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Incentive Stock Options/Non-Qualified Stock Options

This is a general tax overview of stock options. Options are used to reward employees for their participation in and commitment to the success of an employer corporation. Stock options are but one of several forms of equity incentives which range from outright gifts of stock to specialized restricted stock purchase agreements. Our discussion here will be limited to the tax treatment of incentive stock options (ISO) and non-qualified stock options (NSO). Both ISOs and NSOs are subject to a variety of other federal rules relating to their creation and exercise, including some rules not related to taxation issues. This site is not intended to be an authoritative source of information concerning non-tax rules relating to federal and state securities laws and accounting considerations.

Generally, when an individual is granted a compensatory stock option, that individual receives a contract right to purchase shares in a corporation for a fixed term at a fixed price - in most cases at the fair market value of the stock on the date the option was granted. Companies typically grant options to employees, consultants, or other persons associated with the company to encourage their loyalty and for purposes of participation in the success of the company. Most compensatory options are granted pursuant to an employer's stock option plan. Companies generally adopt stock option plans that permit grants of both ISOs and NSOs. Their tax treatment is different as is discussed below.

Many companies have found that ISOs are a useful tool for providing tax-advantaged achievement incentives to attract and compensate key personnel. If statutory ISO holding periods and other rules are met, the optionee incurs no tax liability upon exercise (unless the optionee is subject to the alternative minimum tax as is discussed elsewhere at this web site), but instead incurs tax liability only upon the sale or other disposition of the stock, and even then is only taxed at the long-term capital gains rates rather than the higher ordinary income tax rates. The grant and exercise of ISOs are statutory creatures, and must be granted and exercised in accordance with an employer plan and the technical requirements of IRC Section 422 and applicable regulations in order to preserve the tax benefits. With ISOs, the employer is not entitled to receive a compensation deduction on the employee's profit and loss statement as a result of either the grant or the exercise of an ISO by an employee.

In contrast, many companies favor NSOs because their exercise entitles the employer company to a compensation deduction on their profit and loss statement making it more attractive to the employer and hence less attractive to the employee. An employee can always tell if he has an NSO, rather than an ISO, if the exercise of the stock option results in his employer withholding income tax on exercise of the option and including the economic value of the option in the employee's W-2 compensation.

NSOs are not limited by federal income tax laws as to the number of shares, price per share, length of term, or the identity of the recipient of the option. Upon the optionee's exercise of the NSO, the employer company is entitled to receive a compensation deduction (and conversely the service provider recognizes taxable income) in the amount of the difference between the option price and the value of the stock at the time of the exercise. Obviously, the tax consequences of the NSO are less advantageous to the employee than are the tax consequences of an ISO. Under IRS regulations, the employer has a withholding obligation on the value of the spread (current NSO value less NSO exercise price) at the time of the employee exercise. Usually NSOs are immediately sold to cover the option cost of the stock as well as the required income tax withholding.

There are myriad other rules concerning stock options which need to be understood by the optionee/employee. Some of these rules are as follows:

• ISOs may be granted to employees only.
• An ISO must be exercised during employment thereby discouraging job shopping.
• NSOs can be granted to employees as well as others rendering services to the company or those who are employees of a parent or subsidiary corporation of the company.
• To qualify as an ISO, an option must be granted at an exercise price equal to the fair market value of the optioned stock on the date the option is granted.
• An employee who owns more than 10% of the combined voting power of all classes of stock of a company (or any parent or subsidiary of the company) cannot be granted an ISO at an exercise price less than 110% of the fair market value of the stock on the date the option is granted.
• An ISO may be exercisable only as to $100,000.00 worth of stock in any one calendar year.
• NSOs are paid for with cash by the employee. Most companies have arrangements with brokerage firms for the immediate sale of NSOs to provide the cash for the exercise and to pay required income tax withholding amounts.
• If the employer plan so provides, ISOs may be exercised with a promissory note, with shares of company stock, or with other non-cash consideration. Submitting other employer shares of stock in payment for the exercise of an ISO is a cashless, efficient way of exercising ISOs. An employee optionee will not be able to do so, however, unless the original employer plan, the corporate resolution granting the ISO, and the option grant itself, specifically permit non-cash consideration.

The following exhibits compare ISOs vs NSOs in terms of consequences to the company as well as in terms of consequences to the employee optionee.

COMPARISON: ISOs VERSUS NSOs: CONSEQUENCES TO COMPANY