Internal Revenue Service tax rules on common stock can differ, depending on whether you purchased shares on the public market or through an employee stock option plan. You typically must pay capital-gains tax when you sell shares of common stock for a profit. If you received common stock through an employee stock option plan, you also might face taxation on earnings at your regular income tax rate.
Companies sometimes offer their common stock to their employees, in the form or stock options, before or after making a public offering. If you are awarded employee stock options, you typically have the choice to purchase shares of stock at a fixed price. When you exercise your options, you purchase the shares at the price stipulated in the agreement. Typically, employee stock options offer shares at lower prices than the stock sells for on the public market. If you purchase common stock on the public stock market, you typically must pay the current public price per share.
The IRS considers earnings on common stock to be capital gains. The amount of tax you must pay often depends on how long you hold your shares. If you keep your stock for one year or more before selling, the IRS considers your earnings to be long-term gains. If you sell your common stock within a year of purchasing it, your earnings are considered short-term gains. The IRS typically taxes short-term gains at a higher rate than long-term gains. However, if you sell shares of common stock for less than your purchase price, the sale might qualify as a capital loss that reduces your income tax liability.
Nonqualified Stock Options
Companies often offer nonqualified stock options, also referred to as nonstatutory stock options, to their executives. When you purchase nonqualified shares, you often face tax liability. Because these shares typically are offered a lower price than shares on the public market, the difference constitutes a capital gain during the year you exercise your options, and the IRS typically taxes those earnings at your regular income tax rate. When you sell your shares, you also might face tax liability for long-term net capital gains, taxes levied on earnings during the lifetime of your stock investment.
Incentive Stock Options
Companies offer incentive stock options, also referred to as statutory stock options, to all types of employees. Incentive stock options typically offer a lower tax liability than nonqualified stock options. When you exercise incentive stock options, you do not face tax consequences until you sell your shares. In certain cases, you might qualify for long-term capital-gains tax rates, which often are lower than your regular income tax rate. To qualify for long-term capital gains rates, you must hold your incentive stock option shares for at least two years after the stock option award date, and for at least one year after purchasing your shares. If you qualify for long-term capital-gains tax rates but sell your shares for less than your exercise price, you typically can report your loss as a long-term capital loss. This can lower your taxable income and reduce your tax liability.
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