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Question: How should I deal with the exercise of stock options?
Answer: Consider the following example:
An employee has an option on a stock. In the year one, he exercises the option and buys the stock. Two years later, he sells the stock.
The exercise price of the option is $60. The value of the stock on the date the option is exercised is $100. The employee later sells the stock for $150.
This example may be illustrated by the following illustration:
--- $150 - price stock for which stock is later sold
--- $100 - value of stock on date option is exercised and stock is purchased
--- $60 - cost to buy stock, "exercise price" of option
In this situation, the employee has a gain of $40 on that day he exercises his option and buys the stock.
Two years later, he has a further gain of $50 when he sells the stock.
If the option is a nonqualified option, the $40 is treated as ordinary income.
The $50 is treated as capital gain. It will be short-term capital gain or long-term capital gain, depending on the amount of time that elapses between the date when the option is exercised (and stock acquired) and the date when the stock is ultimately sold.
If more than one year elapses, it will be long-term gain. If one year or less elapses, it will be short-term gain.
In the software:
Upon the exercise of nonqualified stock options:
1. Stock sold. If the stock is sold immediately after exercise, you may report the $40 as Wage-Like Income.
2. Stock retained. If the stock is retained after exercise, you may wish to do the following:
- Enter a $60 major expense for the purchase (1 year only).
- Enter the $100 of stock as a Cash & Investment (thus Net Worth will increase by $40 net).
- On the View/Edit taxes screen for the current year, override the calculated value to enter an additional $40 as "Other Income" (thus giving the correct tax effect).
Qualified stock options
The tax treatment of qualified options is a bit more complicated.
The $40 could escape tax completely. The $40 would escape tax completely if the employee waits for a year after buying the stock before selling it (or, if longer, two years from the date he received the option).
The $50 gain on sale of the stock is treated the same as with nonqualified options - short term or long term gain, depending on how long the person holds the stock before selling it.
However, there is a catch. For qualified options, the $40 is a "preference item" for the Alternative Minimum Tax. That means that if the employee is subject to the Alternative Minimum Tax (as many employees are), then the entire $40 value will be taxed at the alternative minimum tax rate.
If the value of the exercise is substantial (tens of thousands of dollars, say), it could make the employee subject to the Alternative Minimum Tax, even if the employee was not subject to it before.
The AMT tax rate is higher than the capital gains rate, but may be lower than the regular tax rate for the individual.
Also, if the employee sells the stock before the 1-year or 2-year minimum, the stock loses its special quality. The exercise generates $40 of ordinary income, just like a non-qualified option.
In the software (using the example above of a $60 exercise price, $100 current stock value, $40 spread, and $50 gain on later sale of the stock:
The treatment in the software depends on the situation:
1. AMT:No, Holding:Yes
If you know that the AMT will not apply, and you expect the stock to be held for the 1-year or 2-year minimum do the following:
- Enter a $60 Major Expense for the purchase (1 year only).
- Enter the $100 of stock as a Cash & Investment with a tax basis of $60. (Net Worth will increase by $40 net, and there will be no immediate tax effect.)
2. AMT:No, Holding: No
If you know that the AMT will not apply, and you expect the stock to be sold before the 1-year or 2-year minimum, you may report the $40 as Non-Wage Income. (This is the same as the treatment of a non-qualified stock option.)
If you know that AMT will apply, make the same entries as in the situation above where AMT does not apply.
But in addition, on the View/Edit Taxes screen, override to enter the $40 (in our example) of "other income." This will be treated as income for both regular and Alternative Minimum Tax purposes. But if the Alternative Minimum Tax applies, then the fact that it also counts for regular tax purposes will not matter.
How do you know whether the Alternative Minimum Tax applies? See if the Alternative Minimum Tax line on the View/Edit Taxes screen has a value greater than zero. If so, then the Alternative Minimum Tax applies.
If the AMT applies only because of the stock exercise, you currently can not get an accurate tax result from the software. You will have to figure the tax separately and override the tax result. You can get into the general range, however, by assuming AMT does apply.
Property Division Implications
You also want to be able to reflect the tax impact on the division of property.
This FAQ explains how: