In our last post, you learned how employee stock options work – strike price, vesting and exercises (not the sweaty gym kind). In today’s post, we’ll explain how the two main employee stock options (ISO’s and NQSO’s) are taxed since nothing is more frustrating than owing a big chunk of tax in April that you were not expecting.
Nonqualified Stock Options
What is an NQSO?
Most stock options offered to employees and directors are nonqualified stock options (NQSO’s). Another term for these options is non-statutory stock options. A NQSO is generally any stock option that does not meet the qualifications of an Incentive Stock Option (discussed below), hence the term “nonqualified.”
How is an NQSO taxed?
First, let’s get this out of the way – no matter which type of option you have there is no tax impact to you when granted the options. However, you will have taxable income when you exercise NQSOs! When you exercise an NQSO you are taxed on the spread between the exercise price and the fair market value (FMV) or trading price. This is ordinary income that should be included in federal taxable wages on your Form W-2 for the year and specifically denoted in Box 12, code V. Your company should also withhold taxes on this income, like they do your regular wages. For directors, the income will be reported on Form 1099 with your other cash fees, if applicable.
Let’s explain with an example: Assume you have NQSO’s for 100 shares of Google with an exercise price of $50/share. If Google is trading at $70/share and you exercise all 100 options, your ordinary income from the exercise will be $2,000 (($70 -$50)*100).
Once you acquire the stock via exercise, your basis in the stock is equal to the exercise price plus the ordinary income you reported (50/share + $20/share = $70/share). This usually ends up as the trading price upon exercise. If you immediately sell the stock to get the cash, you should have no significant capital gain or loss to report. However, if you hold the stock and the price goes up, you could have taxable capital gains when you sell. If the stock goes down in value, you could have a capital loss subject to the $3,000 net capital loss limitation rules.
Most investment advisors recommend a diversified portfolio. If you exercise a significant amount of options, you should seek advice on the risk of having a single company’s stock represent a significant portion of your investment holdings, especially if that company is also your employer. Exercising your options, selling the shares and then reinvesting the proceeds into a broader range of assets should be considered and discussed with your financial advisor.
Incentive Stock Options
What is an ISO?
Incentive stock options (ISO’s), pronounced “ice-O’s,” are stock options that meet certain statutory requirements which make them eligible for special tax treatment. ISO’s can only be offered to employees of a company (not directors). There are other option/plan requirements imposed on the issuing company and we’ve listed the major ones below:
ISO’s can only be granted to employees (non-employee directors or independent contractors cannot be granted ISO’s)
ISO’s must be exercised while the option holder is an employee or within 3 months after termination of employment (with some exceptions for death and disability)
The employee may not, at the time of grant, own more than 10% of the voting power of all outstanding company stock (with some exceptions)
The strike price of the ISO must not be less than the fair market value of the stock when the ISO is granted.
The aggregate fair market value of stock bought by exercising ISOs that become exercisable for the first time during the year cannot exceed $100,000 during that calendar year. This isn’t an all-or-nothing rule, so if you exercised $150,000 of ISO’s that became exercisable during the year, $100,000 will qualify for ISO taxation while the remaining $50,000 are taxed as nonqualified stock options, discussed below.
How is an ISO taxed?
Aside from having a cool name, what else makes an ISO so great? Two things: tax deferral and capital gains treatment. We’ll explain.
Unlike an NQSO, ISO’s are not taxable when exercised unless you are in the alternative minimum tax (we’ll assume for this post you’re not in AMT and will address AMT planning for stock options in a future post). Rather, the option holder takes a lower basis in the shares received upon exercise – only the exercise price is included in the basis of the shares. Assuming the Google options in the previous example were ISO’s, you would pay $5,000 at exercise to acquire $7,000 worth of shares. Unlike the NQSO’s, there would be no taxable income and your basis in those shares would be the $5,000 you paid.
Now here’s the second benefit - If you hold those shares for 1 year or more, you will recognize long-term capital gain income on the sale. The ISO not only allowed you to defer paying tax, you may have converted what would have been ordinary income if the option was an NQSO into long-term capital gain income taxed at a lower rate.
Remember to qualify for long-term capital gain treatment the shares must be held for at least one year after exercise. If you sell earlier than one year, the gains will be taxed at higher ordinary income rates.
The combination of this post and our previous post on the topic give you a complete picture of stock options and how they are viewed by the IRS and other taxing authorities. Still, complexities can occur within these transactions. The Tax Warriors® at Drucker & Scaccetti are experts at understanding how the exercising of stock options may affect your taxable income. We take a 360-degree view of your financial world, realizing exercising options may affect more than just the taxable income recognized from the transaction. Call on us to discuss your specific situation. We’ll be happy to help.