Generally speaking, you generally should expect to be paying some form of tax on your chosen options. But there are numerous strategies to take to minimize your potential tax bill. Plus, if your taxes rise, you’re still making some solid profit from your stock choices. This makes it very workable for people who are leery about making investments in a volatile market. With a large capital amount, you can offset most losses and still make a profit. If you can do this, then investing in options seems like a much safer and more profitable move.
Generally, stock options are a contractual right, granted by the company whose shares you purchased in the deal. They give you the right to sell those shares at a pre-determined price within a defined period of time. The price you agree to purchase will be a price specified in the clause of purchase – often set at a premium above the market price. If the buyer is unable to buy the shares, they lose their right to sell them to you.
If you bought the shares at a time when the market was depressed (at a time when shares were costing much less than today’s prices), you may be able to offset some or all of your tax bill with an IRS settlement. The government recognizes that if you have capital in a company, it will be difficult to sell it to recover its debt, especially if that debt is in a negative equity position. They, therefore, allow you to claim a tax-free interest in their debt, which is known as an “excess” allowance. You can claim an excess on both the tax-free and taxable interest portion of the loan. If you have enough excess funds, the IRS allows you to repay all or a part of the loan to the IRS, resulting in a tax settlement.
You must report any stock-price increases as capital gains, which are subject to the capital gains tax. Only certain long-term gains are subject to tax, namely net gains (gain not realized from selling) plus non-taxable gains (gains realized from an exchange). Any stock-price increases due to the exercise of stock options are subject to capital gains taxes.
Options contracts generally result in a discount at which the total cost basis for the shares is calculated. The discount is figured by taking the present value of the stock’s strike price less the present value of the option’s strike price, less the amount by which the option’s strike price exceeds the fair market value of the stock (the intrinsic value). Option exercise results in the sale of an unlimited number of shares of stock at a discounted cost basis.
The tax treatment of stock options depends upon the employment status of the person exercising the option, whether the option is an option within a qualified retirement account and whether the employee has previously received compensation that includes stock options. If the employee has not received such compensation, then the employee is considered a retired employee for purposes of the tax law. An important factor that affects the tax treatment of these options is whether the employee paid taxes on the option during his or her employment. In many cases, an option may be treated as an ordinary expense. The tax benefits will therefore depend on whether the option was acquired from an eligible employer or was granted during the employee’s retirement.
Options are generally taxed on sale as well as on purchase, as the buyer of the option is considered to be the same entity as the person that actually purchases the shares. In some cases, however, an option can be taxed as a qualified dividend. A qualified dividend is normally taxed only once; however, if the stock’s value increases substantially (otherwise known as an increase in dividends), the dividends may be taxed again, even if the stock’s value remains the same. In addition, shares that are acquired through an IPO will usually be taxed upon distribution or sale. Also, if the option is acquired from an entity that is not a qualified enterprise, then a distribution charge will be imposed on the option proceeds.
The Employee Retirement Income Security Act (ERISA) governs American employees’ tax treatment of employer-sponsored incentive stock options and certain other types of employee benefit plans. This act includes sections that address types of transactions related to options and also provide guidance on the tax treatment of stock options awarded during employment. It is important for plan participants to become aware of their rights with respect to these policies and to understand ERISA and its applications. This will ensure that plan participant do not miss out
on the tax incentives that they are entitled to and could be subject to under federal tax law. For more information on employer-sponsored incentive stock options, IRS publications titled Employee Retirement Income Security Act (ERISA) and “The Tax Law and the Options Portability and Accountability Act” are available from the Internal Revenue Service, among other sources.