We have previously explained the benefits of ISOs and how they differ from NSOs, but there is still an important difference to discuss. When ISOs are exercised and held for one year (two years from the grant date), the gain receives capital gain treatment, while NSO gains are considered wages upon exercise. The newest trend in employer stock options is to let employees convert their incentive stock options (ISOs) into non-qualified stock options (NSOs).
Benefits of Converting to Non-Qualified Stock Options
Some have touted this as a great development. The idea behind this practice is that when an employee separates from their company, vested ISOs have a 90-day window to be exercised, while NSO grants can be held for up to 10 years. This means the purchase of ISOs would require cash up front on short notice, whereas an employee could sit on the exercise of NSOs and have no cash outlay. Similarly, the employee could keep leverage on the NSO shares. Finally, there is the alternative minimum tax (AMT) cost of exercising ISOs in one fell swoop.
Potential Drawbacks of Converting to Non-Qualified Stock Options
While there may be valid reasons to make the move, it’s not the panacea that employers have made it out to be. First, if an employee is not planning on leaving any time soon, there is no reason to consider the move at all. Whether ISO or NSO, the leverage will be the same, you’re just giving up tax advantage for no purpose. If an employee has a 90-day or nine-year window to purchase after leaving, it doesn’t matter if they’re still with the company.
Second, even if an employee is leaving soon, the cash up front may not be an issue. There are other options besides using your own cash. One option is using a non-recourse loan. In a non-recourse loan, a lender (usually not a bank) agrees to pay the cost to exercise (including the tax owed) and then takes a percentage of the upside value and a stated interest rate. Whether or not the idea makes sense depends largely on the performance of the stock. The loan is paid once the stock becomes tradable to the employee. The benefits are that the non-recourse loan option takes care of the cash out of pocket problem, and the risks are that the company becomes valueless (since the loan is non-recourse), as well as paying the tax.
Another option might be a prepaid variable forward (PVF) contract. In a PVF contract, a third party agrees to purchase the stock outright, but the price they pay is dependent on the performance of the stock in the future. Since the contract isn’t settled, there is no tax paid up front. However, the tax will still be due for the exercise. The benefit is that the employee gets to sell now, the downside is they lose a lot of the upside potential.
How to Decide Which Approach is Best
The decision tree should really start with exploring non-recourse loans. If the cashflow of a loan will likely net more than NSO conversion, then go with the loan. Since it’s impossible to know the future price of the stock, be reasonable with your assumptions. There will most likely be a breakpoint at which the stock benefits you if it goes above a particular price, and if not, then it’s a net loss.
If the loan doesn’t work out, then some mix of strategies probably makes the most sense. The right decision may be to use a PVF contract to sell some or all NSOs, and then use the proceeds to purchase and hold ISOs up to the AMT limit. Convert any leftover ISOs to NSOs and wait out a liquidity event with little skin in the game.
Whichever route you’re leaning towards, talking to an expert and getting unbiased advice is always a good idea. The advisors at WRP Wealth have the experience and insights you need to make the best decision for your situation. To learn more about your stock options and get ongoing financial advice, subscribe to our blog.