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Whether you are working for a start-up company or a large Fortune 500 corporation, if you receive stock options as a part of your compensation, it can be confusing. Incentive stock options or non-qualified stock options may have been a part of your compensation package, but what does that mean for you? We will explore the nuances of incentive stock options and non-qualified stock options and what they mean for you.
What are Incentive Stock Options?
Incentive stock options (ISOs) are also known as qualified stock options or statutory stock options. ISOs allow corporations’ employees to purchase shares of the company’s stock at a discounted share price. In addition, incentive stock options typically qualify for favorable capital gains tax treatment in the eyes of the Internal Revenue Service (IRS) under Section 422 of the Internal Revenue Code. Stock options that do not qualify for this favorable tax treatment are non-qualified stock options.
Incentive stock options are typically reserved for employees in top management positions and other high-value employees. In contrast, non-qualified stock options are a more widely used form of compensation for employees.
What Happens When You Receive Incentive Stock Options?
Incentive stock options have strict rules that must be followed to qualify for favorable long-term capital gains tax treatment.
Share Grant
Companies grant or issue incentive stock options at a given strike price. The strike price will reflect the price at which the employee may purchase the stock in the future should you choose to exercise the options. The strike price is typically close to the market value of the stock when the options are granted. However, the strike price cannot be less than the fair market value of the shares at the time of the issuance. This is the options’ grant date.
When the shares are granted, the employee is also provided with a vesting schedule that provides the dates when the shares may be exercised. In addition, the schedule provides the number of shares that may be exercised at each vesting period.
The grant will also establish the offering period for the stock options. This is the period when you have the right to exercise the shares. For incentive stock options, this is ten years. If the shares have not been exercised within this 10-year time frame, they expire.
Share Exercise
Once the shares vest according to the schedule, the employee has the option to purchase the shares at the grant price. Once the shares have been exercised, you must then hold the shares for a minimum of one year and one day to qualify for favorable tax treatment. In addition, you must hold the shares for a minimum of two years from the share grant date.
For example, let’s say Company X provides you with 1,000 shares of Company X stock at a strike price of $10 on January 1, 2021, which has the following vesting schedule:
- 200 shares vest on August 1, 2022
- 200 shares vest on August 1, 2023
- 200 shares vest on August 1, 2024
- 200 shares vest on August 1, 2025
- 200 shares vest on August 1, 2026
On January 1, 2022, you would have the option to exercise the option to buy 200 shares of Company X stock at $10. However, to receive favorable long-term capital gains tax treatment, you would need to hold those 200 shares until at least August 1, 2023 (two years from the date of the grant and one year from the date of exercise). For the remaining shares, you would have to hold the shares for at least one year from the date of exercise to qualify since the two-year holding period from the date of the grant will have already passed.
Share Sale
If you hold the shares for greater than one year, the profit received on the sale date will be taxed at long-term capital gains rates. Continuing from our example above, on August 1, 2022, you choose to exercise the 200-share option for $2,000 (200 shares at a $10 strike price). You must then hold the shares for at least one year until August 1, 2023. If you then choose to sell the shares on November 1, 2023, when the stock is $15, the $1,000 profit will be taxed at long-term capital gains rates. The current capital gains rates are 0, 15, or 20 percent, depending on your current tax bracket.
It is important to note that no taxable income is recorded until the exercised shares have been sold.
Special Considerations for Incentive Stock Options
Incentive stock options carry two complications that do not apply to ordinary compensation. Both can produce a tax bill in a year when you have not sold a single share.
Alternative Minimum Tax
While there is no taxable event for ordinary income tax purposes for incentive stock options, you should be aware of the alternative minimum tax implications related to the exercise of the shares. Should you choose to exercise your shares, the difference between the stock’s market value at the time of the exercise and the strike price of the shares will be considered as income for alternative minimum tax purposes, which can increase your tax liability. Your financial advisor will be able to help you understand the alternative minimum tax implications of exercising your shares and plan accordingly.
Sale Before One-Year After Exercise
If you choose to sell the shares within one year of the date of the exercise of the shares, the capital gains received on the sale of the stock will be considered short-term capital gains and will be taxed at ordinary income tax rates.
What Happens When You Receive Non-Qualified Stock Options?
Non-qualified stock options are taxed as ordinary income and are a more widely used form of compensation for the employees of a corporation. Non-qualified stock options do not meet the requirements for favorable long-term capital gains tax treatment as outlined in Internal Revenue Code Section 422.
Share Grant
Similar to incentive stock options, the company provides the employee with the option to purchase a certain number of shares at a pre-determined stock price according to the vesting schedule outlined for the employee. The shares must be held until the vesting date for the employee to have the right to purchase the shares.
Share Vesting
Once the shares vest, the employee retains the right to purchase the shares at the pre-determined strike price. The employee can exercise the shares over the offering period provided with the grant (maximum of 10 years). No taxable income is triggered when the shares vest.
Share Exercise
Once the shares have vested, you may choose to exercise your right to purchase the shares. However, exercising the shares is a taxable event.
If you choose to exercise your shares, you will be taxed on what is known as the bargain element of the share exercise. The bargain element is equal to the total number of shares times the difference between the market value at the time of the exercise and the strike price of the share grant.
For example, Company A provides you with a 10,000 share non-qualified stock option on August 1, 2021, that vests on August 1, 2022, at a $20 strike price. You choose to exercise the stock option on September 1, 2022, when the stock price is $30. The bargain element for exercising these options will be $100,000 (10,000 shares * ($30-$20)).
This bargain element is considered ordinary income and is included in your W-2 compensation reported to you by your company. The amount of compensation included in your W-2 is now considered to be the cost basis of your shares and will be used to help to determine the amount and nature of any future gains and losses.
Once the shares are sold, you will determine the nature and amount of your capital gain on the shares. However, if the shares are held for less than one year after exercise, any gain or loss would be considered a short-term capital gain taxed at ordinary income tax rates. If you hold the shares for greater than one year, any gain or loss would be considered to be long-term in nature and would be taxed at the lower long-term capital gains tax rates.
Special Considerations for Non-Qualified Stock Options
Non-qualified stock options are simpler to plan for than incentive stock options, but the tax arrives earlier, and it arrives whether or not you have the cash on hand to pay it.
Potential Significant Tax Liability Upon Exercise
For non-qualified stock options, it is important to consider the tax implications of exercising your shares as they can be significant. In our example above, you would be recognizing (and paying taxes on) an additional $100,000 in income for the year. If you are not prepared to pay the taxes due on the exercise, this can lead to significant issues at tax time.
There are several ways to exercise the shares to help reduce this risk. Your financial advisor can walk you through this process and help you to determine the best way to exercise your shares.
What Is Early Exercise and the 83(b) Election?
Some companies allow early exercise, which lets you purchase your shares before they have vested. If you file an 83(b) election with the IRS within 30 days of the purchase, you elect to be taxed on the spread at the time of exercise rather than at vesting. When the shares are bought at or near fair market value, that spread is small or zero, so the election can lock in a minimal tax cost and start the long-term capital gains holding period immediately.
The trade-off is risk. The election is irrevocable, the 30-day filing window is strict, and any tax paid is not refundable if the shares later lose value or you leave the company before vesting. Modeling the numbers with a CPA before filing is essential.
What Planning Moves Reduce the Tax Bill?
Several strategies can reduce the total tax owed on stock options:
- Exercise incentive stock options in tranches across multiple tax years, keeping the bargain element in each year below the level that triggers alternative minimum tax.
- Coordinate exercises with liquidity events such as an IPO or an acquisition, so the cash to pay the tax arrives alongside the tax itself.
- Exercise during a market dip, when the spread between the strike price and the fair market value is at its narrowest.
- Watch surtax thresholds, particularly the 3.8% Net Investment Income Tax, which can apply to the gain on the sale of the shares.
- Layer in complementary strategies such as charitable giving, retirement plan deferrals, or Qualified Small Business Stock treatment where the shares qualify.
What Paperwork Do You Need to File?
The reporting requirements differ by option type:
- Incentive stock options: Form 3921 from your employer, Form 6251 to calculate alternative minimum tax, and Form 8801 to claim the AMT credit in later years.
- Non-qualified stock options: the bargain element appears on your W-2 under code V, and the sale is reported on Form 8949 and Schedule D.
Misreporting these forms is one of the most common reasons option holders receive IRS notices. The cost basis reported by your broker often excludes the amount already taxed as ordinary income at exercise, which means the same income can be taxed twice unless the basis is adjusted on Form 8949.
Understanding the differences between incentive stock options and non-qualified stock options can be complicated when evaluating options to consider surrounding the vesting of shares and subsequent exercise and sale.
If you have any questions regarding the difference between incentive and non-qualified stock options, how to plan for the exercise of your options, or to learn more about our services, please feel free to contact us for more information.
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