Compensation Beyond the Paycheck: Incentive Stock Options and Non-Qualified Stock Options

This is the second post in my series on compensation beyond the paycheck. Last week we explored Restricted Stock Units and this week we dive into Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). While both options can benefit you, it’s important to know how they’re different so you can get the most value from them.

What are NSOs and ISOs?

Let’s start with some basics. Stock options give you the ability to buy a certain number of shares of stock at a specified price. This provides incentive for you to stick around until the options vest. It also motivates you to help make the company as valuable as possible.  You want the share price of your company to go up, so that you can purchase the stock at a discount and then sell it for a profit.  Employers like options because, among other things, they attract good employees, allow them to save cash and provide incentive for the employee to stick around and do good work.

The option grant language looks something like this:

XYZ Corp grants Jenny options to acquire 10,000 shares of XYZ’s common stock at 25 cents per share.  25% of the option shares will vest on the one-year anniversary of your vesting commencement date and 1/4th of the total option shares will vest in yearly installments thereafter during continuous service.

So after her first year, Jenny will have the option to buy 2,500 shares of XYZ’s common stock at $.25 regardless if the stock is worth $.25/share or $250/share. And every year that she can purchase more shares at $.25. If Jenny decides to leave after year two, she only gets to keep those options that have vested.

What is the difference between ISOs and NSOs? ISOs tend to have more favorable tax treatment (more on that below). As such, they also tend to have more requirements.  For instance, they can only be granted to employees, the exercise price must not be lower than the fair market value at the time of grant and they must be part of a stock option plan approved by shareholders or the company’s board.

NSOs, on the other hand, can be granted to anyone — not just employees, but consultants and directors. Also the exercise price doesn’t need to be less than the fair market value of the stock at the time of grant.  However, the grantee (the person who receives the options) may be subject to penalty and tax if it doesn’t.


Tax implications

ISOs and NSOs have very different tax consequences. ISOs, as I mentioned earlier, have more favorable tax treatment.  For instance, you don’t have to pay tax when ISOs are granted or when you exercise those options.  Additionally, you qualify for long-term capital gain or loss if you hold the stock for more than a year after you exercise your option and more than two years after it was granted to you.

Bear in mind, though, that exercising ISO options may create an Alternative Minimum Tax (AMT) liability. The difference between the value of the stock at exercise and exercise price is an adjustment for the AMT.  You can find my primer on AMT and the effect of ISOs here. After exercising an ISO, you should receive from your employer a Form 3921, Exercise of an Incentive Stock Option Under Section 422(b). This form will report important dates and values needed to determine the correct amount of capital and ordinary income (if applicable) to be reported on your return

Gains on NSOs are taxed as ordinary income.  Specifically, you pay income tax on the difference between the exercise value and the fair market value of the stock as soon as you exercise your option. That income is also subject to withholding and employment taxes. If you are or were ever an employee of the issuing company, the company is required to withhold the money for you. They will likely do this by holding on to some of your shares. If you were a contractor to the company, you will have to come up with the withholding in cash or provide other verification of tax compliance based on the grant agreement.

If you sell your ISOs before the one- and two-year marks, your sale will be treated an NSO.  That means you pay ordinary income tax on the excess, if any, of the lesser of (1) the fair market value of the shares on the date of exercise, or (2) the proceeds from the sale or other disposition, over the purchase price.


Some issues to consider

As you can imagine, these options can get a bit tricky. And while I can’t highlight all of the specific pitfalls, here are a few that you should keep an eye on.

  • A day can make a huge difference: Remember that options come with date restrictions. So keep track of your option’s exercise date and don’t wait until the last minute to exercise your options. You don’t want to let valuable options expire because you forgot to keep track.  I also want to reiterate that long-term capital gain kicks in for ISOs and NSOs after you’ve held the stock for more than a year. So don’t get excited on your year mark and sell right away. It could result in a 20% taxation swing if you’re in the 35% marginal bracket for ordinary income tax and 15% for long term capital gains.
  • Where will the money come from? When you exercise either type of option, you’re going to have come up with money for the purchase. The easiest and cleanest way to do this is with cash. But there are other methods for cashless exercise, which usually involves a broker giving you a short-term loan. In addition to the cash you’ll need to pay for the options, you’ll also have to pay your tax bill. If you’re an employee you’re company will likely withhold the tax for you. If you’re a contractor, you may own this money up front.
  • Liquidity Issues: Finding out the value of your options is much easier with a public company.  You can just look up the share price online. However, in private companies they value is not so clear. So if you worked for a private company, you run the risk the company may never have an “exit event,” which will mean you won’t be able to sell your shares. That means a loss on what you paid for the options.
  • Deciding when to exercise: As with any financial decision, you should look at your total financial situation and your financial goals to see how this type of purchase fits into your overall situation. You’ll also need to do your due diligence on the company you’re investing in. Remember that this is still playing the market. You can’t predict what will happen. Having options in a private company makes it even riskier. So to be safe, make sure you can afford to lose any money that you invest in these options. And remember it’s not all or nothing.  Just because you have 10,000 options, it doesn’t mean you have to exercise them all. You can exercise anywhere from 1 to 10,000. Most contracts have a limitation on partial shares (e.g. ½ shares).

Lastly, keep a copy of your stock option grant agreement. That’s where all of the details related to your specific options should be outlined. And, as always, I don’t suggest going this alone. Get in touch with a financial and/or tax advisor to help you sort through your specific scenario.

As always, I would love to hear your thoughts. Get in touch with me at the links below.