Incentive and non-qualified stock options (ISOs and NSOs) are two types of equity compensation that companies use to attract, incentivize, and retain top talent. Incentive stock options receive preferential tax treatment but come with limitations that don’t apply to non-qualified options. In this article, we’ll explore these two different types of stock options, who can receive them, and how they’re taxed.
Stock Option Basics
- Stock options give their holders the right to purchase a certain amount of a company’s equity shares for a specified price.
- Before shares can be purchased, the options must first vest, or become full property of the grantee. This typically happens according to a schedule that’s laid out in the company’s equity compensation plan.
- Using options to purchase shares is referred to as exercising stock options.
- The price options holders must pay for their shares is called the exercise price or strike price.
- When exercising stock options, the bargain element is the difference between the strike price and the current fair market value (FMV) of the shares purchased.
Eligibility & Exercise
Companies can grant incentive stock options only to employees. When an employee exercises ISOs, there is no regular income tax consequence. However, the bargain element of the exercise is reportable for thealternative minimum tax (AMT) calculation. This won’t necessarily result in additional taxes due, but it’s important to consult with a tax planning professional who has experience working with pre-IPO employees to make income and tax projections so you understand any potential tax impact before exercising ISOs.
To get the full tax benefit of ISOs, employees must hold the resulting shares for more than two years after the options are granted and more than one year after exercise. If these conditions are met, the net gain after sale is subject to long-term capital gains tax. Selling them earlier than this not only can result in more expensive short-term capital gains tax but also strips them of their tax benefit, making the bargain element subject to regular income tax.
Early Exercise & 83(b) Election
Many companies allow employees to exercise their stock options before vesting, a practice referred to as early exercise. One strategy some employees use to limit the bargain element of ISO exercise is to exercise their options early and file an 83(b) election. While employees don’t have full rights to their purchased shares until after vesting, a timely 83(b) election locks in the FMV of the stock for tax purposes at the time of exercise, when it may be significantly lower. Additionally, early exercise starts the clock on the holding periods described above, allowing employees to sell shares earlier without adverse tax consequences.
The main drawback of ISOs is that because they’re available only to employees, you can lose them if you separate from your employer. ISOs typically expire 90 days after an employee leaves the issuing company. Some employers, however, allow exiting employees to convert their ISOs to NSOs, which typically expire after ten years. This can be attractive if an employee is leaving and isn’t ready to exercise. However, it’s often worthwhile to explore alternative funding options like non-recourse loans or prepaid variable forward contractsto reap the tax advantages of exercising ISOs instead of converting them.
Eligibility & Exercise
Companies can grant NSOs to employees, contractors, vendors, consultants, and others. However, they don’t offer the same tax benefits as ISOs. For employees, the bargain element of NSO exercise is included with employment compensation and subject to regular income tax. This can make NSO exercise more financially challenging for employees, since they must pay not only the strike price but also taxes on gains that exist only on paper.
Holding NSO shares for more than one year after exercise makes the resulting net gain subject to long-term capital gains tax. As with other types of investments, profits from the sale of NSOs held for a year or less get short-term capital gains treatment.
Depending on the issuing company, both ISOs and NSOs can also be considered qualified small business stock (QSBS). Since 1993, shares of qualifying small businesses have received special tax treatment to incentivize small business investment. For shares to receive QSBS treatment, the issuing company must
- Be a domestic C corporation
- Have less than $50 million in assets at the time shares are issued
- Use at least 80% of assets for business operations
- Belong to a qualified industry, such as tech, wholesale, retail, or manufacturing (service industries are generally excluded)
Gains from the sale of QSBS can be fully excluded from federal taxes in some circumstances. To take advantage of this tax benefit, employees must hold their QSBS shares for more than five years. If you think your shares may be QSBS, it’s important to work with a qualified financial professional to ensure you preserve your tax benefits.
Work With a Trusted Expert
When you have stock options, you have a lot of consequential decisions to make. This can be overwhelming for startup employees, who are often working long hours to help make their business as successful as possible. The experienced team at WRP Wealth Management specializes in helping employees like you navigate the complex IPO process and implement strategies to make the most of the opportunity your equity compensation provides. Find more insights on our blog, or browse our library of free resources.