How Are Options Taxed? Employee & Traded Options

An option in finance is a contract that grants the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specific date. These financial instruments can include shares of stock, commodities, or market indexes, and their value fluctuates with the underlying asset. Understanding the tax implications of options is important for individuals engaging with these contracts. The tax treatment of options varies significantly based on whether they are received as employee compensation or are traded on public exchanges.

Taxation of Employee Stock Options

Employee stock options are generally categorized into two main types: Non-qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). Each type carries distinct tax consequences from grant to exercise and sale of the underlying stock.

Non-qualified Stock Options (NSOs)

Non-qualified Stock Options (NSOs) do not receive special tax benefits. At grant, there is typically no taxable event. When an employee exercises NSOs, the difference between the stock’s fair market value (FMV) on the exercise date and the exercise price, known as the “bargain element,” is taxed as ordinary income. This amount is subject to federal income, Social Security, and Medicare taxes, and employers report it on Form W-2 as wages.

Once the stock acquired through NSO exercise is sold, any subsequent gain or loss is treated as a capital gain or loss. The cost basis for calculating this includes the exercise price plus the ordinary income recognized at exercise. The holding period for determining capital gain begins the day after the exercise date.

Incentive Stock Options (ISOs)

In contrast, Incentive Stock Options (ISOs) can offer more favorable tax treatment, but are subject to stricter rules and holding period requirements. No regular income tax is due when an ISO is granted or exercised. However, the bargain element is considered an adjustment for Alternative Minimum Tax (AMT) purposes in the year of exercise, potentially triggering a separate tax calculation on Form 6251.

For a qualifying disposition, two holding period requirements must be met: the stock must be held for at least two years from the ISO grant date and at least one year from the ISO exercise date. If these conditions are satisfied, the entire gain from the sale of the stock (sale price minus exercise price) is taxed as a long-term capital gain, generally at lower rates than ordinary income.

A disqualifying disposition occurs if the stock acquired from an ISO exercise is sold before meeting both holding period requirements. In this scenario, the lesser of the bargain element at exercise or the gain at sale (sale price minus exercise price) is taxed as ordinary income in the year of sale. Any additional gain is then taxed as a capital gain, which can be short-term or long-term depending on the holding period after exercise.

Taxation of Traded Options

Options bought and sold on public exchanges, such as call and put options on stocks or exchange-traded funds (ETFs), have distinct tax implications for both buyers and sellers. These transactions primarily result in capital gains or losses, governed by rules applicable to capital assets.

For an Option Buyer

For an option buyer, the initial purchase of an option contract establishes a cost basis. If the option is sold before expiration, the difference between the sale price and the premium paid results in a capital gain or loss. This gain or loss is classified as short-term or long-term based on how long the option was held.

When a call option is exercised, the buyer purchases the underlying stock, and the premium paid is added to the cost basis of the acquired stock. If a put option is exercised, the buyer sells the underlying stock, and the premium paid reduces the proceeds from the sale, impacting the capital gain or loss on the stock. If an option expires worthless, the premium paid is treated as a capital loss in the year of expiration.

For an Option Seller

For an option seller, receiving the premium when writing an option is held until the position is closed, exercised, or expires. If the seller buys back the option to close their position, the difference between the premium received and the cost to buy back the option results in a capital gain or loss. If a written option expires worthless, the entire premium received is treated as a short-term capital gain.

When a call option written by a seller is exercised, the seller delivers the underlying stock, and the premium received increases the proceeds from the sale, influencing the capital gain or loss on the stock. If a put option written by a seller is exercised, the seller is obligated to buy the underlying stock, and the premium received reduces the cost basis of the acquired stock.

Section 1256 Contracts

Certain broad-based index options, such as those on the S&P 500 (SPX) or Nasdaq 100 (NDX), are classified as Section 1256 contracts. Under this rule, any gains or losses are treated as if 60% are long-term capital gains or losses and 40% are short-term capital gains or losses, regardless of the actual holding period. These contracts are also “marked-to-market” at year-end, meaning unrealized gains or losses are treated as realized for tax purposes.

Key Tax Concepts and Reporting Requirements

The Internal Revenue Service (IRS) distinguishes between different types of income, which are taxed at varying rates.

Ordinary Income vs. Capital Gains

Ordinary income is generally derived from regular earnings like wages, salaries, and interest, and is taxed at an individual’s marginal income tax rate. Capital gains arise from the sale of capital assets like stocks and options for a profit. Short-term capital gains, from assets held for one year or less, are taxed at ordinary income rates. Long-term capital gains, from assets held for more than one year, typically benefit from lower tax rates.

Cost Basis

Cost basis is the original value of an asset for tax purposes, including the purchase price and any associated costs. It is used for calculating capital gains or losses when an asset is sold. For stock acquired through NSOs, the cost basis includes the exercise price plus any ordinary income recognized at exercise. For ISOs, the cost basis for regular tax purposes is generally the exercise price if qualifying disposition rules are met, but an adjusted basis applies for AMT calculations.

Wash Sale Rule

The wash sale rule prevents taxpayers from claiming a loss on the sale of a security if they purchase a “substantially identical” security within 30 days before or after the sale. This 61-day window disallows the deduction of the loss. The wash sale rule can apply to options, particularly if an option is sold at a loss and a substantially identical option or the underlying stock is reacquired within the specified period.

Reporting Requirements

Taxpayers receive Form 1099-B from their brokers, which reports the proceeds from sales of options and stock acquired through options. Taxpayers use Form 8949, Sales and Other Dispositions of Capital Assets, to list all capital asset sales, separating them into short-term and long-term transactions. The totals from Form 8949 are transferred to Schedule D, Capital Gains and Losses, which calculates the net capital gain or loss for the tax year.

Ordinary income from NSO exercise is reported on Form W-2 as wages. If an ISO exercise triggers an Alternative Minimum Tax liability, this is reported on Form 6251. Employers report ISO exercises on Form 3921 and NSO exercises on Form 3922.