The U.S. federal taxation of stock options for U.S. taxpayers depends on whether the options are classified as incentive stock options (ISOs) or nonstatutory stock options (NSOs).
Incentive Stock Options (ISOs)
ISOs may provide a tax advantage to the holder if (i) the optionee does not sell the shares before the expiration of two different holding periods and (ii) the optionee is not subject to alternative minimum tax (AMT) in the year of exercise.
- To obtain the tax benefit, the optionee must not dispose of the shares for at least two years from the date of grant and one year from the date of exercise—which may be a longer period than the standard capital gains holding period.
- The tax benefit, as compared to NSOs, is that there is no tax withholding or FICA payroll tax on exercise, and the spread at sale is taxed as capital gain; however, the spread on the exercise date counts as AMT income and may subject the holder to AMT in the year of exercise.
- The company gets no tax deduction with respect to ISOs, and as a result, the company recognizes no anticipated tax benefit under ASC Topic 718. Therefore, ISOs may have a greater expense impact on the company’s financial statements.
- ISOs involve a number of administrative burdens for the company: tracking compliance with ISO requirements, including the $100,000 limit (see below); tracking shares for disqualifying dispositions; and, in the year of exercise, reporting to the IRS on Form 6039 and employee information statement on Form 3921.
- ISOs also provide less flexibility for modifications and methods of exercise (e.g., no “net” exercise), which can hamper the company’s ability to efficiently manage these options in certain scenarios,—for example: when an employee terminates employment, in connection with an M&A transaction, or if the ISOs become “underwater.”
- The ISO rules state that in any given calendar year, not more than $100,000 of the value of options (exercise price times the number of shares) can first become *exercisable* (not vested) in that calendar year and still be treated as ISOs. So if an optionee gets a grant that is fully early-exercisable for 100,000 shares with a strike price of $2 per share ($200,000 of value), then only $100,000 of that grant (half the shares) can be an ISO. If that same 100,000-share grant becomes exercisable as it vests (25,000 shares vest each year, with no early exercise), then the entire grant can be an ISO (because not more than $25,000 worth of ISOs are exercisable for the first time in each year). Also, if an optionee gets multiple grants that are vesting/becoming exercisable, there aren’t two $100,000 limits for each calendar year; there is only one $100,000 limit.
Nonstatutory Stock Options (NSOs)
NSOs provide greater flexibility and tax advantages for employers.
- NSOs are taxed based on the spread at exercise, and the company must withhold payroll taxes for employee optionees.
- NSOs won’t cause the optionee to be surprised by an AMT bill in the year of exercise, and there is only one holding period (one year from exercise) to track.
- The company gets a tax deduction when the option holder is taxed and therefore gets a potential tax benefit, which can reduce the expense recognized with respect to NSOs as compared to ISOs.
- NSOs impose a lower administrative burden on the employer (e.g., no need to track time of disposition of shares and no special reporting—just report the spread on W-2 or 1099 for the year of exercise).
- NSOs offer greater flexibility to amend options to extend the post-termination exercise period or unilaterally reprice underwater options without needing to undertake a tender offer to obtain optionee consent.
Which are better, ISOs or NSOs?
There is no fixed answer to the question of whether ISOs or NSOs are superior, and it depends on the individual’s personal tax situation. ISOs aren’t taxed as ordinary income in the year of exercise, but they are taxed as AMT income. So while there may not be withholding at exercise, the optionee may have an ugly tax bill on April 15 of the next year.
In addition, ISOs lose ISO status three months post-termination, so if the optionee wants to have the right to exercise more than three months post-termination, the grant turns into an NSO—and that flexibility may outweigh the withholding tax consequences.
Also, the ultimate tax treatment depends on the amount of time between exercise and sale, the tax rates in effect at both exercise and sale, and whether the optionee has lots of other items subject to AMT in the year of exercise (e.g., if the optionee is itemizing in the year of exercise, they may pay more taxes due to AMT).
It’s best for optionees to do financial planning with their tax advisor and financial planner, including at the time they want to exercise, because it may make more sense to exercise the NSO portion of the grant in one year and the ISO portion in a different year if their AMT income is likely to fluctuate between years.
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