Tax Withholding and Reporting for US Stock Options

May 03, 2022

In the United States, stock plan participants may recognize compensation income, and sometimes, employer withholding of taxes, when they execute transactions involving stock compensation.

In addition, the company that issues the stock compensation may have an associated obligation to report transactions, income, and/or tax withholdings to the IRS.

This blog focuses on some of the tax withholding and reporting basics for employee stock compensation. To learn more, view our online Stock Plan Fundamentals Course.

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Tax Reporting for Incentive Stock Options

Stock options that comply with Section 422 of the Internal Revenue Code are considered incentive stock options (“ISOs”). As the name suggests, preferential tax treatment could occur if shares acquired under an ISO are held for a statutory holding period after exercise. As such, ISOs are not subject to tax for regular income tax purposes until sale or other disposition.

At the time the ISO is exercised, the company does not have any regular tax withholding or income reporting obligation. The exercise itself is not a tax trigger for ordinary income tax purposes.* However, the exercise will trigger a need to provide an end-of-year informational statement to the participant, with a copy filed with the IRS, even if the shares are not sold. This is a requirement of Section 6039 of the internal revenue code.

A disposition of shares acquired from the exercise of an ISO may trigger an income reporting responsibility. This happens when the shares are disposed in a “disqualifying disposition,” prior to meeting the threshold for a qualified disposition under Section 422’s requirements.  

Typically, this is a transaction that occurs within a statutory holding period, which is both one year from the exercise date of the option, and two years from the grant date. A disqualified disposition can also be triggered by other situations, such as an option exercised more than 90 days after termination of employment.

In the case of a disqualified disposition of ISO acquired shares, the company has an obligation to report income on the employee’s W-2, which is the lesser of:

  • The spread at the time the option was exercised
  • The actual gain on the disposition (sale)

A same-day-sale stock option exercise, where the shares are exercised and subsequently sold immediately, is considered a disqualified disposition and the income reporting obligation is triggered.

Regardless of disposition status, when an ISO is exercised the company must also furnish an information statement (Form 3921 required under Section 6039 reporting) to both the participant and the IRS informing them of the transaction.

Tax Reporting and Withholding for Non-Qualified Stock Options

Upon exercise of a non-qualified stock option (“NQSO”), stock optionees recognize compensation income equal to the current spread in the stock (the difference between the market value of the stock and the exercise price on the exercise date.)

This income is reportable on a Form W-2 for both employees and former employees. For non-employees, the company prepares a Form 1099-NEC to report the income.

For employees, the company is also required to withhold ordinary income taxes on the exercise, even if the shares are not sold.

Reporting stock option compensation income on a Form W-2

For federal income tax reporting purposes, compensation income for nonqualified stock option exercises is aggregated with employees’ other income in the following boxes of Form W-2:

  • Box 1 (Wages, tips, and other compensation)
  • Box 3 (Social Security wages), if applicable
  • Box 5 (Medicare wages and tips).
  • Box 12, with code V Where the exercise is also subject to state or local taxation, the income should also be reported in the applicable boxes for these tax authorities:
  • Box 16 (State wages, tips, etc.)
  • Box 18 (Local wages, tips, etc.)

In addition to reporting the income recognized for NQSO exercises, any taxes withheld upon exercise should be combined with employees’ other withholdings for the year and reported in Boxes 2, 4, 6, 17, and 19, as appropriate.

For additional information on tax withholding and reporting for US stock compensation, view our guide to US Tax Withholding and Reporting for Stock Compensation

*This article covers U.S. ordinary income tax considerations. Certain forms of stock compensation may have alternative minimum tax implications and are outside the scope of this article.

 

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    By Jennifer Namazi

    Content Director

    NASPP