Be Tax-Smart with Stock Options
Executives are often rewarded for their business acumen with nonqualified deferred compensation (NQDC) and stock options. To keep taxes to a minimum, it’s important to be just as smart when it comes to tax planning for these complicated forms of compensation. This means both understanding the unique rules that apply to each compensation type and taking steps to use them to your advantage.
These plans pay executives in the future for services currently performed. They differ from qualified plans, such as 401(k)s, in several ways. For example, NQDC plans can favor highly compensated employees, but any NQDC plan funding isn’t protected from an employer’s creditors. One important NQDC tax issue is that employment taxes are generally due once services have been performed and there’s no longer a substantial risk of forfeiture - even though compensation may not be paid or recognized for income tax purposes until much later. So, your employer may withhold your portion of the employment taxes from your salary or ask you to write a check for the liability. Or your employer may pay your portion, in which case you’ll have additional taxable income. Keep in mind that the rules for NQDC plans are tighter than they once were, and the penalties for noncompliance can be severe: You could be taxed on plan benefits at the time of vesting, and a 20% penalty and potential interest charges also could apply. So check with your employer to make sure it’s addressing any compliance issues.
Incentive stock options
Incentive stock options (ISOs) receive tax-favored treatment but must comply with many rules. ISOs allow you to buy company stock in the future (but before a set expiration date) at a fixed price equal to or greater than the stock’s fair market value (FMV) at the date of the grant. Therefore, ISOs don’t provide a benefit until the stock appreciates in value. If it does, you can buy shares at a price below what they’re then trading for, as long as you’ve satisfied the applicable ISO holding periods.
Here are the key tax consequences:
- You owe no tax when the ISOs are granted.
- You owe no regular income tax when you exercise the ISOs.
- If you sell the stock after holding the shares at least one year from the date of exercise and two years from the date the ISOs were granted, you pay tax on the sale at your long-term capital gains rate.
- If you sell the stock before long-term capital gains treatment applies, a “disqualifying disposition” occurs and any gain is taxed as compensation at ordinary-income rates.