graphical user interface, application by Anne Nygård courtesy of Unsplash.

Understanding Employee Stock Options: ISOs, NSOs, and Key Considerations

Bill Rautiola |
Categories
Plan

Many employees and executives are offered employee stock options as a form of equity compensation. 

It is common for start-up companies to offer stock options as a method of attracting and retaining talent, while also allowing employees to participate in the potential growth of the company. Furthermore, stock options can prove to be a very meaningful form of additional compensation on top of a regular salary. A famous example is Google. Early employees were able to purchase shares for pennies and later sold the shares for hundreds of dollars.

However, choosing when to exercise and sell employee stock options - whether they are incentive stock options (ISOs) or non-qualified stock options (NSOs) - is an important decision that many face at some point in their careers. Planning out the process from grant to sale and making a calculated decision can materially affect both the outcome and ultimate taxation of the stock options. 

The structure and taxation of employee stock options can be complex, so taking the time to understand the nuances is crucial.

Basics of Employee Stock Options (ESOs)

Employee stock options are offered by employers as a form of compensation and simply give an employee the right to purchase company stock at a predetermined price, within a predetermined time frame (typically up to 10 years). For those familiar with standardized option contracts, ESOs function similarly to a long call option. 

There are two primary types of employee stock options: Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). ISOs offer potentially favorable tax treatment, while NSOs are more flexible, but are generally taxed as ordinary income.

How the Process Works:

Grant - A company decides to offer stock options with a strike price (example: $10/share) to certain employees. This is referred to as a grant. There are generally no immediate tax implications to the employee at the time of grant. 

Exercise - Once the employee is vested (vesting schedules vary – refer to plan documents), they may choose to exercise their options. In other words, they can purchase company shares at the price of $10 a share, even if the stock is trading at a much higher price, such as $30 a share.

  • There are several methods for exercising (purchasing) options, which vary by plan. It’s common to deposit cash into the account to purchase the shares.
  • ISOs: Generally, no income tax is due at exercise. However, the difference between the current stock price and exercise price is an AMT add back item and may trigger Alternative Minimum Tax (AMT).
  • NSOs: Ordinary income tax is due at exercise. The difference between the current stock price ($30) and the exercise price ($10) is subject to ordinary income tax in the year of exercise. The employee must have sufficient cash available to cover both the share purchase and the tax liability.

Sale – The date the employee chooses to sell the exercised shares. The timing of the sale can have significant tax implications.

               ISOs

  • Selling the shares in a qualifying disposition generally does not result in income tax being due. A qualifying disposition, among other potential requirements, is generally met when the following two conditions are met:
    • The sale occurs at least one year after the exercise date.
    • The sale occurs at least 2 years after the initial grant date.
  • If the qualifying disposition requirements are met, generally the entire gain or loss will be considered long-term capital gain or loss – and taxed at preferential rates.
  • In the case of a disqualifying disposition, (where the holding requirements were not met) the entire gain will be subject to NSO tax treatment on the exercise and sale.

NSOs 

  • Selling the shares result in a capital gain or loss. If held for longer than a year after exercise, the gains are treated as long-term capital gains.

 

Considerations

An important item of consideration is that only $100,000 of ISOs that vest in a single calendar year is eligible for favorable ISO tax treatment. Any excess is treated as an NSO.

 Additionally, ISOs that fail to meet the holding period requirements are given NSO tax treatment. This can result in ordinary income tax being due on a portion and short-term capital gains rates on the gain above the exercise price.

Final Thoughts

Stock options can create significant wealth for employees if a company is successful. They act as motivation and align incentives between shareholders and employees. Deciding what to do with your employee stock options can be a big financial decision. 

Given the complexity and potential tax consequences, it may be wise to consult with your financial and/or tax advisor when evaluating your options.

-Bill Rautiola, RICP ®, AIF ®, PPC ®

 

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice.