Stocks options are a form of equity compensation given to employees, often at early stage companies.
Options provide the holder the right, but not the obligation, to purchase company shares at a pre-determined price. These options can be highly lucrative, especially for early employees of start-up companies.
There are two main types of stocks options:
- Non-Qualified Stock Options (NQSOs or NSOs)
- Incentive Stock Options (ISOs)
NQSOs and ISOs have a lot in common but differ significantly regarding taxation. In general, ISOs are far more complicated.
Similarities Between NQSOs and ISOs
The following are several terms and definitions that NQSOs and ISOs share:
- Grant Date – The date your company provides the stock compensation agreement, often upon your date of hire or following a promotion. More often than not, you are not given any options on this date, but you are provided a promise of stock options in the future, provided you meet the vesting requirements.
- Vesting Schedule – Stock options are often subject to specific vesting requirements, which could be performance-based or time-based. For example, you may be granted 1,000 options that vest over the next four years. In this case, 250 options would vest each year for the next four years.
- Exercise Price (or Strike Price) – This is the price you may purchase company shares once your options vest. For example, an option may have a strike price of $10.00 per share. That means, regardless of the actual price of your company’s stock, you will have the option to purchase the stock for $10 per share.
- Expiration Date – The point at which your options expire and you can no longer exercise your ability to purchase shares at the strike price, often 10 years from the grant date.
- 409a Valuation (for private companies) – The most recently determined price of a privately held company (for a public company, this type of valuation is not necessary because its stock price is known every day in the public markets).
- Bargain element – The difference between the share price and exercise price. For example, if you have options with an exercise price of $10.00 and your company shares are currently trading at $15.00, the bargain element is $5.00. (This is very important for tax planning.)
While these terms and conditions are shared between NQSOs and ISOs, the tax treatment and related financial planning strategies differ significantly.
Differences Between NQSOs and ISOs
The main difference between NQSOs and ISOs is tax treatment. Basically, NQSOs are far simpler than ISOs.
Taxation of NQSOs
NQSOs are subject to tax upon exercise. When you exercise your stock options, the bargain element (the difference between the current share price and the exercise price) is taxed as ordinary income (Federal, State, social security, and Medicare taxes apply).
If you decide to hold onto your company shares after exercise, any additional gain (or loss) will be taxed at capital gains tax rates.
Taxation of ISOs
ISOs are not subject to ordinary income tax upon exercise, but the bargain element is an Alternative Minimum Tax (AMT) preference item and you may be subject to a tax bill during your next filing (that’s beyond the scope of this post).
The shares you acquire through exercising an ISO are taxable once you sell them (not upon exercise like NQSOs). And when you sell your shares determines the type of sale (or disposition) and the tax impact.
A combination of (1) when you were granted the ISOs, (2) when you exercised the options, and (3) when you sold the resulting shares determines whether the sale was a Qualifying Disposition or a Disqualifying Disposition. A qualifying disposition receives favorable tax treatment, but comes with some baggage (costs and risks).
- Qualifying Disposition – The sale of shares acquired through ISO exercise two years after the grant date and one year from the exercise date.
- Disqualifying Disposition – Any sale that does not meet the two criteria of a qualifying disposition.
The taxation of a disqualifying disposition is the same as NQSOs, the difference between the sale price and the option strike price (bargain element) is taxed as ordinary income.
The tax benefit of a qualifying disposition is the bargain element is taxed at long-term capital gains rates, generally far more favorable (lower) than ordinary income rates.
Strategies for NQSOs
While you do not have control over the taxation of your NQSOs (the bargain element will be taxed as ordinary income), you do have control over when you exercise your NQSOs (and realize this additional income).
Because exercising NQSOs will recognize additional income, you can plan ahead to exercise your NQSOs in low-income years and/or try to reduce your taxable income as much as possible in these years.
EXERCISING IN LOW-INCOME YEARS
If you are certain that you will have relatively low-income years in the near future, you can hold off on exercising your NQSOs until those years.
For example, you may anticipate a sabbatical, taking time away from work to care for a newborn, or starting a business. Exercising during these low-income years could translate to meaningfully lower taxes on your NQSOs.
The main risk of waiting to exercise your stock options is a decline in your company's share price. A steep decline in the share price during this waiting period could quickly and easily offset any tax benefit of deferring exercise.
REDUCING TAXABLE INCOME
You may also seek ways to (legally) reduce your taxable income in years that you plan to exercise NQSOs.
Reducing your taxable income could include making traditional (pre-tax) retirement contributions instead of Roth contributions, health savings account (HSA) or flexible savings account (FSA) contributions, bunching charitable deductions, realizing portfolio losses, and more.
Although you may not regularly make traditional retirement contributions or use these other tax-advantaged accounts, strategically using these tools during NQSO exercise years may smooth out your tax picture.
Strategies for ISOs
The decisions around ISO exercise tend to fall on a spectrum between tax benefits and investment risk.
- Early exercise of your options creates the potential for lower taxes, but opens you up to AMT liability and investment risk
- Exercise and immediate sale of your options eliminates investment risk but is subject to ordinary income taxation
EARLY EXERCISE FOR QUALIFYING DISPOSITION
By exercising ISOs early, you start the clock on the holding period required for a qualifying disposition. After exercising, you must hold the resulting shares for one year and have held the shares two years past the ISO grant date to meet the criteria for a qualifying disposition.
The benefit is any resulting gain will be taxed at long-term capital gains rate (currently 15% or 20% depending on your income) instead of ordinary income rates, which could be upwards of 30% or more.
The greater the difference between your ordinary income rate and the long-term capital gains rate, the more potential for this strategy.
However, this strategy comes with upfront costs and investment risk. Although exercising ISOs is not an ordinary income event, the bargain element is an AMT preference item and may lead to an AMT tax liability. Secondly, you must come up with the funds to purchase the shares at the strike price. And lastly, you are choosing to concentrate in your company stock for at least one year.
IMMEDIATE EXERCISE AND SALE
You may choose to exercise your ISOs and immediately sell the resulting shares to capture any gain. This is considered a "disqualifying disposition" and the tax treatment is the same as NQSOs.
Although this gain will be subject to ordinary income tax, you will guarantee your return and not be subject to investment risk.
Employee stock options are a potentially highly lucrative form of compensation. But they are also potentially highly complicated from a planning and tax perspective.
By understanding the terms and conditions of these options, their tax ramifications, and potential strategies to employ, hopefully you can demystify this concept and make a plan for your specific situation.