Tax Category Tax: calculations, VAT, self-employment tips and more

Tax Calculation on Stock Options

Tax calculation on stock options can be confusing and complex. There exist several flavours of stock options, each having unique tax treatment characteristics. Knowledge of the tax implications associated with stock options allows you to proactively tailor your transactions so as to minimise future tax liabilities.

Equity Options

Gains and losses from trading publicly listed equity options are treated as capital gains. The tax rules for these transactions mostly mirror those governing normal stock trades. Equity option positions held for less than a year result in short-term capital gains treatment. Per IRS Topic 409, if you trade in LEAP (long-term equity anticipation) options and hold the position for over a year, then the proceeds qualify as a long-term capital gain. As of 2009, the long-term capital gains tax rate is 15 per cent.

Broad-Based Index Options

Some options are derivatives based upon an underlying index. If the applicable index is considered to be "broad-based," then options transactions based upon it are given special tax treatment. An example of a broad-based index is the S&P 500. The Dow Jones Index is similarly a broad-based index. There are a plethora of different stocks within different industries that compose each of those indices. Conversely, an index that tracks a particular sector is not considered broad-based. An example would be the XLF index, which only tracks financial sector stocks. If an option qualifies as being broad-based, then 50 per cent of the transaction is treated as short-term capital gain with the other 50 per cent being treated as a long-term capital gain no matter what the holding period of the position.

Incentive Stock Options

Some employees have pay packages that include the issuance of employee stock options. If the company issuing incentive stock options adheres to the rules as outlined in IRS Publication 525, then the employee is allowed to treat the transaction under the same tax methodology used to calculate tax liability on typical equity options. Qualified incentive stock options held for less than a year receive short-term capital gains treatment, and those held for over a year qualify as a long-term capital gain at the lower associated tax rate.

Non-Qualified Stock Options

Incentive stock options which were not granted in conformance to IRS guidelines are referred to as NQSO's. NQSO's are generally treated the same as incentive stock options with one salient exception. There are no tax implications when qualified incentive stock options are exercised. However, if you exercise a NQSO, then you are liable for short-term capital gains on the differential between the market value of the NQSO and the exercise price you actually paid. Many employees are unaware of this nuance and are later shocked to find out they have a huge tax liability from just exercising their employee stock options without any actual cash profit yet to show from it.

Shorting Any Option

Option short sales are all treated as a short-term capital gain. This is applicable even if you shorted a LEAP option and did not cover for over a year. Long-term capital gains rate is only triggered by being long a put or call for at least one year.