Understanding ISOs and NSOs
Employee stock options are a popular form of compensation offered to workers by startups to incentivize them to obtain and retain employment for the company.
These options are not actual shares in the company, but rather a promise that employees can purchase shares in the equity of the company for a predetermined price ( strike price ) after a certain period, called a vesting period.
In the world of employee stock options , there are two types of options available: incentive stock options (ISOs) and nonqualified stock options (NSOs).
Incentive Stock Options (ISOs)
Incentive stock options are incentives that can only be offered to employees. They are well-known for being associated with lower tax liabilities, which makes them more attractive options.
Here are a few major characteristics of ISOs:
- Non-transferable, except in the event of a death of the owner
- A maximum stock value of $100,000 can be exercised each year
- Stock option owners who also retain at least 10% of the company must pay a premium for exercising
Nonqualified Stock Options (NSOs)
Nonqualified stock options can be offered to employees, investors, contractors, consultants, or any other service providers. These options are generally considered more advantageous for the company versus the employees since when issued, they allow the company to make tax deductions on their income at the end of the year.
Here are a few components of NSOs:
- Stock options that do not meet requirements to be an ISO
- Fewer restrictions versus an ISO
- No cap on the value
- Transferable per the original agreement
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What’s the Difference Between an ISO and an NSO?
Though there are several differences between an ISO and an NSO, the main thing that sets them apart is how they are taxed.
ISOs are specifically reserved for employees only and taxed at the capital gains tax rate, which was 0%, 15%, or 20% in 2020 if the shares were held for more than a year.
NSOs, on the other hand, are eligible to be offered to non-payroll entities and require taxes to be paid on the difference between the discounted strike price and the market price of a share.
How are ISOs taxed?
Since employees are not required to pay taxes on stocks at the time of exercising them, incentive stock options (ISOs) are more highly sought after. Employees must only pay taxes at the time of sale of stock. Depending on the amount of time a share is held, it can be taxed in two different ways:
- If a share is held at least one year after grant and two years after the vesting date, the gains are classified as capital gains as opposed to standard income.
- If a share is sold before one year has passed after grant and two years after vesting , the gains are classified as ordinary gains and are taxed at the regular rate. Taxes, though, are not due until the shareholder files their taxes at the end of the year or the end of the calendar year in which they are sold.
The largest risk associated with ISOs exists in them losing value before they are sold. There is also being charged an alternative minimum tax (AMT) which can amount to be more than the ordinary or capital gains rate, depending on the employee’s income bracket for the year.
If you want to take full advantage of the benefits of ISOs, you must wait one full year after vesting to sell them; otherwise, you forfeit your right to pay capital gains tax on them, which is one of the biggest benefits that ISOs have to offer.
How are NSOs taxed?
No matter when you choose to exercise or sell a nonqualified stock (NSO), taxes must be paid on the difference between the discounted strike price in your agreement and the market price of the shares at the time of sale. Taxes are due even if you don’t choose to sell them, as well.
When you are taxed on ISOs, the tax rate is identical to personal income rates. These taxes are also due at the time of exercise or sale.
Gains resulting from NSOs are considered personal income and are taxed as such. This means that Medicare, Social Security, and payroll taxes are deducted from gains.
Check out this article to learn more about how ISOs and NSOs are taxed.
Key Terms in Employee Stock Options
The legal framework that governs employee stock options includes many new terms that you might not be aware of. Being knowledgeable about these terms is the best way to ensure that you fully understand any employee stock option agreement that you may be a part of.
Here are some of the most important employee stock options terms that you should know:
- Incentive Stock Options (ISOs) : stock options reserved for employees of a corporation; associated with the most favorable tax implications
- Nonqualified Stock Options (NSOs) : stock options eligible to be granted to non-payroll entities; subject to personal and payroll tax
- Strike Price : the pre-determined price of a stock option
- Fair Market Value : the actual cost of a share in the current market
- Stock Grant : occurs when an employer gives stock options to an employee or other entity
- Exercise : occurs when an employee or other entity chooses to take the shares they are entitled to
- Holding Period : the period in which an employee or other entity keeps ownership of a stock
- Vesting Period : the period in which an employee or other entity must wait before they can exercise their stock options
Here is an article where you can learn more about employee stock options.
Taxes – Does AMT Affect ISOs or NSOs?
When it comes to incentive stock options, sometimes an alternative minimum tax or AMT applies. This tax applies to the difference between the strike price and the market price on stock options when the stock is sold.
Just like standard tax, the alternative minimum tax is only applied once stocks are sold. When this happens, both the alternative minimum tax and standard tax rates are calculated. The stockholder then pays whichever amount is the higher of the two.
Alternative minimum tax was created to ensure that high-income earning individuals pay their fair share in taxes. If the gains from a group of stock options are significant, chances are, the alternative minimum tax will apply.
If you must pay the alternative minimum tax, you need not pay the entire amount calculated. Rather, the only amount owed is the difference between the standard tax calculation and the AMT calculation.
Learn more about the alternative minimum tax and how it impacts incentive stock options by checking out this article .
Get Help Your Stock Options
Nonqualified and incentive stock options are great ways for corporations to reward their employees for their loyalty and tenure. However, the tax implications can get complicated, especially if you’re not familiar with stock options. All too often, those with stock options don’t know they have to pay an alternative minimum tax until it’s too late, which can cause them to owe money on shares they didn’t make a profit off.
Don’t get caught in the taxation trap - post a project on ContractsCounsel today to get connected with corporate lawyers who specialize in ISOs and NSOs today.
