When offered, equity compensation can be a transformative component of your over financial picture. It’s also often misunderstood, especially the more complicated forms like incentive stock options.
Between vesting schedules, exercise decisions, and tax implications, stock options create added layers of complexity. Whether you’ve recently received a grant or held options for years, knowing how and when to act can have a meaningful impact on your long-term financial outcomes.
In this guide, we’ll walk through the key differences between incentive stock options and non-qualified stock options, how each is taxed, and the decisions you’ll face throughout the lifecycle of your stock options.
Incentive Stock Options (ISOs)
Incentive stock options (ISOs) allow employees to purchase company stock at a predetermined price (called the exercise price). Typically, the exercise price is less than the fair market value at best.
For example, if an employee is granted 1,000 ISOs with an exercise price of $20/share, that means the cost to exercise all shares is $20,000. If the fair market value is $30/share, that’s an instant profit of $10/share, or $10,000 total.
When an employer grants ISOs, the employee will be given a vesting schedule, as well as important information regarding:
- The number of shares
- Exercise price
- Expiration date (last day shares can be exercised before they expire).
Shares can only be exercised once they’re fully vested. Vesting could happen all at once or occur over a period of time. For example, 50% of your ISOs might vest after two years, another 25% the year after that, and the final 25% a year later.
With ISOs, you have the right and opportunity to purchase shares of company stock for a discount- but you do not have the obligation to buy. If you do nothing with your shares, they will remain simply vested and unexercised. Eventually, they’ll expire, typically 10 years after the grant date.
How to Exercise ISOs
If you choose to exercise your options, there are a few different ways to go about it.
First, if you have the cash (or can pull from other liquid assets), you may exercise with cash.
If you don’t, you may be able to execute a cashless exercise or sell-to-cover exercise- though this only works if the fair market value is higher than the exercise price. With a cashless exercise, you sell a portion of the shares to cover the cost of exercising.
The other option is to do a same-day sale. Just as it sounds, you can exercise your options and sell on the same day, pocketing the proceeds or reinvesting elsewhere.
How Are ISOs Taxed?
ISOs are not taxable when exercised. However, if you choose to exercise ISOs and hold (rather than sell right away), you are likely to incur alternative minimum tax (AMT).
The bargain element, which is the difference between the fair market value and exercise price, is used when calculating tentative minimum tax (TMT). If the TMT is higher than what your ordinary income tax bill is, then you’ll owe AMT for that tax year.
So while exercising ISOs does not create ordinary tax liability, it is likely you’ll owe AMT instead. The good news is, this AMT is like a “prepayment” on the eventual sale of your ISOs, and you can recover it in future tax years as AMT credit.
This is just a brief overview of AMT. You may want to speak to a tax professional for a deeper look at how exercising ISOs may affect your tax bill.
Selling ISOs
When you do decide to sell, you will owe capital gains tax on the profit. Whether it’s considered long-term or short-term capital gains will depend on whether you make a qualified or disqualified sale of stock.
Qualified sale: The profits from a qualified sale are subject to the long-term capital gains tax rate, which is capped at 20% (depending on your total taxable income). To qualify, the options must be held for at least two years since the grant date and one year after exercise.
Disqualified sale: If the sale of stock does not meet the criteria for a qualified sale, it’s considered a disqualified sale. Profits are taxed at the short-term capital gains tax rate, which mirrors your ordinary income tax rate (up to 37%).
If you exercised and sold immediately, this would be considered a disqualified sale. Using our example from earlier, let’s say you exercised 1,000 shares at an exercise price of $20/share. The fair market value on the day of exercise is $30/share, meaning you sold for an immediate $10,000 profit:
(Number of shares x fair market value) – (number of shares x exercise price) = Profit
(1,000 shares x $30/share) – (1,000 shares x $20/share) = $10,000
You would owe short-term capital gains tax on the $10,000 profit.
Non-Qualified Stock Options (NSOs)
Non-qualified stock options are fairly simple in comparison to ISOs—though they’re generally less tax-advantaged.
Generally speaking, NSOs work in the same manner as ISOs (the primary difference is how they’re taxed). You’re granted options, which are subject to a vesting schedule. Once fully vested, you have the option (but not the obligation) to exercise shares at a predetermined price and either sell immediately or hold indefinitely.
How Are NSOs Taxed?
Tax at exercise is the primary difference between ISOs and NSOs. In the year you exercise options, you’ll owe ordinary income tax on the spread- the difference between the exercise price and the fair market value on the date of exercise.
If you were granted 1,000 shares of NSOs at $20/share and the fair market value was $30/share, you would owe ordinary income tax on the $10,000 spread. This amount is also subject to Social Security and Medicare tax.
Whether you choose to exercise and hold or exercise and sell, the spread is still subject to ordinary income tax.
Selling NSOs
When NSOs are sold for a profit, you’ll owe capital gains tax. If the shares are held for less than a year, gains will be taxed at the short-term rate. If they’re held for longer than one year, they’ll be subject to the more favorable long-term tax rate.
You will only be taxed on gains above the adjusted cost basis (essentially, the fair market value the day of exercise), since tax was already paid on the spread.
Comparing ISOs vs. NSOs
ISOs are available only to full-time employees, while NSOs can be offered to board members, consultants, contractors, and other stakeholders. While ISOs are generally more tax-advantaged, they can be the more complicated offering- especially when AMT is owed.
In either case, you may find strategic planning opportunities in deciding when to exercise and at what point you choose to sell.
Making the Most of Your Stock Options
ISOs and NSOs operate similarly, but each carries some distinguishing tax characteristics. If you’re managing either ISOs or NSOs (or, perhaps, both), it can help to speak to a professional before making decisions around exercising or selling.
If you’d like to talk through your options with our team, our doors are always open. Reach out to schedule an appointment today.
