The Basics of Equity Compensation

Taxes

Stock option taxation can be complicated. It is important for an employee to read the company's guidelines carefully, understand the type of grants received, and consider consulting an experienced advisor.

The timing and method of how stock options are exercised directly affect:

• Which taxes are paid
• How much tax is paid

Prior to exercising, the difference between exercise price and current market value is a tax-deferred profit.

With stock options and equity compensation in general, there are three kinds of taxes to keep in mind:

1. Ordinary income tax
2. Short-term capital gains tax
3. Long-term capital gains tax

Ordinary Income Tax

The ordinary income tax brackets currently range from 10% to 37% depending on level of income. For most people with equity compensation, the long-term capital gains rate is lower than their ordinary income tax rate so they will favor plans that emphasize this preferential tax treatment.

Capital Gains Tax

When a stock option is ultimately sold, short- or long-term capital gains taxes are paid based on the gains earned (the difference between the selling price and the exercise price). The short-term capital gains tax is the same as the ordinary income tax rate. The long-term capital gains tax rate is lower than some income tax rates, currently ranging from 0% to 20%, and applies if the employee holds the shares for longer than one year and a day, otherwise the short-term rates apply.

Income Tax Brackets

Exercising and selling stock options raises total income. Depending on the amount of profit gained and how it is taxed, an employee may have to pay a portion of their taxes at a higher tax bracket rate. Income will be taxed at the employee’s normal rate, but anything above the income limit for that tax bracket will be taxed at a higher rate.

It is possible to minimize taxes with some planning. By spreading out an exercise program to two or more years, you can keep your total income for each year within your desired tax bracket.

Foreign Stock Option Taxation

Global or multinational companies offering stock option plans are subject to different tax laws and rates depending on the country.

Similar to U.S. requirements, stock option tax rates vary depending on the type of option (qualified for favorable tax treatment, local or foreign company issue, etc.) and length of time between exercise and sale. Certain countries limit the amount of money that can be sent outside the country and some countries apply social charges or social security taxes in addition to ordinary income tax rates. Therefore, it is important to research these laws/regulations for the country in which the stock options are granted.