- ISOs allow employees to purchase company stock without paying taxes on the difference between the exercise price and stock's current market value
- ISOs have requirements that must be met, including holding the stock for a minimum of two years from the grant date and one year from the exercise date
- Non-Qualified Stock Options (NSOs) allow employees to purchase company stock at a predetermined price, but are not subject to the same tax benefits as ISOs
- The tax implications of both ISOs and NSOs should be carefully considered before accepting them as part of compensation
Equity compensation is a complex topic with a lot of confusing terms. So before reading this article, take a minute to familiarize yourself with some of the common terms you will see throughout this post.
- Equity: Stockowners are partial owners of a company. That ownership is called equity.
- Grant: The number of shares an employee receives or may purchase on a predetermined date.
- Vesting (vesting period/schedule): You have full ownership of your shares when they are fully vested.
- Exercise: When you exercise your grant and buy shares.
- Expiration: The date your grants expire.
- Strike Price: The price you can buy shares at a future date.
- Spread: The difference between the price you pay for a share (strike price) and the fair market value (what it’s worth).
Read more: An introductory guide to equity compensation
Incentive Stock Options (ISOs) explained
Incentive Stock Options (ISOs) allow employees to purchase company stock at a predetermined price without having to pay taxes on the difference between the exercise price and the stock's current market value.
ISOs are generally offered to key employees, such as executives, and come with certain requirements that must be met before they can be exercised.
To qualify for the tax benefits of an ISO, employees must hold the stock for a minimum of two years from the grant date and one year from the exercise date.
If these requirements are met, the employee can sell the stock at the capital gains tax rate, which is generally lower than the ordinary income tax rate.
ISOs also have a limit on the total value of stock that can be granted to an employee in a given year (see below).
Non-Qualified Stock Options (NSOs) explained
Non-Qualified Stock Options (NSOs) allow employees to purchase company stock at a predetermined price, known as the exercise price or strike price.
NSOs are not subject to the same tax benefits as Incentive Stock Options (ISOs), and as such, they generally have more flexible terms than ISOs. They are typically offered to a broad range of employees, from executives to support staff.
NSOs offer employees the right to purchase company stock at a discounted price, though this discount is typically less than the discount offered on ISOs.
Because NSOs do not have the same tax benefits as ISOs, they are taxed on the difference between the strike price and the stock's current market value at the time of exercise.
This difference is treated as ordinary income and subject to federal and state income taxes and Social Security and Medicare taxes.
ISO and NSO tax treatment summary
ISOs and NSOs are taxed differently due to the distinct tax treatment they receive.
- ISOs are not taxed when granted or exercised, but the spread between the exercise price and the stock's fair market value upon the stock's sale is taxed as a long-term capital gain. However, if the holding period requirements are not met, the ISOs will be taxed as non-qualified stock options instead.
- NSOs, on the other hand, are taxed on the spread between the exercise price and the stock's fair market value at the time of exercise as ordinary income. This income is subject to federal and state income taxes and Social Security and Medicare taxes.
Requirements for incentive stock options
Specific requirements must be met to qualify for ISOs:
- ISOs can only be granted to employees, not independent contractors or non-employee directors.
- The ISO plan must be approved by the company's board of directors and shareholders.
- The exercise price must be at least equal to the stock's fair market value at the time of grant.
- The employee must exercise the option within 10 years of the grant date, unless certain qualifying events occur.
- Exercisable ISOs' total fair market value is limited to $100,000 a year. Any excess value will be treated as an NSO.
- Employees must exercise ISOs within three months of leaving the company.
- You must hold onto ISOs for at least two years from the grant date. Additionally, the shares acquired through exercising the ISO must be held for at least a year after exercise.
Note: A "disqualifying disposition" is when the ISO is sold before this period. The result is a loss of tax benefits. When sold after, it's called a "qualifying disposition."
When ISOs meet these requirements, the spread is not subject to ordinary income or employment tax. However, it is subject to the alternative minimum tax (AMT).
The AMT ensures that specific taxpayers (typically high earners) pay a minimum tax by restricting certain tax deductions and exclusions.
If a company attempts to issue ISOs that do not meet all the necessary qualifications, the option grant will still be considered valid. However, the options will be classified as NSOs instead.
Exercise options for employees with ISOs and NSOs
ISOs often follow a vesting schedule that begins on the grant date (the day the employee receives the incentive stock option). Once an employee's options have vested, they can be exercised.
If an employee holds their shares for a minimum of one year after the exercise date---and at least two years after the grant date---they will only have to pay long-term capital gains taxes instead of ordinary income taxes. For most, this will mean a lower tax burden since the current capital gains rate is 15% for those with incomes between $44,626 to $492,300.
The process of exercising NSOs is less complex than ISOs. Employees who exercise NSOs pay ordinary income tax on their gains (strike price - fair market value at exercise date).
Capital gains tax applies for gains between the purchase and sale. There are two possible capital gains taxes at play here, depending on the holding period: short-term if held less than a year or long-term if held more than a year.
It is important for employees to understand the terms and tax implications of both ISOs and NSOs before accepting them as part of their compensation package.
Consultation with a financial advisor or tax professional may be helpful in determining the best course of action. Additionally, it is important to carefully consider the potential risks and rewards of stock options, as they may be subject to volatility and fluctuations in the market.