Navigating Stock Option Taxation: Understanding ISO vs NSO

Many startups attempt to incentivize employment with stock options as a form of compensation, especially during the early days when they need people to run them. Stock options are important for improving employee morale and motivation, reducing turnover and making people feel like they’re more a part of a growing business.

Stock options can also have significant benefits for startups, particularly when it comes to their taxes. However, the tax implications with stock options tend to be complex, underscoring the need for strategic planning. In this post, we’ll help startups better understand their stock options, how they’re taxed and offer suggestions for navigating any complications.

Understanding Stock Options

Stock options are different from stock equity. Also known as an “equity option,” stock options give investors or employees the right to buy or sell stock for a negotiated price by a certain date. For this reason, stock options tend to be preferred to stock ownership. There are some key terms that you’ll want to know as it pertains to employee stock options:

• Grant: In terms of employee stock options, a grant is a promise to provide options in the future.
• Vesting schedule: Vesting is the process of fulfilling the grant, and the vesting schedule determines the vesting date, or the day when you can begin to make stock purchases.
• Exercise price: Also known as a grant price or strike price, an exercise price is the fixed cost employees pay per share to own stock.
• Fair market value: Fair market value is the stock’s cash price in the open and unrestricted market with both parties—i.e., the buyer and the seller—having reasonable knowledge of the situation.

The two main types of employee stock options are Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).

Incentive Stock Options (ISOs) vs. Non-Qualified Stock Options (NSOs)

The two main types of employee stock options are ISOs and NSOs. Here’s a closer look at each of the two options and their tax implications:

What are ISOs?

ISOs are an incentive stock option that can only be offered to employees. Under the right circumstances, they can have some significant tax advantages if holding requirements are met. Here’s a look at some of the key characteristics of ISOs:

• They must be held for more than two years after grant, and any shares obtained upon exercise of an ISO must be held for more than one year.
• They must be exercised within 10 years of the grant date.
• They can only be granted by an entity that’s taxed as a corporation.
• ISOs are not taxed for federal income tax purposes until the holder either sells or disposes of shares. They’re also subject to Alternative Minimum Tax (AMT) considerations.

What are NSOs?

Unlike ISOs, NSOs can be offered to more than just employees, but service providers, consultants, advisors and more. They may be granted by an entity that’s taxed as a corporation, partnership or LLC. Here’s a look at some of the NSO basics:

• NSOs are taxed as ordinary income tax for federal tax purposes and do not qualify for special treatment. When exercised, the individual will pay ordinary income tax on the difference between the exercise price and the fair market value at the exercise date. This differs from ISOs, which are not taxed until the individual either sells or disposes of shares.
• Shareholders must hold stock for more than one year after exercise.
• Expiration is set by the plan agreement.

How Are Stock Options Taxed?

Here’s a closer look at how the various employee stock options are taxed:

Taxation at Exercise

One of the biggest differences between ISOs and NSOs is how they’re taxed. ISOs, for instance, may qualify for special tax treatment if certain holdings requirements are met. They’re not taxed for federal income tax purposes at exercise. This differs from NSOs, which are taxed for regular federal income tax purposes at exercise, as defined by the Internal Revenue Code. This taxed amount is equal to the difference between the exercise price and fair market value of the shares at the exercise date.

ISOs are not taxed for federal income tax purposes until the holder either sells or disposes of shares. The difference between exercise price and fair market value is subject to Alternative Minimum Tax (AMT) considerations.

Taxation at Sale

Here’s a look at how ISO and NSO taxes are applied when the stock acquired from employee options is sold:

• ISOs: In a qualifying disposition, subjects may have to consider a long-term capital gains tax if various holding periods are met. In a disqualifying disposition, it’s taxed partially as ordinary income and the rest as capital gains.
• NSOs: Any gain or loss after exercise is taxed as capital gain or loss. The holding period determines the short-term or long-term capital gains tax rates.

The 83(b) Election Strategy

The 83(b) election can also be used to benefit employee equity tax planning. Specifically, it allows employees to elect to pay taxes on the total fair market value at the time of the grant as opposed to once the stock has been vested. This can result in significant tax savings, especially if the stock’s value increases—or is expected to increase—over time.

The 83(b) is a one-page document that is particularly beneficial for startups who may be offering stock that’s expected to increase as it grows and flourishes. However, it must be filed within 30 days of the grant date to qualify. Failure to file on time and you can expect to be taxed on the fair market value of the stock once it has been vested.

Tax Planning Strategies for Employees

Looking for more tips to help your employees with their tax planning? Here are a few pointers to consider:

• Exercise ISOs early to better minimize the AMT impact.
• Properly plan the timing of exercises and sales to help optimize tax treatment.
• Make sure you keep thorough records of all transactions so there’s a paper trail of everything.
• Consider consulting with a tax professional to help keep your efforts on track. A qualified tax professional can also help you optimize planning strategies to maximize the tax benefits of offered stock options.

Common Mistakes to Avoid

Failure to know the ins and outs of tax law when it comes to employee stock options could have some dire consequences. That said, it’s important to make sure you’re in the know. This is also where it can pay to work with a tax professional to guide your efforts. Some of the common pitfalls include:

• Failing to know the key differences between ISOs and NSOs.
• Not taking advantage of or missing the 83(b) filing deadline.
• Not accounting for AMT when exercising ISOs.

The Role of Employers in Stock Option Taxation

While some of optimizing stock option taxation falls on the startup’s employees, employers can help too. For example, simply providing clear documentation and communication about the options granted and their tax pros and cons can go a long way. Some other ways employers can help include offering educational resources or workshops on equity compensation and making sure that there’s compliance with reporting and withholding requirements on the business level.

Understanding Your Stock Options

Employee stock options are a great way to incentivize people to join your startup and stay with your startup as it grows. However, understanding tax implications and taking advantage of the opportunities can be complicated. That’s why it’s important to proactively plan and consider consulting with professionals who can better guide your tax strategy. Effectively managing offered stock options can have significant tax benefits, both in the short- and long-term.

Partner with Graphite Financial for Expert Equity Tax Planning

For help navigating the complex stock option taxation, contact Graphite Financial today. As qualified experts at helping startups and their employees with all of their tax needs, we also offer personalized service that’s designed to address individual financial situations. We’ve worked with hundreds of startups on their accounting and financial planning and are standing by and ready to help your startup and your people with their stock equity tax planning. Contact us today for more information and to schedule a consultation.

FAQs

What are the key differences between ISOs and NSOs?

When it comes to federal income taxes, ISOs are not taxed until the holder either sells or disposes of shares. They’re also subject to Alternative Minimum Tax (AMT) considerations, which may be advantageous. This differs from NSOs, which are taxed for regular federal income tax purposes at exercise. This taxed amount is equal to the difference between the exercise price and fair market value of the shares at the exercise date.

How does the Alternative Minimum Tax (AMT) affect ISO exercises?

ISOs must consider AMT. For instance, if you exercise your ISO stock option, but don’t sell them in the same year, the difference between the price paid and what they’re worth when you exercise is counted as income.

What is the 83(b) election, and when should it be considered?

The 83(b) allows employees to elect to pay taxes on the total fair market value at the time of the grant as opposed to once the stock has been vested. This can result in significant tax savings, especially if the stock’s value increases—or is expected to increase—over time.

How are stock options taxed when I sell my shares?

This largely depends on the type of stock equity option offered. We suggest working with a tax professional to better understand how stock options are taxed when shares are sold.

Can contractors or advisors receive ISOs, or are they only for employees?

ISOs are strictly for employees. NSOs, conversely, can be offered to employees, advisors, consultants and service providers.

What are the holding period requirements for favorable tax treatment on ISOs?

ISOs require a one-year vesting period before they can be sold. They also offer better tax treatment on profits than other types of plans, like NSOs.

How can I minimize my tax liability when exercising stock options?

It’s important to thoroughly understand your options and holding period requirements. If possible, try to exercise options when they’re granted so you don’t have to buy at fair market value. Empower yourself with education and consider working with a professional for assistance.