Navigating State Taxes on Employee Stock Options: A Comprehensive Guide

When you are granted employee options while residing in one state, exercise them in another, and sell your shares in yet another, the question of which states you need to pay taxes to arises. This situation can be incredibly complex and varies widely depending on the specific circumstances. This article aims to provide clarity by answering the question: If you are granted employee options while residing in state A, exercise them while residing in state B, then sell them while residing in state C, which states do you pay taxes to?

Understanding the Tax Landscape

This question is far too complex to answer without detailed information. Each state has its own set of rules and regulations regarding the taxation of employee stock options, making the process of determining which state's taxes apply a nuanced one. Factors such as income tax, residency rules, and the nature of the stock options can all play a critical role in the final tax outcome.

Key Assumptions

To simplify the explanation, let's assume that:

State A, B, and C all have income tax policies in line with federal regulations. There are no interstate compacts affecting the situation. Your options are nonqualified options with an exercise price equal to or greater than the fair market value of the underlying shares at the time of grant. The shares are not subject to any post-exercise restrictions. Your options were exercised for cash or by using previously-owned shares rather than using the option shares themselves.

Tax Responsibilities at Different Stages

One of the most important aspects of understanding state taxes on employee stock options is the timing at which taxes become due. Here is a breakdown of when and where you would pay taxes based on the stages of the option:

State B at Exercise: You would pay ordinary income tax in State B at the time of exercise on the excess of the share value over the exercise price. This means that you are taxed based on the difference between the value of the shares when they are sold and the price you paid to exercise your options. State C at Sale: You would then sell the shares in State C. The nature of your gains (i.e., short-term or long-term) and the corresponding capital gains or losses would be determined based on how long you have held the shares from the date of exercise to the date of sale. You would pay capital gains tax in State C based on the difference between the basis (the value you used when you sold the shares) and the sale price.

Residency Rules and Potential Audits

The concept of residency is critical when it comes to state taxes. Residency is not solely about where you are currently living; it is determined by a cluster of various factors, which can include where you maintain your home and where you have your primary economic ties (such as employment and banking accounts).

In certain situations, if you move from a high-tax state to a low-tax state within a few months of a substantial gain (such as selling millions of shares of stock), the state you left may conduct a residency audit. They may argue that you did not truly become a resident of the new state and attempt to collect taxes from the high-tax state.

Nonqualified Stock Options: Exercising and Selling

For nonqualified stock options (NSOs), a few key tax points are important:

Exercising NSOs: You generally do not pay taxes when the options are granted if the exercise price is at least equal to the fair market value usually established by a so-called 409A valuation. 83b Election: If you timely file an 83b election, you can avoid taxes over time for the grantor. However, if you do not file this election, you may need to pay ordinary income tax upon exercise. Federal Alternative Minimum Tax (AMT): Qualified stock options (ISOs) are subject to the federal AMT but not the gain tax when exercised. Non-qualified stock options, on the other hand, may yield a potential gain recognized on exercise along with a step-up in basis for capital gains tax purposes. Sale of Shares: Upon the sale of the shares, you will recognize a gain or loss based on the difference between the basis and the sale price, which could result in capital gains taxes.

Conclusion: A Path to Clarification

Depending on the path you and your stock options take, there could be taxable events on any of these dates: date of grant, exercise, vesting, or selling the resulting shares. However, for most employees, the most common path involves only federal and state taxes on exercise, with state taxes applying in the state where you reside on the day of exercise.

Given the complexity of state tax rules, it is always advisable to consult a tax professional to ensure compliance with all applicable laws and regulations.