Stock options are a common way to compensate employees or retain employees. A stock option is a benefit given to an employee whereby the employee can purchase a certain number of shares of their company’s stock in a specific time frame at an established price. Stock options often cost a business little to issue but are a great benefit for an employee if the company is successful and the stock’s value increases. The equity gained from owning stock options can be far more valuable to the employee than what the equivalent cash would have been. However, there are tax implications involved, which vary depending on whether the company issues non-qualified or qualified stock options.
Here are the differences between non-qualified or qualified stock options, as well as the tax consequences of each:
Qualified Stock Options
Qualified stock options, often referred to as an Incentive Stock Option Plan (ISO) or Statutory stock options, have a lot of restrictions that both the employee and company must adhere to, including:
- They can only be granted to an employee
- Qualified stock options are non-transferable, and must be exercised when employed or 3 months after termination (unless disabled which then is 1 year instead of 3 months)
- A company can only grant an ISO to its employee under written agreements
- Qualified stock options must be exercisable within 10 years of being granted with a price that is at least as much as the fair market value at the time that they are granted.
- The value of qualified stock options cannot exceed $100,000 at the time of the grant.
Non-Qualified Stock Options
Non-qualified stock options (NSOs), also known as nonstatutory stock options, are much less restrictive than qualified stock options, because they can be given to anyone, may be transferable and are not subject to limitations on exercise price or on the amount that can be granted. While some advantages of non-qualified stock options are beneficial to both sides, the downside for the recipient is that there are less favorable tax consequences.
Tax Implications
Stock options are an excellent way for companies to compensate employees and service providers because of the equity that the recipient gains balanced with a low cost to the company. However, it is essential for both businesses and employees to understand the tax implications for non-qualified vs. qualified stock options to determine the best way to handle them.
Qualified stock options, or ISO, are more desirable from the employee’s point of view. Income does not need to be reported when the options are granted or when exercised, only when the stock is sold. He or she can avoid paying ordinary income or employment taxes on gains and instead pay long-term capital gain if the stock is held more than a year from the time it was exercised and two years from the time it was granted. The capital gains rate paid will depend on the employee’s tax bracket, but in general long-term capital gains tax rates are much lower (max is only 15%) than ordinary income tax rates. However, generally the employee must hold on to the stock for a longer period than NSOs and the Alternative Minimum Tax (AMT) may come into play (usually if the options are not exercised and the shares are not sold in the same year, an AMT adjustment is required which could cause AMT tax liabilities). There is typically no tax advantage to the employer for giving qualified stock options because the employer typically cannot claim a corporate tax deduction. For more information on the details, see section 422 of the Code.
Non-qualified stock options are more desirable from the employer’s point of view. A business is entitled to a tax deduction equal to the amount that the recipient must report as income on his taxes in the same year that the options are exercised and taxable. The recipient is generally liable for taxes at the ordinary income rate for options at the time they are exercised (or sometimes transferred), calculated on the difference between the exercise price and the fair market value (FMV) on that date. Furthermore, once the stock is owned (from exercising), then with a sale the recipient would pay an ordinary tax rate on any gain or a long-term gain if they held it for more than a year. In some cases, tax liabilities can be created on the grant date if the option fair market value can be “readily determined.” It can be readily determined if it is actively traded on an established market or if all of the following are true:
- The option can be transferred
- The can be exercised right away
- The option is not subject to conditions or restrictions (except for the condition to ensure payment of purchase price) that affect the FMV
- The FMV of the option privilege can be readily determined
For more information see IRS Publication 25. Before making any decision with stock options, it is always best to speak with a tax professional to ensure you comply with all tax law.