A stock warrant is similar to a stock option in that both give you the right to purchase shares of the stock at a guaranteed strike price and you are able to exercise this right for a limited time. However, warrants are issued by a company for its own stock and are usually good for several years. Options are contracts sold by parties unrelated to the company and typically have expiration dates of a few months. The taxation of stock warrants is much like that of stock options, but there are some differences.
Companies issue stock warrants as an extra to encourage investors to buy the firm’s stock or bonds. In some cases, the stock or bond and the warrant are sold as a package deal, and part of the price is allocated to the warrant by the terms of the sale. This allocated amount is an investment and is a nontaxable cost basis. Alternatively, you might buy a stock warrant on the market. In this case, the premium you pay for the warrant is your cost basis.
When you exercise warrants to buy the underlying stock, you pay the stated strike price to the issuing company. The difference between the strike price and the price of a share, minus the cost basis, is taxable income. Suppose you exercise warrants with a strike price of $30 per share to buy 100 shares of XY Company and you originally paid $500 for the warrants. Your total investment is thus $3,500. If the market price on the day of exercise is $50, the stock is worth $5,000 and the difference is $1,500. This $1,500 is taxable as ordinary income in the year of exercise. It is not a capital gain because you did not own the shares prior to exercising the warrants.
You can sell the shares you acquire by exercising stock warrants immediately. If instead you decide to hold on to the stock, the exercise price becomes your cost basis. Any further gains or losses are capital gains or losses. If you sell the shares one year or less from the date of exercise, you have a short-term capital gain (or loss) that is taxable as ordinary income at the same rate as your other income such as wages or salary. If you hold the shares for more than a year after exercise, it’s a long-term gain or loss. Long-term gains are taxed at a maximum rate of 15 percent as of 2013.
Employee stock options are actually stock warrants, despite the name. Most ESOs are nonqualified stock options issued to employees as an incentive or reward. When an employee exercises a nonqualified stock option, the difference between the strike price and the market price on the day of exercise is called the bargain element. This bargain element is considered compensation by the Internal Revenue Service and must be reported on the employee’s W-2 statement. The bargain element is taxed as ordinary income and is subject to payroll tax withholding, including income taxes as well as Social Security and Medicare taxes. A second type of ESO, incentive stock options, operates under a special set of rules that allow the bargain element to be treated as a long-term capital gain, rather than as compensation. If you are given ISOs, you have to wait at least a year to exercise them and then hold the stock for one more year before the bargain element is eligible for this tax break.