What is an incentive stock option vs. a non-qualified stock option?

Kolleen Schocke |

Equity as a form of compensation has become increasingly popular among companies hoping to hire and retain top talent. While ESPPs and RSUs have gained traction in recent years when it comes to incentivizing employees through equity, stock options continue to remain the traditional favorite for start-ups and established companies alike.

Stock Options are a form of equity compensation that grants you the right to purchase company shares for a specific price in the future.

While you do stand to benefit from future share appreciations, stock options generally carry more risks compared to RSUs. If share prices fall in the future, your options can go underwater. Also, if you resign from your company, your unvested options expire if not exercised within a certain period (typically 90 days) after the termination of your employment.

Companies generally offer the following two types of options:

  1. Incentive Stock Options (ISO) (also referred to as statutory stock options or qualified stock options) are a tax-advantageous form of stock options that are offered exclusively to the employees of the company and
  2. Non-Qualified Stock Options (NSO) (also referred to as non-statutory stock options) are stock options that do not meet the requirements of IRC Topic 427[1] but can be offered to both employees and non-employees.

While both possess certain similarities such as the need to purchase the shares to attain ownership and no federal tax liability on vesting, there are a few significant differences between ISOs and NSOs that can be summarized below:

 

ISO

NSO

Eligibility

Internal Employees Only

Employees, Independent Contractors, Directors, Consultants

Limitations on Exercisable Stock Value

$100,000 limit for a specific class of (>10%) shareholders

None

Options Validity

5 Years for >10% shareholders and 10 Years for the rest

No maximum limits but generally set at 10 years

Bargain Element Taxability for Federal and Payroll Taxes in the year of exercise

None

Yes. The spread is treated as ordinary income and is taxable

W-2 withholdings

None

Yes. Mandatory wage withholding rules apply in the year of exercise

Bargain Element Taxability for AMT purposes

Yes. The spread is treated as an adjustment to ordinary income in the year of exercise

None

Capital Gains Treatment on share sale

Preferential tax treatment based on whether it is a qualifying or disqualifying disposition

No preferential treatment. Long-term or short-term capital gain tax rates apply based on the holding period

 

How are ISOs taxed?

An advantage of ISO is that you will not have to report any income on your federal and payroll taxes when you exercise the option, under current tax law. Income is reportable only when you sell the shares and even then, you can claim preferential tax treatment on your capital gains income based on the holding period. On the downside, the bargain element or the spread, (the difference between the exercise price and the fair market value on the date of exercise), is reportable as income under the Alternative Minimum Taxation (AMT) rules in the year of exercise.

Let’s say your company granted you 1000 options on Apr 1st, 2020.

Exercise price

$20 per share

Value on exercise date

$50 per share

Exercise Date

Jan 2nd, 2021

Sale Price

$100 per share

 

Assuming they were ISO grants, your tax liability will be as below:

When Sale Date is

Tax Liability

Taxation of

Bargain Element = (50-20) *1000

Capital Gain = (100-50) *1000

On or before Jan 1st, 2022

Disqualifying Disposition - Short Term Capital Gain (STCG)

Marginal tax rate

Marginal tax rate

On or before Mar 31st, 2022

Disqualifying Disposition - Long Term Capital Gain (LTCG)

Marginal tax rate

LTCG Tax Rate

On or after Apr 1st, 2022

Qualifying Disposition – LTCG

LTCG Tax Rate

LTCG Tax Rate

 

How are non-qualified stock options taxed?

When you exercise stock options under an NSO plan, the bargain element needs to be reported as ordinary income in the year of exercise and is taxed at marginal tax rates. Additionally, you will incur capital gain taxes when you sell your NSO holdings. The proceeds will be treated as short-term if you sell it within one year of vesting, else it will be considered a long-term capital gain. 

Continuing with our above example, if you had received NSO grants instead, your tax liability will be below:

 

 

When Sale Date is

 Tax Liability

Taxation of

Bargain Element = (50-20) *1000

Capital Gain = (100-50) *1000

On or before Jan 1st, 2022

STCG

Marginal tax rate

Marginal tax rate

On or after Jan 2nd, 2022

 LTCG

Marginal tax rate

LTCG Tax Rate

 

ISO and AMT

A risk with ISOs is the possibility of share value depreciation, especially after you have been subjected to AMT in the year of exercise. If share prices fall in the future, not only has your profit eroded due to AMT, your LTCG proceeds also take a hit.

While avoiding AMT on ISO stock options is possible by way of filing an 83(b) election[2], paying the AMT itself might not be a bad option. Remember you can carry forward the difference between AMT and your regular tax to successive tax years as an AMT credit.

Our team specializes in devising personalized option selling strategies and helping clients take a proactive approach towards their taxes based on individual financial goals. Contact us to learn more about incentive stock options tax treatment and the impact of AMT on your option grants.

 

 

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[1] https://www.irs.gov/taxtopics/tc427

[2] https://www.irs.gov/pub/irs-drop/rp-12-29.pdf