Your profit of $10 per share is considered compensation. If you hold the shares and the price eventually increases to $30 per share, and you decide to sell, the additional increase of $5 per share occurred while you actually owned the stock and is a capital gain. If you own the stock for more than a year, you have a long-term capital gain. Otherwise, it is a short-term gain.
Incentive Stock Options
Companies sometimes award incentive stock options (ISOs) to valued employees. An ISO has a tax advantage provided you meet certain conditions. All of the profit from the exercise and eventual sale of the options becomes a long-term capital gain. You must wait at least one year after the options are awarded before exercising them. You then must hold the stock for one additional year. For example, assume you have ISOs with an exercise price of $15 per share, and you wait more than a year to pay the exercise price when the stock is selling at $25 per share. A year later the price has gone up to $30 per share and you sell. All of your profit of $15 per share is taxed as a long-term capital gain.
When you buy a traded option contract you pay a premium. This means the tax basis when you exercise the option consists of the exercise price, the premium you paid and any transaction costs. Your profit is always a capital gain equal to the proceeds of the sale of the stock minus the tax basis. Since most of the time you likely will immediately sell the shares, your profit is taxed at ordinary tax rates as a short-term capital gain. However, if you hold the stock for at least a year, your profit becomes a long-term capital gain. The same rule applies to put options that give you the right to sell, rather than buy, a security at a stated price. This means you must own the stock for more than a year before you sell it to exercise a put option.