Know the tax treatments for ISOs and NSOs

Incentive stock options (ISOs), nonqualified stock options (NSOs), restricted stock: Executives are keenly interested in knowing which of these employee stock alternatives and their corresponding tax treatments is best.

ISOs can be attractive to employees because holders don’t have to pay tax until their shares are sold, and then they pay capital gains tax on the spread between the exercise price and the sale price, assuming a qualifying disposition. However, ISOs are subject to alternative minimum tax (AMT) and less favorable tax treatment upon disqualifying dispositions if certain holding-period requirements are not met. (There are additional requirements for options to be treated as ISOs that a holder needs to understand.)

Private companies, meanwhile, issue a limited amount of ISOs for two reasons:
  1. They get no income tax deduction for ISOs (unless there is a disqualifying disposition).
  2. There is a $100,000 limit on the value of stock for which ISOs can be exercised each year.

NSOs are not subject to the special tax treatment of ISOs, yet they have other benefits. No income is reported when the option is granted, and the company receives a tax deduction when the employee exercises the option.  

Jane Doe’s tax journey
To examine ISOs and NSOs, let’s use a hypothetical case.

Jane Doe is an executive at Private Company. She is 58. Jane’s stock ownership in Private Company represents about 75% of her net worth. Given she’d like to retire in five years, this is an important time in her career. Will she have enough money to enjoy herself? Jane would be wise to understand the tax treatment of various stock options.

Jane’s compensation includes restricted stock, discussed in detail in Watch for tax traps and opportunities with restricted stock. She also has ISOs and NSOs.

Jane holds 10,000 ISOs, some of which are vested (meaning the options can be exercised) and some of which are not.

Jane is happy with her ISOs because they aren’t subject to income tax upon grant or exercise. She has to pay tax only when the stock is sold.

To demonstrate, Jane exercises 1,000 ISOs and receives 1,000 shares. The exercise price is $10 per share. Three years later, she sells the stock for $15 per share.

To calculate Jane’s ISO capital gain:

Sales price per share: $15
Minus the exercise price: $10
Equals gain per share: $5
Times number of shares sold: 1,000
Equals total capital gain (long-term): $5,000

Jane’s tax is on long-term capital gains, because she kept the stock at least a year.

If the shares decline in value after Jane exercises the ISOs, she takes a capital loss.

Disqualifying dispositions
To retain favorable tax treatment, Jane has to hold her ISOs for a required amount of time. Stock can’t be sold for two years after the ISO is granted or one year after the ISO is exercised. If she doesn’t meet these rules, Jane must report income in the year of this disqualifying disposition.

Say that Jane exercises 1,000 ISOs when the current stock value is $12. The exercise price is $10 per share. Only six months later, she sells the stock for $15 per share.

Stock value at exercise date: $12
Minus exercise price: $10
Equals spread (ordinary income): $2
Times number of shares sold: 1,000
Equals total ordinary income to be reported: $2,000
In this case, Jane also has to report a capital gain when she sells the stock.
Sales price: $15
Minus her basis in the stock: $12 (the exercise price of $10 plus the ordinary income, or spread, of $2)
Equals capital gain: $3
Times number of shares sold: 1,000
Equals total capital gain (short-term): $3,000

If the stock value declines after exercise, Jane won’t recognize capital gain or loss because her entire gain on the stock (the difference between the sale price and the exercise price) has already been recognized as ordinary income.

She decides to keep the stock to avoid a disqualifying disposition.

As time goes by
Jane later discovers she owes income tax upon exercising her ISOs because she failed to realize the spread upon exercise is a tax preference item that may trigger the AMT.

The aim of the AMT is to keep higher-income earners from paying too little tax because of deductions and exemptions. Taxpayers subject to the AMT must figure out how much tax they would owe using normal tax rules, then add back any deductions or exclusions they took ― such as the spread on ISOs ― to calculate their regular tax. They use this higher number to calculate the AMT.

When Jane exercised the 1,000 ISOs for $10 per share, the fair market value of the stock was $12.

Stock value at exercise date: $12
Minus exercise price: $10
Equals spread: $2
Times number of ISOs exercised: 1,000
Equals the AMT preference amount: $2,000 (which may or may not affect Jane’s actual income tax liability, depending on her overall situation)

There is danger in the AMT. If Jane exercised lots of ISOs and the stock value increased dramatically, she might have substantial AMT liability. If the value later plunged, before she sold the stock, Jane could incur a large tax bill on phantom, or unrealized, gains. There are strategies to decrease the chance of having to pay an AMT, including the following:

  • Limit the number of ISOs exercised in a given year: Calculate the amount of ISOs to exercise that will cause the regular tax and the AMT to be equal amounts. That way, Jane would not be subject to an AMT.
  • Plan. Estimate how many ISOs can be exercised in each future year without triggering the AMT; update the plan each year to reflect changes in the stock value and other circumstances.
  • Exercise the ISOs early in the year and monitor the stock price. If the price decreases during the year and the decline may continue, sell the shares. This will result in a disqualifying disposition but eliminate the AMT preference item and also avoid tax on phantom income. If the stock price increases and the increase may continue, hold the shares. Jane doesn’t have to worry about paying an AMT on phantom income because she believes she will ultimately realize the income.

Moving on: Jane’s nonqualified stock options
In our hypothetical, Jane holds 100,000 NSOs from Private Company. NSOs are any options that don’t meet requirements for ISOs. Their tax rules are simpler than those for ISOs: There is no tax upon grant but, unlike ISOs, there is tax upon exercise. The income amount upon exercise equals the stock value at the exercise date, minus the exercise price.

Income when Jane exercises NSOs
Say Jane exercises 10,000 NSOs in year one, at a price of $10 per share. The stock value on the exercise date is $15 per share.

Stock value on exercise date: $15
Minus the exercise price: $10
Spread at exercise date: $5
Total income: $5 X 10,000 shares = $50,000

The $50,000 is treated as compensation and is ordinary income for Jane. In addition, Private Company gets a $50,000 tax deduction.

Income when Jane sells the stock
In the same scenario, Jane sells the 10,000 shares of stock in year 10 for $50 per share.

Stock value on exercise date: $50
Minus exercise price: $10
Minus spread at exercise date: $5
Gain upon sale: $35
Total income upon sale in year 10 is $35 X 10,000 shares = $350,000

The $350,000 for tax purposes is a long-term capital gain.

Loans on NSOs
Private Company could give Jane a loan to fund her exercise of the options. Jane isn’t personally liable to repay the loan, as the stock is security for the loan. In this situation, the exercise is ignored for tax purposes because 1. Jane hasn’t taken personal risk that the stock value will decline, and 2. there has been no transfer of stock for tax purposes. Jane won’t report income until the loan no longer exists.

These rules don’t apply to a loan through a third party, a full recourse loan or one backed by collateral from the borrower.

Keep in mind
The rules regarding the taxation of both ISOs and NSOs are relatively simple. NSOs are more straightforward, while ISOs present the potential challenges of the AMT and disqualifying dispositions. With either choice, a holder needs to know the tax consequences, so, like Jane, he or she can be happy and financially secure going forward.

Jeff Martin
T +1 202 521 1526

Eric Myszka
T +1312 602 8397

Rebecca Calvo
T +1 832 476 3778

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