Michael Callahan
When you’re new to employee stock options, there’s a lot of — sometimes confusing — information to absorb before you can make any decisions. The difference between incentive stock options and non-qualified stock options is one of the topics that trips up a lot of people. ISOs and NSOs function very similarly, but there are a few key differences between them—primarily in how they’re taxed.
What are Incentive Stock Options?
Incentive stock options are a type of employee stock option that a company can grant only to its employees. ISOs are sometimes considered preferable to NSOs because of their tax treatment. Depending on what you do with ISOs, you may keep more money than you would with NSOs.
Here’s a basic overview of the tax treatment of ISOs. You’re not taxed when you’re first granted stock options. When your options vest, you may decide to exercise them and buy the shares you’ve been granted. With ISOs, exercising an option doesn’t trigger any tax—but you do still have to pay tax on any money you earn when you eventually sell your shares.
Timing is very important here. If you sell shares within the same year that you exercised your employee stock options, you have to report your profit to the IRS as ordinary taxable income. If you hold onto your shares for at least a year and a day, when you do sell them any gain is taxed as a capital gain. Because many individuals have a higher income tax rate than capital gains tax rate, holding onto shares can be advantageous.
Let’s say your employer grants you ISOs. Upon vesting, you can buy 1,000 shares for a grant price of $10. You’re not taxed on this $10,000 purchase. If you immediately turn around and sell your shares for the current market value of $30,000, the IRS considers your $20,000 gain to be ordinary taxable income. You may pay 35 or 37 percent tax on that profit. If you hold onto those shares and sell them 14 months later for $35,000, you might pay a capital gains tax of 15 or 20 percent on a $25,000 gain.
What are Non-Qualified Stock Options?
Non-qualified stock options can be granted to a company’s employees as well as other service providers such as independent contractors and consultants.
With NSOs, you’re taxed twice: First when you exercise your options, and then again when you sell. Say you exercise 1,000 shares for $10,000, which have a market value of $30,000. The difference between your grant price and the market value is called the spread—in this case, $20,000. As soon as you exercise NSOs, you trigger a tax on the spread, even though you haven’t yet made any money from your shares.
When you do sell your shares, you’re taxed on any gain. If you sell them within a year of exercise, you’ll pay your ordinary income tax rate on what’s considered a short-term gain. If you hold onto the shares for more than a year, that’s considered a long-term gain and you’ll pay the capital gains tax.
Which Type of Employee Stock Options Do I Have?
Obviously, it’s important for tax planning purposes that you know whether you’ve been granted ISOs or NSOs. (Or both, if you’re an employee and eligible for both types of stock options.) Refer to the grant agreement your employer provided when you were granted options. This information, along with any other relevant terms, should be clearly explained within the grant agreement.
What Else Should I Know About ISOs vs. NSOs?
While it’s true that ISOs do have more favorable tax treatment in certain circumstances, having ISOs may raise your tax bill if you owe the alternative minimum tax. (The AMT is designed to ensure that high-income filers have to pay a certain amount in taxes each year, no matter how many deductions and/or credits they have.) If you’re a candidate to pay the AMT, the spread on your ISO exercise is considered income. When you buy $30,000 worth of shares for $10,000, the $20,000 spread is counted toward your income when calculating how much you owe for the AMT.
Another thing to know about ISOs vs. NSOs is what happens when you leave the employer. ISOs are granted to employees, so your ability to exercise these stock options may be tied to your employment. Commonly, you’ll have 90 days to exercise vested employee stock options after leaving the company. Because NSOs can be granted to non-employees, they generally don’t have the same requirements. Your specific grant agreement will clarify any terms around exercise requirements.
These are the basic ways that ISOs and NSOs differ, but there are also some other, subtle differences between them. This is one more reason why it’s advisable to talk to your financial planner and tax planner before exercising stock options.
Sachetta Callahan is here to help demystify all things related to employee stock options. We know that making the right decisions around stock options can be confusing, and we want to make it as easy as possible for our clients. If you have any questions about stock options or financial planning, contact me today!
Michael J Callahan, CPA, CFP®, MST, Partner, Director- Wealth Management Michael is a Certified Financial Planner™ practitioner, Certified Public Accountant, and holds a Master’s Degree in Taxation from Bentley University. Mike has been involved in personal financial planning, as well as both business and individual taxation for more than 15 years.