Are Stock Options Considered Earned Income?

Whether stock options are considered earned income depends on the type of option and the recipient’s actions. The Internal Revenue Service (IRS) has specific rules for this classification, and the tax treatment is not uniform. This classification impacts how proceeds are taxed, their subjection to payroll taxes, and other areas of personal finance.

Understanding Earned Income and Stock Options

The IRS defines earned income as compensation received for services performed, such as wages, salaries, tips, and net earnings from self-employment. This category of income is distinct from unearned income, which includes items like interest, dividends, and most capital gains. The distinction is important because earned income is subject to Social Security and Medicare taxes, often referred to as FICA taxes.

A stock option is a form of compensation that gives an employee the right, but not the obligation, to purchase a specific number of shares of company stock at a predetermined price. This predetermined price is known as the strike price or exercise price. The process begins on the grant date when the company awards the options, but an employee must satisfy a vesting schedule before they can act on them.

Once vested, the employee can exercise the option, meaning they purchase the stock at the locked-in strike price, regardless of the stock’s current fair market value. The ability to buy stock at a price lower than its market value is the primary financial benefit of the option.

Taxation of Non-Qualified Stock Options (NSOs)

For non-qualified stock options (NSOs), the taxable event that generates earned income occurs at exercise. The difference between the stock’s fair market value (FMV) on the exercise date and the strike price is the bargain element. This amount is considered compensation, taxed as ordinary income, and is subject to federal, state, Social Security, and Medicare taxes.

For example, exercising 100 options at a $10 strike price when the FMV is $50 creates a $4,000 bargain element. This amount is added to their taxable wages for the year.

After exercising the options, the employee’s tax basis in the stock is its fair market value on the exercise date. Using the prior example, the basis is $5,000 ($50 x 100 shares). Any future appreciation is treated as a capital gain when the shares are sold.

Taxation of Incentive Stock Options (ISOs)

Incentive stock options (ISOs) receive different tax treatment than NSOs. The exercise of an ISO does not trigger a regular income tax event. An employee can exercise ISOs and acquire shares without immediately owing ordinary income tax on the bargain element.

The bargain element from exercising an ISO is an income adjustment item for the Alternative Minimum Tax (AMT). While no regular tax is due at exercise, a large bargain element could trigger AMT liability for that year. Taxpayers must calculate their taxes under both the regular system and the AMT system and pay whichever is higher.

The tax treatment upon selling the shares depends on whether the sale is a qualifying or disqualifying disposition. A qualifying disposition requires that the stock be sold more than two years after the grant date AND more than one year after the exercise date. If these holding periods are met, the entire gain is taxed as a long-term capital gain, and no portion of the profit is treated as earned income.

A disqualifying disposition occurs if either holding period requirement is not met. The tax treatment is then split: the bargain element at exercise is taxed as ordinary compensation income in the year of the sale. Any additional profit is treated as a capital gain.

Reporting Stock Option Income on Your Tax Return

For NSOs, the bargain element is treated as wages and included in Box 1 of the employee’s Form W-2. Employers often use code “V” in Box 12 of the W-2 to identify this income.

When an employee exercises an ISO, the employer provides Form 3921, Exercise of an Incentive Stock Option. This form provides the employee and the IRS with the grant date, exercise date, strike price, and fair market value on the exercise date. This information is used to calculate the AMT adjustment and to determine the gain or loss when the shares are sold.

The sale of stock acquired through either option type is reported on Form 8949, Sales and Other Dispositions of Capital Assets, which flows to Schedule D. For ISOs, the cost basis reported on this form is the original strike price.

How Stock Option Income Affects Financial Planning

Compensation income from exercising NSOs or from a disqualifying disposition of ISOs is earned income, which increases an individual’s modified adjusted gross income (MAGI). This can affect eligibility for Roth IRA contributions, which phase out at certain MAGI levels. This income is also subject to FICA taxes, which fund Social Security and Medicare. While this increases the tax bill at exercise, it also boosts the earnings record for Social Security, potentially leading to larger benefits in retirement.