Tax Withholding and Reporting for US Stock Options

In the United States, stock plan participants may recognize compensation income, and are sometimes subject to employer withholding of taxes, when they execute transactions involving stock compensation.

In addition, the company that issues the stock compensation may have an associated obligation to report transactions, income, and tax withholding to the IRS.

This blog focuses on some of the tax withholding and reporting basics for employee stock compensation. To learn more, view our online Stock Plan Fundamentals Course.

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Tax Reporting for Incentive Stock Options

Stock options that comply with Section 422 of the Internal Revenue Code are considered incentive stock options (ISOs). As the name suggests, preferential tax treatment could occur if shares acquired under an ISO are held for a statutory holding period after exercise. As such, ISOs are not subject to tax for regular income tax purposes until sale or other disposition.

At the time an ISO is exercised, the company does not have any regular tax withholding or income reporting obligations. The exercise itself is not a tax trigger for ordinary income tax purposes.[1] However, under Section 6039 of the Internal Revenue Code, at the end of the calendar year in which the exercise occurs, the company is required to report the exercise to the IRS on Form 3921 and provide a copy of this form the optionee. 

A disposition of shares acquired from the exercise of an ISO may trigger an income reporting responsibility. This happens when the shares are disposed of in a “disqualifying disposition,” which is any disposition that does not meet the holding period required  for a qualifying disposition.  

Disqualifying dispositions are those that occur within one year from the exercise date of the option or two years from the grant date. Only dispositions that occur after the passage of both of these time periods are considered qualifying dispositions. 

In the event of a disqualifying disposition, the company has an obligation to report income on the employee’s Form W-2. This income is the lesser of:

• The spread at the time the option was exercised
• The actual gain on the disposition (i.e., sale, gift, or other disqualifying transfer)

A same-day-sale stock option exercise, where the shares are exercised and subsequently sold immediately, is considered a disqualifying disposition and the income reporting obligation is triggered.

Regardless of disposition status, when an ISO is exercised the company must furnish Form 3921 to both the optionee and the IRS. For more information on Form 3921, see our guide titled Figuring Out Section 6039 Reporting.

ISOs Exercised After Termination of Employment

As noted above, ISOs must meet the requirements of Section 422, one of which is that the optionee must be an employee continuously from the time the option is granted until three months prior to the date on which it is exercised. Thus, when ISOs are exercised more than three months after the optionee has terminated employment, the option is no longer considered an ISO. The transaction is treated as an exercise of a nonqualified stock option.

This relieves the company of the Form 3921 reporting obligation, but the exercise will be subject to tax withholding and is reportable on Form W-2 (see discussion of nonqualified stock options below).

This three-month period is extended to 12 months for terminations due to disability and is waived entirely in the event of an optionee's death. 

Tax Reporting and Withholding for Nonqualified Stock Options

Upon exercise of a nonqualified stock option (NQSO), optionees recognize compensation income equal to the current spread in the stock (the difference between the market value of the stock and the exercise price on the exercise date.)

This income is reportable on a Form W-2 for both employees and former employees. For nonemployees, such as outside directors, consultants, and contractors, the company prepares a Form 1099-NEC to report the income.

For employees and former employees, the company is also required to withhold employment taxes, including federal income tax, Social Security, and Medicare, on the exercise even if the shares are not sold. There may be withholding obligations in optionee's state, city, and county as well.

Reporting Stock Option Compensation Income on a Form W-2

For federal income tax reporting purposes, compensation income for nonqualified stock option exercises is aggregated with employees’ other income in the following boxes of Form W-2:

• Box 1 (Wages, tips, and other compensation)
• Box 3 (Social Security wages), if applicable
• Box 5 (Medicare wages and tips).
• Box 12, with code V

Where the exercise is subject to state or local taxation, the income should also be reported in the applicable boxes for these tax authorities:

• Box 16 (State wages, tips, etc.)
• Box 18 (Local wages, tips, etc.)

In addition to reporting the income recognized for NQSO exercises, any taxes withheld upon exercise should be combined with employees’ other withholdings for the year and reported in Boxes 2, 4, 6, 17, and 19, as appropriate.

For additional information on tax withholding and reporting for US stock compensation, view our guide to US Tax Withholding and Reporting for Stock Compensation. 

[1] This article covers US ordinary income tax considerations. Exercises of ISOs can have alternative minimum tax (AMT) implications, which are outside the scope of this article.