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Stock Options – To Qualify or Not To Qualify



Compensation packages often include stock options, which are used to reward, incentivize and retain key employees.  There are two types of stock options that can be granted – Qualified Stock Options, also called Incentive Stock Options (ISO), and Non-Qualified Stock Options (NQSO).  The major difference between ISOs and NQSOs is their tax treatment.  ISOs are potentially more attractive from an employee’s perspective as will be highlighted below.

Incentive Stock Options (ISOs)

There is no income tax due upon the granting of ISOs and there is no income recognized when an ISO is exercised.  This is a major benefit of ISOs when compared to NQSOs.  However, alternative minimum tax (AMT) needs to be considered when exercising ISOs.  If the stock received through the exercise is sold at least one year after the exercise date and two years after the grant date, any gain resulting from its eventual sale is considered a capital gain.  Otherwise, the sale would be considered a disqualifying disposition and would generate ordinary income as opposed to capital gain income.

In order to qualify as an ISO, the option must meet the following requirements:

  • The option must be granted pursuant to a plan which, among other requirements, includes the aggregate number of shares, which may be issued under options and the employees (or class of employees) eligible to receive the options.
  • The option must be granted within 10 years from the date the plan is adopted or the date the plan is approved, whichever is earlier.
  • The exercise price must equal or exceed the fair market value of the stock at the time of the grant.
  • The option must not be exercisable after the expiration of 10 years from the date it is granted.
  • The option can only be issued to employees of the company.
  • For employees who own 10% or more of the company, the exercise price must be at least 110% of the fair market value at the time of the grant and the option must expire 5 years from the date the option is granted.
  • The option must be non-transferable except by will or by the laws of descent and cannot be exercised by anyone other than the option holder during the option holder’s lifetime.

It is important to note that if the aggregate fair market value (as of the grant date) of stock with respect to which ISOs are exercisable for the first time during any calendar year exceeds $100,000, such options are treated as NQSOs.

Non-Qualified Stock Options (NQSOs)

Similar to ISOs, there is no income tax effect when NQSOs are granted.  However, when NQSOs are exercised, ordinary income, classified as compensation, will be recognized by the employee.  The ordinary income is equal to the spread between the fair market value on the date of the exercise and the exercise price.  The fair market value on the date of exercise becomes the employee’s cost basis for the stock received upon exercise.  If the stock is sold within one year of exercise, any further gain or loss is considered short term capital gain or loss.  If the stock is held for more than one year before it is sold, any further gain or loss is considered long term capital gain or loss.

Employees may have the option to implement a cashless exercise.  This is helpful when the employee does not have enough cash to exercise the options. In a typical cashless exercise, the company or broker involved lends the employee money to pay for the exercise.  A portion of the stock received through the exercise is then sold through the market in order to immediately repay the loan.

Example

A simple example can illustrate the favorable tax treatment on ISOs from the employee’s perspective.

An employee receives an ISO on January 1, 2014 for 1,000 shares of stock with a grant price of $5 per share.  The employee exercises the ISO on June 1, 2015 when the fair market value is $15 per share.  As a result of the exercise, the employee has purchased 1,000 shares of the company stock for $5,000.  Without the ISO, the employee would have paid $15,000 for the same 1,000 shares.  This is not a taxable event at this point.  The employee’s cost basis for the 1,000 shares is $5,000.  The employee holds the 1,000 shares for more than one year and then sells the shares on July 15, 2016 for $22 per share realizing $17,000 of long-term capital gain.   At this point, the tax due would be $3,400 ($17,000 gain times the assumed long term capital gains tax rate of 20%).

If the employee had sold the 1,000 shares on March 15, 2016 it would have resulted in a disqualifying disposition.  The employee would report $17,000 in ordinary income and pay a tax of $6,732 assuming the employee is subject to the highest marginal ordinary income tax rate of 39.6%.

If the employee from above had received NQSOs instead of ISOs, he would recognize income equal to the spread between the exercise price and the fair market value of the stock at the time of exercise in the year he exercises the NQSOs.  In 2015, the employee would recognize $10,000 of ordinary income resulting from the exercise.  If he holds the 1,000 shares for more than one year and sold them on July 15, 2016, he would recognize $7,000 of long-term capital gain in 2016.  Between 2015 and 2016, the employee would pay a total tax of $5,360.

If the employee exercised the NQSOs and held the 1,000 shares for less than one year and sold them on March 15, 2016, he would recognize $10,000 of ordinary income in 2015 upon exercise and $7,000 of short term capital gain income in 2016 upon sale.  Between 2015 and 2016, the employee would pay a tax of $6,732.

As mentioned previously, AMT needs to be considered if you are exercising ISOs.  The spread between the exercise price and the fair market value of the stock at the time the ISO is exercised is treated as a tax preference item for AMT purposes.  This could cause the employee to be subject to alternative minimum tax in the year of exercise.  The stock’s AMT basis is increased by the income recognized for AMT purposes.  Because of this basis adjustment, there would be a negative AMT adjustment upon disposition.  This would generally also result in a minimum tax credit against regular tax in the year of disposition.

The Affordable Care Act imposes a net investment income tax on unearned income at a rate of 3.8% as well as a 0.9% Medicare tax on wages.  As discussed, an employee does not recognize income when ISOs are exercised and therefore does not owe the 3.8% net investment income tax.  The capital gain on the sale of shares received as a result of exercising ISOs, however, is included in net investment income and is subject to the net investment income tax.  In the case of a disqualifying disposition of ISO shares, the ordinary income recognized by the employee is compensation and is, therefore, not subject to the net investment income tax but is subject to the 0.9% Medicare tax.  With NQSOs, the amount recognized as compensation income upon exercise is not subject to the net investment income tax, but is subject to the 0.9% Medicare tax.  Once the NQSO is exercised and the stocks are transferred to the employee, however, subsequent dividends and gain on disposition of the shares are subject to the net investment income tax.

As the above examples show, the employee with an ISO pays the least in taxes, assuming a disqualifying disposition does not occur.  So the next time you are lucky enough to have a choice between an ISO and NQSO, you are armed with the knowledge to wisely choose what is exactly right for you.




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