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Top Ten Stock Option Mistakes Employees Make

Top Ten Stock Option Mistakes Employees Make

Stock options can offer employees and investors potential profits, but they also come with intricate tax implications. Here are ten common mistakes people make with stock options and the tax consequences that come with them:

  1. Not Reporting Exercise of Non-Qualified Stock Options (NQSOs):

    • When you exercise NQSOs, the difference between the market price of the stock and the strike price counts as ordinary income, and it's taxable.
  2. Misunderstanding of Incentive Stock Options (ISOs) and Alternative Minimum Tax (AMT):

    • The spread between the fair market value at exercise and the strike price is a preference item for AMT. Many people are unaware and do not set aside funds for the potential AMT liability.
  3. Selling ISO Shares Too Soon:

    • To get favorable long-term capital gains treatment, you must hold ISO shares for at least one year from the date of exercise and two years from the grant date.
  4. Not Keeping Track of Your Basis:

    • When you exercise stock options, it's essential to keep track of your basis, which can be adjusted by AMT credits or when adding compensation income.
  5. Not Planning for Liquidity:

    • After exercising stock options, you might need to come up with cash to cover the tax liability. It's essential to plan ahead, so you have the necessary funds available.
  6. Double Counting Income:

    • For NQSOs, the income is included in the W-2, so ensure it's not reported again as a capital gain.
  7. Misunderstanding ESPP Taxes:

    • Employee Stock Purchase Plans (ESPP) have qualifying and disqualifying dispositions, each with its tax treatment. Misunderstanding can lead to overpaying taxes.
  8. Forgetting State Tax Obligations:

    • If you've worked in multiple states between the grant date and the exercise date, you might owe taxes in more than one state.
  9. Ignoring the Impact of the 3.8% Net Investment Income Tax:

    • High earners need to consider the additional tax on gains from the sale of stock options.
  10. Forgetting about Stock Option Grants in Estate Planning

    • Stock options can have significant value and should be considered in estate and gift tax planning.

Navigating stock options and their tax implications can be complex. Engaging a tax professional familiar with stock option planning can be a valuable move to avoid these common pitfalls.

Here are few examples of such mistakes:

1. Olivia M – Overlooked AMT and Failed Liquidity Planning Olivia was elated when her incentive stock options (ISOs) gained substantial value. She exercised them, acquiring stocks with a strike price of $20 when their current market rate was $70. Ignoring the potential implications of the Alternative Minimum Tax (AMT), she found herself with a substantial AMT obligation. To add to her troubles, she hadn't set aside any funds for this tax liability. In her excitement, she also splurged on a new car and a luxurious vacation. Come tax season, she was caught off-guard with a whopping tax bill of $50,000, which she couldn't immediately pay. The penalties and interest further added to her financial woes.

2. Ethan R – Double Counted Income and Mismanaged ESPP Taxes Ethan was thrilled with the gains from his stock options. When he received his Form W-2, he didn't notice that his stock option gains were already included. He declared the gains again, leading to double taxation. Later that year, he sold stocks from his Employee Stock Purchase Plan (ESPP) before the qualifying holding period. This premature sale meant the gains were taxed at a higher ordinary income rate. The combination of these mistakes led to an unexpected tax bill of $35,000 and, once discovered, the added stress of rectifying the errors with the IRS.

3. Aisha P – Lost Track of Basis and Ignored State Taxes Aisha exercised her stock options while residing in Florida. A year later, after moving to New York, she sold them. Unaware of New York's tax obligations, she didn't report the sale. Simultaneously, she also miscalculated her tax basis by failing to account for previously paid Alternative Minimum Tax. When the state tax bill arrived, combined with the federal tax discrepancies due to her miscalculated basis, she was shocked. Aisha ended up owing a total of $40,000 in unexpected taxes.