Stock options are incomeFollow

...and should be taxed as such. Currently, at least in the US, the vast majority of very high income earners get the vast majority of their wealth via stock options, not straight salary. And it is taxed at a much lower rate (the so called long term capital gains rate, which applies if the stock option is held for a few years). Naturally, there are those who have no problem with this, arguing that stock options are investments and drive the economy, etc.

As usual, those folks have reality smack down their ideology...link:

http://www.nytimes.com/2009/03/27/business/27options.html?em

Highlights:

"Composite Technology...decided in January to lower the price at which its workers could use their stock options to buy shares in the company. The managers and directors slashed the price on all of the company’s 23.4 million options to 35 cents."

"The repricing could be of particular benefit to Mr. Wilcoxon, who has a whopping 4.2 million options, previously priced at $1.13. The company lost $53 million in its latest fiscal year, and its stock fell to 27 cents on Thursday from as high as $1.36 last July."

and:

"With prices plunging across a variety of industries, companies also often assert that stock price movements are not really a reflection of employee performance."

Meaning that they are NOT using stock options to reward employees for a job well done, but just to avoid the taxes most of us pay. If the stock goes up, they win. If the stock goes down, well they can just lower the conversion rate between stock options to shares, and if it goes up again, they still win.

Last time I checked the capital gains tax rate (as posted on this forum at that time, with links) it was zero for up to US$50,000 per year.

And just to touch on the subject line, stock options *are* income. At the point of purchase, you must pay taxes on the differential value of the option(s).

So. If you are granted 50,000 options at $10 at 20%/year vestment as in Smash's example, and let's say at year three, the value has increased to %15/share and you decide to exercise the 30,000 options you have available. You must pay $300,000 to buy the options, which are now worth $450,000. You must at that time pay income taxes on $150,000. This is because at the moment you purchase the option, you gain $150,000 of income immediately. You paid $300k to buy $450k worth of assets, and the government views the difference as income. This number adds directly to your taxable income line on your forms.

If you hold those options for another year and then sell them at say $18/share, you are only taxed on the difference in value between when your purchased the stock and when you sold it ($3/share, or $90,000). That tax will be treated as capital gains and taxed potentially at a lower rate than normal income.

Another way to look at this whole exchange is that you pay $300,000, and sell for $540,000. Out of the $240 profit, $150k is taxed as income (probably right around 40%), and $90k is taxed as a long term capital gain (closer to 20%). You don't get any of it "tax free" though.


The more common approach most people use (assuming you don't have $300k lying around to buy the options ahead of time), is to just to a same day exercise. So you'll just sit on those 50,000 shares for as long as possible (typically 10 years from the vestment date). Let's say that by then, the stock has risen to $30/share. You then do a simultaneous purchase/sell. Basically, you buy the options with the money you get from selling the resulting stock, all as one exchange (same prices). Since there's no holding onto the stock, all taxes are income in this case. You'd sell your 50k shares for $1.5 million, and then buy them for $500k, resulting in a 1 million dollar profit all of which will be taxed as income.


There really is no special magic involved. A stock option is just an option to buy at a set price. Essentially, it's free money if the value goes up, and no loss to you if the value goes down. Once you exercise an option it's a regular share of stock and entails the same risks as stock. Another way to look at this is that the only way you *ever* get a less than income tax rate is if you take the risk. You have to exercise the option, then hold the stock for a set period of time to get a lower tax rate. You only get the lower rate for the difference in price between when you buy and when you sell though. The difference between the option price and the stock value when you exercise is *always* treated as income.

Yes. I did limit my statements to those. That's because most stock options are non-qualifying options. Qualifying Stock Options have a whole list of requirements to "qualify", not the least of which is that you can't retroactively change the grant price...


You're correct in principle though. Qualifying stock options require that you hold them even longer to get those benefits though. So the principle of not getting lower taxes without taking higher risk still holds. You cannot do a same day exchange, or even a buy and sell in one year. The minimum time between exercise and sale is 3 years IIRC. If you sell earlier than that date, then the options become non-qualifying and follow the tax rules I listed above.

/shrug

And simplistic calls for options to be income will be affected by this how?


Maybe, at the end of the day, we might just conclude that if a business wants to reward an employee with X amount of value (after taxes even), they'll figure out a way to do it, and maybe it's not terribly useful for the government to spend serious amounts of time trying to craft legislation to prevent it? That's kinda my take on things anyway...