Welcome back! Over the past several weeks, we’ve been tackling the ins and outs of employee stock options. If you missed it, don’t forget to check out the first two articles in this series:
Today, we’re tackling two different types of stock options: Non-Qualified Stock Options (NQSOs) and Incentive Stock Options (ISOs). Truthfully, NQSOs tend to be more prevalent in the tech space than ISOs, but both are often available and it’s worthwhile to understand how each of these options can work to your advantage.
Keep in mind that, while both NQSOs and ISOs can be useful tools when they’re offered as part of your compensation, none of this is guaranteed. Stock options aren’t necessarily a magic bullet, and in every situation, you’ll end up owing taxes, and you may not always get the return you were expecting.
Your safest bet is to have a strategy in place for each of your options and to understand what tax planning will need to take place when they become available to you.
NQSOs are relatively common, and if you’re working at a new company you will likely run into this type of stock option. These stock options, like many, are useful incentives for companies to offer employees as they don’t require upfront capital, a valuable commodity to a new startup.
How They Work
NQSOs allow employees to purchase company stock at a set price, which usually falls below fair market value. By getting in on the ground floor with these options, you can purchase company stock at a low rate, and sell your options at a later date when the value of your company’s stock has increased.
NQSOs and Taxes
NQSOs are taxed during two different phases of the grant process. They’re first taxed on your exercise date, or the date when you (the employee) purchases the stock from your company. At this time, you pay ordinary income tax on the spread (Fair Market Value – Exercise Price). Your company will also often withhold the federal, state, and payroll taxes, which can be found on your W-2. Be sure to check on the company’s policy about tax withholding.
Your NQSOs are taxed a second time when you sell the stock. Once you sell, you’ll owe capital gains taxes. If you hold the stock for a year or more, you can qualify for long-term capital gains taxes, which are often more favorable.
A Word to the Wise
If NQSOs are available to you, you’ll want to take a close look at the provisions of your NQSOs including:
- Grant date
- Exercise date/price
- Sales date
- Offering period
This will help you gain a deeper understanding of when you can purchase the stock, at what price, and for how long that option is available.
Be aware of your company’s clawback provision, which could stipulate their right to withhold or take away your option in the event of a merger, acquisition, layoff, or retirement.
Looking at Your ISOs
Incentive Stock Options (ISOs) are less common than NQSOs because they carry special tax treatment and aren’t subject to Social Security, Medicare, or other withholding taxes. With this tax treatment comes a strict set of rules for an ISO to qualify in the eyes of the IRS.
How They Work
ISOs are very similar to NQSOs, except they come with a more restrictive set of rules and tax obligations. ISOs are stock options that are available for purchase by employees at a rate that’s below fair market value. However, unlike NQSOs, when employees purchase ISOs, they don’t owe ordinary capital gain tax as a result of exercising their options. This is a huge tax benefit of ISOs that is often overlooked. Additionally, ISOs can only be distributed to employees, contractors do not have the option to be compensated with ISOs.
ISOs and Taxes
However, beyond the initial exercise of your options, taxes get a bit more complex. When it comes to your ISOs, there are two types of dispositions you can have:
- Qualified disposition. This states that the sale of an ISO was made at least two years after the grant date, and one year after the stock options were exercised. A qualified disposition gives you favorable long-term capital gains tax options as opposed to having to pay ordinary income tax on the gains you receive from the sale of your ISOs.
- Disqualifying disposition. If your ISOs sell before two years after the grant date, and/or less than a year after the stock options were exercised, you’re looking at a disqualifying disposition. In these cases, you (the employee) will need to report any bargain element (like exercising your ISOs below fair market value) from the exercise of your options as ordinary income. You’ll be subject to ordinary income taxes at this time.
It’s also important to remember that AMT (Alternative Minimum Tax) plays a role in the exercise and sale of your ISOs. Qualifying ISOs can be reported as long-term capital gains, but the bargain element at exercise may trigger AMT. This is why it’s critical to work with a tax professional if you are planning to leverage ISOs to ensure you understand your tax obligations.
Want to learn more about the AMT? Click here to watch our video.
A Word To The Wise
Although ISOs can have many favorable tax advantages for employees, there are a few things to keep in mind. First and foremost, employers don’t have to withhold any taxes from ISOs. So, if you do make a disqualifying disposition, you’ll need to pay federal, state, Social Security, and Medicare taxes along with ordinary income tax on any gains you receive from the sale.
It’s also important to remember that there are strict stipulations on what value of ISOs can be granted to you each year, and your claim to them if you should leave the company. In fact, the annual cap is $100,000 in grant value. If you leave your company, you usually will have 3 months to use your remaining ISOs before they become unavailable to you.
How are NQSOs Different From ISOs?
NQSOs differ from their qualified counterparts, ISOs, in their tax treatment. “Non-qualified” options simply refer to the tax status, since they don’t meet the Internal Revenue Code requirements for ISOs. NQSOs aren’t taxable when they’re granted.
However, unlike their ISO counterpart, the owner of NQSOs has to pay ordinary income tax at the time of exercise equal to the difference between the value of the security at the time of exercise and the purchase price. If the NQSO owner is an employee of the company, this amount is subject to withholding and employment taxes – which can get pricey for both parties.
Both NQSOs and ISOs have the ability to positively impact your financial life. However, tax implications for both of these stock option types can be complex. It’s wise to speak with a tax professional to fully understand the implications of your options, and to build a strategy that maximizes them while minimizing their taxable impact.