There are two main types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). Both are subject to different tax rules. Knowing the difference is an essential part of your financial planning. Of the two, ISOs can be more complicated from a taxation standpoint.
An incentive stock option is an option granted under a plan, if the terms of the option and the plan meet certain Code requirements. By paying the exercise price, the employee acquires the optioned stock. An ISO may have an exercise price of no less than 100% of the stock's value at the date of grant of the option, but of course the stock may appreciate in value after the date of grant. If it does, the employee will be able to acquire stock by paying the lower exercise price rather than its current value.
In addition to the chance for a bargain purchase, employees obtain preferential tax treatment upon exercise of their ISOs. Without such treatment, an employee would pay taxes when the options were exercised on the amount of the “spread” between the stock's value and the exercise price actually paid by the employee. With preferential tax treatment, the employee does not pay taxes until the stock is sold or otherwise disposed of, which may be several years after the taxable year in which the option is exercised.
The following is a detailed discussion of the employees’ preferential tax treatment and of the employer's deduction.
- The employee does not realize any income upon the grant of an ISO.
- On exercise of an ISO (the acceptance by the employee of the employer's offer to sell stock at the exercise price), an employee realizes no income. If, however, the employee does not qualify for such preferential tax treatment at the time of exercise because, for example, they do not meet the employment requirement when the option is exercised (discussed below), they generally realize ordinary income in the year of exercise, in the amount of the “spread”— the difference between the fair market value of the stock received and the exercise price paid. The spread is subject to the alternative minimum tax (AMT) regardless of whether income is realized.
- The AMT can take away some of the financial cushion of ISOs. If you hold onto your ISOs, you will need to report the difference between the grant price and exercise price as part of your alternative minimum taxable income. AMT is a critical component in working through an ISO exercise and hold strategy. Insiders of publicly traded companies may need to hold onto the stock after it has lost significant value. By the time you may be able to sell the shares, they could be worth less than the AMT tax due on the original exercise.
- When an employee sells shares acquired through exercise of an ISO, the employee's gain (if any) generally is taxed as a capital gain. This gain is the difference between the sale proceeds and the employee's basis in the stock (which is the exercise price plus any amount paid by the employee to acquire the option).
- If, before the statutory holding period has expired, the employee sells or otherwise disposes of the shares, a “disqualifying disposition” generally occurs. The preferential tax treatment for such options is lost. Disqualifying dispositions are discussed separately below.
- In order to qualify for preferential tax treatment, the employee must hold the stock for a certain period of time. A sale or other “disposition” of the shares before the end of this statutory holding period results in a “disqualifying disposition,” and the preferential tax treatment is lost.
- The statutory holding period depends upon two dates: the date of grant of the option and the date of the transfer of the shares by the corporation to the employee pursuant to their exercise of the option. The employee must hold the shares for more than two years from the date of grant. Further, the employee must hold the shares for more than one year from the date of their transfer.
- If a disqualifying disposition occurs, the employee must recognize the compensation income they would have recognized when the option was exercised but for the special provisions applicable to ISOs. (Upon exercise of an option that does not qualify for preferential tax treatment, the employee generally must pay tax on the difference between the value of the shares and the exercise price paid for the shares.) This income is recognized in the taxable year in which the disqualifying disposition occurs. Further, the employee must recognize capital gain income if the shares have appreciated since the date of the exercise of the option. The gain is long-term capital gain if the shares have been held for more than one year. If a disqualifying disposition occurs in the year the option was exercised, the maximum amount included in AMT income is the gain on the disposition of the ISO stock.
- Another way for an employee to lose their preferential tax treatment is for the employee to leave employment. Under the Code, an employee may not receive preferential tax treatment upon the exercise of an ISO unless they are still employed at the date of exercise or their employment ended no more than three months before the date of exercise (or one year, in the case of a disabled employee). The employment must be continuous except for certain leaves of absence.
As you can see, there are many different tax ramifications surrounding stock options. With careful planning and projections, we can help navigate and develop a tax advantageous strategy.