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Understanding Stock Options—Even When You’re Not a Billionaire

Dec. 23, 2021, 9:45 AM

There’s been a lot of attention on social media of late focused on stock sales and stock options. It’s not the kind of thing that you typically see wedged in between posts about #CatHerdingDay—a real thing—and the opening of the new Spider-Man movie—I promise, no spoilers—which is why it’s so noteworthy. Here’s what has people talking—er, tweeting.

On Dec. 19, Tesla CEO Elon Musk tweeted:

Since Musk has shared that he doesn’t collect a salary, the tweet quickly became a talking point: How could he rack up $11 billion in taxes?

The answer that quickly circulated on social media was that it must be related to his sale of stock. Musk has sold millions of shares worth nearly $11 billion since he posted a poll on Twitter asking whether he should sell 10% of his Tesla stock.

But since sales of stock are generally tax-favored, there had to be another answer, right? And there was: stock options.

Musk was awarded stock options in 2012 as part of a compensation plan—those options will expire next year. And exercising those options will generate a significant tax bill, prompting Musk to tweet, “I only have stock, thus the only way for me to pay taxes personally is to sell stock.”

Both the exercise of the stock options and the sale of the stock are subject to federal tax. And while most of us aren’t cashing in billions—or even millions—of dollars worth of stock options, they’re not limited to the ultrarich. It’s not uncommon to see stock options offered as a part of a standard compensation package at many companies—like the handful of shares I earned while working part time at the Gap.

Here’s what even those of us who aren’t billionaires need to know about stock options.

Stock Options

A stock option is the right to buy a share of stock at an agreed-upon price. Typically, that price—sometimes called the grant price—is less than the stock’s fair market value. It’s also fixed, which means that it won’t change even if the stock’s fair market value moves up and down. That perk isn’t available to other investors, and it’s valuable, assuming that the grant price is lower than fair market value. And ideally, the value of the stock will continue to rise while the grant price remains set.

Companies generally benefit when investors buy shares of stock at higher prices. So why would they grant employees the right to purchase stock at a lower price than the fair market value? Simple. Stock options aren’t the same as cash, so companies aren’t typically out of pocket at the grant of options. Plus, companies can tie up the shares by restricting transfers and scheduling when the options vest—the date when the shares are eligible to be purchased—based on length of time or other behavior. This helps promote loyalty and tie you to the company since your options don’t belong to you until you pull the trigger.

Option Term

You generally can’t touch your options until they vest, but then the clock starts ticking. When that window—called an option term—expires, you give up the right to buy the shares at the grant price. The option term can vary, but 10 years is relatively standard. A little planning can go a long way here since it may be advantageous to exercise your options over time—when stock prices may be lower—rather than waiting until the end of the term. Assuming the stock continues to increase in value, the later you exercise, the more tax you’ll owe.

Even though you have the right to buy the stock during the option term, you aren’t required to do anything. And since there’s no readily determinable fair market value for most non-qualified stock options (NSOs)—the most common stock options—you generally don’t have any immediate tax consequences when the options are granted or vested.

Exercising Stock Options

Exercising your options does, however, result in tax consequences. When you exercise an NSO, the difference between the stock price and the grant price—the taxable spread—will be reported on your federal Form W-2 as compensation and taxed as ordinary income. For most taxpayers, the boost is not significant—exercising my handful of Gap stock options didn’t knock me into a higher tax bracket. However, in Musk’s case, these dollars would put him in the top tax bracket—that’s 37% in 2021 for federal purposes—state taxes may also apply.

When you exercise your options, your cost basis for your stock shares will be equal to the stock price on the exercise date. And when you sell your shares, the usual capital gains rules kick in—you’ll recognize a capital gain or loss equal to the value on the date of the sale less your cost basis.

Cashless Stock Option Purchase


Exercising your stock options sounds great on paper, but it can be a bit sticky in practice. The exercise of an option generally involves paying cash for the stock. Realistically, many taxpayers—even billionaires—don’t have the funds on hand to pay for a large stock purchase, even at a reduced price. Enter the so-called “cashless stock option purchase.” In a cashless stock option purchase, a third-party broker loans you the money to exercise the options and buy the stock. They then sell an amount of stock necessary to pay back the loan with the proceeds, and the remaining stock is yours. You won’t realize this because it all happens in a flash—on the same day—so it looks and feels like one transaction.

You will still have a gain or loss on the sale of the shares. But realistically, unless the stock is highly volatile, you don’t have to worry about a significant tax consequence with a cashless purchase. There won’t be a marked gain or loss in most cases because the buying and selling happens within a matter of hours or, quite possibly, minutes.

Examples


Here’s an example. Let’s assume that in 2015, I received the right to buy 10 shares of Taxgirl stock for $5 per share beginning in 2018. And let’s assume that in 2019, I exercised that right when the stock was worth $12 per share. The taxable spread is $70, or $120 minus $50. That $70 would be reported on Form W-2 since the right to buy those shares at a lower price is part of my compensation.

What happens next? Let’s assume that in 2021, I sold my shares for $15 per share. My $30 gain—$150 minus $120—would be reported on Form 1099-B and, since I held onto the stock for more than a year, taxed as a long-term capital gain. That’s a good thing, since that’s typically tax-favored—0%, 15%, or 20% in 2021, depending on your taxable income and filing status.

Alternatives


This is a quick primer on NSOs since they’re one of the most common—and the kind of options that are making news with Musk. But keep in mind that not all stock plans are created equal. Alternatives like Incentive Stock Options (ISOs) and restricted stock units (RSUs) may have very different tax consequences.

Questions?


If all of this sounds complicated, you’re not wrong: It can be hugely complex, depending on the circumstances. Whether you’re at a startup or a public company, stock options can be a great way to benefit from company growth. But as with all money and tax-related matters, the details matter. It’s always a good idea to consult your tax or financial adviser with any questions.

This is a weekly column from Kelly Phillips Erb, the Taxgirl. Erb offers commentary on the latest in tax news, tax law, and tax policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl.

To contact the reporter on this story: Kelly Phillips Erb in Washington at kerb@bloombergindustry.com

To contact the editors responsible for this story: Yuri Nagano at ynagano@bloombergtax.com; David Jolly at djolly@bloombergindustry.com

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