Types of Employee Stock Options
There are two types of ESOs available in the United States that differ by the manner in which they are taxed. The first category of ESOs consists of Non-Qualified Stock Options (NSOs). Under NSOs the difference between the price stated in the options and the market price of the stock at the time of the options’ exercise is taxable as ordinary income. Also, employers are eligible to claim a tax deduction in an amount equivalent to that which the exerciser is required to include as additional income. This feature makes NSOs an enticing route for employers, and is likely the reason why NSOs are often the preferred option.
The second category of ESOs consists of Incentive Stock Options (ISOs), which have greater tax benefits for employees. ISOs differ from NSOs in that the difference between the exercise price stated in the options and the market price is not taxed as ordinary income, though it may qualify for other lesser taxes. If shares are held longer than two years after the issuance of the options, and one year after the date of their exercise, then the profit from those shares are taxed as long-term capital gain rather than ordinary income. Employers do not claim deductions from ISOs unless this holding threshold is not met.
The ISO Advantage
One of the biggest advantages of the tax treatment of an ISO is that it protects against a particular risk arising from the tax treatment of NSOs. It is entirely possible that shares will devalue before the exerciser of an option can sell them. NSOs add an additional element of danger to this phenomenon because NSOs are taxed for the differential between market and exercise price at the time of exercise. This means an NSO holder can be taxed on potential profit that is never realized.
As an example, assume an employee exercises a $100 NSO worth $200 at a tax rate of 30%. The employee would be taxed $30 on the $100 “income gain,” even though he or she has not yet converted that value from shares of stock into currency. Now assume the value of the stock the employee currently holds falls to $120 before it can be sold. In this scenario, despite the fact that the employee purchased the stock at $100, he or she will still experience a net loss because of the $30 taxation that occurred at the time of option exercise.
ISOs avoid this pitfall completely because they are taxed upon the sale of stock. If the example above were an ISO as opposed to an NSO, the only tax would be on the $20 profit upon the stocks’ sale, and thus the same conditions would yield a net gain.
The NSO Advantage
However, ISOs have their drawbacks in that there are certain qualifications an option program must satisfy in order to be classified as an ISO. Preferential tax treatment is only awarded to those that meet the requirements of Internal Revenue Code 422 throughout the life of the option. A few of these requirements include: ISOs can only be disbursed to employees of a company (as opposed to independent contractors), they must be granted at fair market value, they are non-transferrable, and they must be granted with 10 years of board approval and exercised within 10 years of their grant.
By contrast, NSOs are much more flexible. NSOs can be granted as compensation to anyone, pricing is not fixed on market price, and their tax treatment remains the same regardless of when the option is exercised. This gives employers more control over how they issue employee stock options, reduces logistical costs involved, and removes most of the troublesome restrictions of ISO programs.
In the last segment of this three part series, we will discuss which class of employee stock option fits you, and how you and your business can benefit from such programs. For more information regarding this topic, please contact Larry Horwitz at firstname.lastname@example.org.