The Tax Requirements for Performance-Based Stock Options

by Chris Hamilton

Performance-based stock options, frequently called incentive stock options, allow employees the option to purchase shares at a set price if they meet conditions or goals established by their employers. When employees meet these goals, they become vested and can trade in their options for shares by paying an agreed-upon price. If they work for a successful company, the current price of the stock will exceed the options price, creating a federal tax liability when they both cash in their options and sell their shares on the open market.


If investors hold onto stock after exercising incentive stock options, they will not report the difference between their options exercise price and the current market price of performance-based stock as capital gains, because they do not show a profit for tax purposes until they sell shares. Investors must compute their gains on paper for the purposes of the alternative minimum tax and file Form 6251 with the Internal Revenue Service, which can increase their tax rates on other sources of income.


The taxable basis for performance-based stock options equals the difference between the price at which an investor cashes in an option and the fair market value of stock, known as the bargain element. If an investor holds onto a stock after cashing in options and the stock further appreciates in value, he adds to the bargain element the difference between the fair market value of stock at the time he cashed in options and the market price when he disposes of the shares.


The IRS considers the sale of stock obtained from a performance-based options plan as either qualified or nonqualified. Qualified earnings receive preferential tax treatment. Investors will pay long-term capital gains tax if they hold onto stock at least one year after they cash in their options and at least two years past the date they became vested in their options before selling. If they hold onto stock less than a year but two years past the date they become vested, investors pay short-term capital gains tax.


Investors will pay income, Social Security and Medicare taxes on the bargain element of their performance-based stock options if they cash them in and sell shares less than two years after the original issue date of options. Gains beyond the bargain element are considered short-term gains if sold after holding for less than a year or long-term if held longer than a year.


Investors should wait at least two years past the issue date of performance-based stock options and at least one year after cashing in options before they sell stock. Income tax rates reach a top rate of 35 percent and Social Security and Medicare taxes equal 13.3 percent as of 2011. The U.S. government taxes long-term capital gains at zero or 15 percent, while it taxes short-term capital gains at regular income tax rates but does not charge Social Security and Medicare taxes on these profits as of 2011.

About the Author

Chris Hamilton has been a writer since 2005, specializing in business and legal topics. He contributes to various websites and holds a Bachelor of Science in biology from Virginia Tech.