Introduction to Incentive Stock Options.
One of the major benefits that many employers offer to their workers is the ability to buy company stock with some sort of tax advantage or built-in discount. There are several types of stock purchase plans that contain these features, such as non-qualified stock option plans. These plans are usually offered to all employees at a company, from top executives down to the custodial staff.
However, there is another type of stock option, known as an incentive stock option, which is usually only offered to key employees and top-tier management. These options are also commonly known as statutory or qualified options, and they can receive preferential tax treatment in many cases.
Key Characteristics of ISOs.
Incentive stock options are similar to non-statutory options in terms of form and structure.
Schedule: ISOs are issued on a beginning date, known as the grant date, and then the employee exercises his or her right to buy the options on the exercise date. Once the options are exercised, the employee has the freedom to either sell the stock immediately or wait for a period of time before doing so. Unlike non-statutory options, the offering period for incentive stock options is always 10 years, after which time the options expire.
Vesting: ISOs usually contain a vesting schedule that must be satisfied before the employee can exercise the options. The standard three-year cliff schedule is used in some cases, where the employee becomes fully vested in all of the options issued to him or her at that time. Other employers use the graded vesting schedule that allows employees to become invested in one-fifth of the options granted each year, starting in the second year from grant. The employee is then fully vested in all of the options in the sixth year from grant.
Exercise Method: Incentive stock options also resemble non-statutory options in that they can be exercised in several different ways. The employee can pay cash up front to exercise them, or they can be exercised in a cashless transaction or by using a stock swap.
Bargain Element: ISOs can usually be exercised at a price below the current market price and, thus, provide an immediate profit for the employee.
Clawback Provisions: These are conditions that allow the employer to recall the options, such as if the employee leaves the company for a reason other than death, disability or retirement, or if the company itself becomes financially unable to meet its obligations with the options.
Discrimination: Whereas most other types of employee stock purchase plans must be offered to all employees of a company who meet certain minimal requirements, ISOs are usually only offered to executives and/or key employees of a company. ISOs can be informally likened to non-qualified retirement plans, which are also typically geared toward those at the top of the corporate structure, as opposed to qualified plans, which must be offered to all employees.
Taxation of ISOs.
ISOs are eligible to receive more favorable tax treatment than any other type of employee stock purchase plan. This treatment is what sets these options apart from most other forms of share-based compensation. However, the employee must meet certain obligations in order to receive the tax benefit. There are two types of dispositions for ISOs:
Qualifying Disposition: A sale of ISO stock made at least two years after the grant date and one year after the options were exercised. Both conditions must be met in order for the sale of stock to be classified in this manner. Disqualifying Disposition: A sale of ISO stock that does not meet the prescribed holding period requirements.
Just as with non-statutory options, there are no tax consequences at either grant or vesting. However, the tax rules for their exercise differ markedly from non-statutory options. An employee who exercises a non-statutory option must report the bargain element of the transaction as earned income that is subject to withholding tax. ISO holders will report nothing at this point; no tax reporting of any kind is made until the stock is sold. If the stock sale is a qualifying transaction, then the employee will only report a short-term or long-term capital gain on the sale. If the sale is a disqualifying disposition, then the employee will have to report any bargain element from the exercise as earned income.
Say Steve receives 1,000 non-statutory stock options and 2,000 incentive stock options from his company. The exercise price for both is $25. He exercises all of both types of options about 13 months later, when the stock is trading at $40 a share, and then sells 1,000 shares of stock from his incentive options six months after that, for $45 a share. Eight months later, he sells the rest of the stock at $55 a share.
The first sale of incentive stock is a disqualifying disposition, which means that Steve will have to report the bargain element of $15,000 ($40 actual share price - $25 exercise price = $15 x 1,000 shares) as earned income. He will have to do the same with the bargain element from his non-statutory exercise, so he will have $30,000 of additional W-2 income to report in the year of exercise. But he will only report a long-term capital gain of $30,000 ($55 sale price - $25 exercise price x 1,000 shares) for his qualifying ISO disposition.
It should be noted that employers are not required to withhold any tax from ISO exercises, so those who intend to make a disqualifying disposition should take care to set aside funds to pay for federal, state and local taxes, as well as Social Security, Medicare and FUTA.
Reporting and AMT.
Although qualifying ISO dispositions can be reported as long-term capital gains on the IRS form 1040, the bargain element at exercise is also a preference item for the alternative minimum tax. This tax is assessed to filers who have large amounts of certain types of income, such as ISO bargain elements or municipal bond interest, and is designed to ensure that the taxpayer pays at least a minimal amount of tax on income that would otherwise be tax-free. This can be calculated on IRS Form 6251, but employees who exercise a large number of ISOs should consult a tax or financial advisor beforehand so that they can properly anticipate the tax consequences of their transactions. The proceeds from sale of ISO stock must be reported on IRS form 3921 and then carried over to Schedule D.
The Bottom Line.
Incentive stock options can provide substantial income to its holders, but the tax rules for their exercise and sale can be complex in some cases. This article only covers the highlights of how these options work and the ways they can be used. For more information on incentive stock options, consult your HR representative or financial advisor.
Incentive Stock Option - ISO.
What is an 'Incentive Stock Option - ISO'
An incentive stock option (ISO) is a type of employee stock option with a tax benefit, when you exercise, of not having to pay ordinary income tax. Instead, the options are taxed at a capital gains rate.
BREAKING DOWN 'Incentive Stock Option - ISO'
Although ISOs have more favorable tax treatment than non-qualified stock options (NSOs), they also require the holder to take on more risk by having to hold onto the stock for a longer period of time in order to receive the better tax treatment.
Also, numerous requirements must be met in order to qualify as an ISO.
Qualified vs. Non-qualified Stock Options.
Depending upon the tax treatment of stock options, they can be classified as either qualified stock options or non-qualified stock options . Qualified stock options are also called Incentive Stock Options , or ISO.
Profits made from exercising qualified stock options (QSO) are taxed at the capital gains tax rate (typically 15%), which is lower than the rate at which ordinary income is taxed. Gains from non-qualified stock options (NQSO) are considered ordinary income and are therefore not eligible for the tax break. NQSOs may have higher taxes, but they also afford a lot more flexibility in terms of whom they can be granted to and how they may be exercised. Companies typically prefer to grant non-qualified stock options because they can deduct the cost incurred for NQSOs as an operating expense sooner.
More details about the differences, rules, and restrictions of qualified and non-qualified stock options are provided below along with example scenarios.
Comparison chart.
How Stock Options Work.
Stock options are often used by a company to compensate current employees and to entice potential hires. Employee-type stock options (but non-qualified) can also be offered to non-employees, like suppliers, consultants, lawyers, and promoters, for services rendered. Stock options are call options on the common stock of a company, i. e., contracts between a company and its employees that give employees the right to buy a specific number of the company’s shares at a fixed price within a certain period of time. Employees hope to profit from exercising these options in the future when the stock price is higher.
The date on which options are awarded is called the grant date. The fair market value of the stock on the grant date is called the grant price. If this price is low, and if the value of the stock rises in the future, the recipient can exercise the option (exercise her right to buy the stock at the grant price).
This is where qualified and non-qualified stock options differ. With NQSOs, the recipient can immediately sell the stock she acquires by exercising the option. This is a "cashless exercise", because the recipient simply pockets the difference between the market price and the grant price. She does not have to put up any cash of her own. But with qualified stock options, the recipient must acquire the shares and hold them for at least oneyear. This means paying cash to buy the stock at the grant price. It also means higher risk because the value of the stock may go down during the one-year holding period.
Rules for Qualified Stock Options (Incentive Stock Options)
The IRS and SEC have placed some restrictions on qualified stock options because of the favorable tax treatment they receive. These include:
The recipient must wait for at least one year after the grant date before she can exercise the options. The recipient must wait for at least one year after the exercise date before she can sell the stock. Only employees of the company can be recipients of qualified stock options issued by the company. Options expire after 10 years. The exercise price must equal or exceed the fair market value of the underlying stock at the time of grant. For employees who own 10% or more of the company, the exercise price must be at least 110% of the fair market value and options expire in 5 years from the time of the grant. Options are non-transferable except by will or by the laws of descent. The option cannot be exercised by anyone other than the option holder. The aggregate fair market value (determined as of the grant date) of stock bought by exercising ISOs that are exercisable for the first time cannot exceed $100,000 in a calendar year. To the extent it does, such options are treated as non-qualified stock options.
Tax Treatment.
Why do people use qualified stock options in spite of these restrictions? The reason is favorable tax treatment afforded to gains from QSOs.
No taxes are due when qualified stock options are exercised and shares are purchased at the grant price (even if the grant price is lower than the market value at the time of exercise). When stocks are eventually sold (after a holding period of at least 1 year), the gains are considered long-term capital gains, which are tax-free for people in the lower two tax brackets (10% and 15%) and are taxed at 15% for people who are in higher tax brackets for ordinary income.
If stocks are sold sooner than the 1-year hold, it's called a "disqualifying disposition,” which is just like an NQSO.
When non-qualified stock options are exercised, the gain is the difference between the market price (FMV or fair market value) on the date of exercise and the grant price. This gain is considered ordinary income and must be declared on the tax return for that year. Now if the recipient immediately sells the stock after exercising, there are no further tax considerations.
However, if the recipient holds the shares after exercising the options, the FMV on the exercise date becomes the purchase price or "cost basis" of the shares. Now if the shares are held for another year, any further gains are considered long-term capital gains. If shares are sold before that timeframe, any further gains (or losses) are counted towards ordinary income.
Let's say an employee was awarded stock options on January 1, 2018 when the stock price was $5. Let's also assume that the employee's income is $100,000 and she is in the 28% marginal tax rate bracket for ordinary income. Now let's take a look at the different scenarios and calculate the tax implications.
Scenario 1 is the classic qualified stock option. No income is declared when options are exercised and no taxes are due in 2018. Stocks are held for over 1 year after purchase so all gains are taxed at the long-term capital gains tax rate of 15%.
Scenario 2 is an example of a disqualifying disposition even though the plan was a qualified stock option plan. The shares were not held for one year after exercise, so the tax benefits of a qualified ISO are not realized.
Scenario 1 and Scenario 2 under the non-qualified category represent the same situation when the grant was under a non-qualified stock option plan. When the options are exercised (2018), ordinary income is declared equal to the difference between the FMV on exercise date ($15) and the grant price ($5). In Scenario 1, the shares are purchased and held for more than one year. So the further gains ($22 - $15) are considered long term capital gains. In Scenario 2, shares are not held for more than one year. So the further gains are also considered ordinary income. Finally, scenario 3 is a special case of scenario 2 where the shares are sold immediately after they are acquired. This is a "cashless exercise" of the stock options and the entire profit is considered ordinary income.
What are Non-qualified Stock Options?
WHAT DOES NON-QUALIFIED STOCK OPTION MEAN?
A non-qualified stock option does not qualify you for preferential tax treatment. You will pay ordinary income tax on the difference between the grant price and the Fair Market Value of the stock at the time you exercise the option.
Vesting is when you have met the required service period and may exercise the option to purchase stock. You are not required, however, to exercise your options as soon as they vest. Your stock option vests on a schedule determined by your company. Your vesting schedule is contained in your grant agreement and may also be viewed on StockPlan Connect, the Morgan Stanley website for stock plan participants.
Morgan Stanley offers several ways to exercise your stock options:
Same Day Sale/Exercise & Sell All.
The goal of this type of exercise is to acquire cash, rather than shares of stock. You are not required to make an upfront payment for exercising your options. Rather, option costs, applicable taxes, and fees are paid with the proceeds of the sale. You receive the net proceeds in cash. This exercise can be placed either as a market or limit order.
The goal of this exercise is to acquire stock without paying for the shares out-of-pocket. With a sell to cover exercise, you sell only enough shares to cover the option costs, fees, and applicable taxes. You receive the remaining balance in shares of stock. This exercise can only be placed as a market order.
Exercise and Hold.
With an exercise and hold, you use your personal funds to cover the option cost, fees, and applicable taxes. If you exercise 100 options, for example, you would pay for and receive 100 shares of your company stock.
A Market Order is an order to sell the shares acquired from your stock option exercise at the current market price. Morgan†Stanley will place the order immediately upon receiving your request to exercise.
A Limit Order is an order to sell shares at a specified price. When the stock price reaches the limit established, your order is submitted for execution. All orders that are placed with a limit price will be good until cancelled (GTC) and will expire one year from the order entry date. A cancellation of an existing GTC limit order can occur for other reasons including, but not limit to: (i) your instruction to cancel; (ii) pursuant to your Company’s plan rules or (iii) the GTC order has expired.
You may exercise your options on StockPlan Connect. We make it easy for you to track and exercise your stock options, and select between proceeds distribution methods online. Note that if you do not exercise your stock options before the expiration date, they will expire with no value. Please refer to your company’s specific plan details.
You can exercise your stock options through StockPlan Connect. Morgan Stanley offers several choices for proceeds delivery:
Deposit into a Morgan Stanley account.
If you are a current Morgan Stanley brokerage client, we will deposit cash or shares directly into your brokerage account on the settlement date. If you do not currently have a brokerage account with Morgan Stanley, we will open a limited purpose account for you. Your proceeds should be available to you three business days after the trade date (to account for a three-day “settlement” period that applies to all stock market transactions).
Check via regular mail.
If you choose this method, Morgan Stanley will mail your sales proceeds. You should receive your proceeds within 8-10 business days from the trade date.
Check via overnight delivery.
Morgan Stanley can send your proceeds via overnight delivery, for a fee. You should receive the proceeds of your sale in the form of a check four days after your trade date (to account for a three-day “settlement” period that applies to all stock market transactions).
Morgan Stanley can wire your proceeds to your bank on the Settlement Date for a fee. Wire transfers are in U. S. dollars.
Foreign currency wire.
Morgan Stanley can wire your proceeds to your bank in your local currency for a fee. You should receive the proceeds 4-5 business days after the trade date.
Foreign currency check.
Morgan Stanley can send you a check in your local currency for a fee. You should receive the proceeds 10-15 business days after the trade date.
The type of exercise impacts your income tax liability.
Exercise and Holds.
The difference between the grant price and the fair market value at exercise is reported as ordinary income. This will establish your new cost basis for the acquired shares. If you hold the stock for one year from exercise date, upon selling the stock, the difference between your cost basis and sale price is treated as long-term capital gain. If you sell your stock prior to the one-year anniversary of the exercise date, the difference between the sale price and the cost basis is treated as short-term capital gain.
The difference between your sale price and the grant price is reported as ordinary income. Please discuss all tax considerations with your tax advisor.
Call the Morgan Stanley Service Center at +1 866-722-7310 (U. S. participants) or +1 801-617-7435 (non-U. S. participants).
Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors do not provide tax or legal advice. Clients should consult their personal tax advisor for tax related matters and their attorney for legal matters. В.
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Incentive Stock Options vs. Nonqualified Stock Options.
Companies and service providers to companies frequently confront this question. Which is better: an Incentive Stock Option (aka a statutory stock option) (an “ISO”) or a Nonqualified Stock Option (aka a Nonstatutory Stock Option) (an “NQO”)?
What are the differences between ISOs and NQOs?
The table below summarizes the primary differences:
I recommend NQOs over ISOs for the reasons I summarized in the article Should I Grant ISOs or NQOs?
To reiterate my arguments in favor of NQOs over ISOs briefly:
ISOs are more complex and difficult to understand for a variety of reasons, including (a) the two holding periods, (b) the annual limitation, (c) the eligibility restriction, (d) the greater than 10% shareholder rule, (e) complexities associated with disqualifying dispositions, but most significantly because of the AMT consequences on exercise when there is a spread. It is easier for companies to simply have one type of award to explain to their service providers – NQOs. Most employees don’t meet the holding period requirements of ISOs in any event – because they wait to exercise until there is a liquidity event – so the primary benefit of ISOs – capital gain on sale of the stock – is not obtained. NQOs are more transparent than ISOs because the tax withholding on exercise is more easily calculated. The spread on the exercise of NQOs is deductible to the employer.
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7 Responses to "Incentive Stock Options vs. Nonqualified Stock Options"
By Bo Sartain May 16, 2018 - 7:03 am.
Joe, great analysis. I like the chart. I’m going to link to this post in our stock option generation wizard as part of the help. Thanks!
By Ji Eun (Jamie) Lee May 17, 2018 - 4:22 am.
Hi Joe, thanks for this informative chart! I’m also going to link to this post in my upcoming Startup Stock Options class presentation. Thanks!
By Bill May 17, 2018 - 12:04 pm.
Joe, great summary. I agree on 3. It is very rare for someone to satisfy the holding periods and typically if they did, it is because they early exercised and would have satisfied the period anyway.
For mid-sized and larger companies generating real revenue, the deduction in Item 5 is huge. I tend to see companies shift away from ISOs once they have enough revenue to get a finance person who understands tax benefits. Even if the deduction just ends up adding to a pile of NOLs, it is valuable to the employer particularly when the employee is unlikely to benefit from the ISO.
In any state other than Washington AMT in 1 is usually a killer as well. With no state income tax, it seems AMT strikes at least somewhat less here for mid-level employees.
By Peter Evanson June 27, 2018 - 12:10 am.
Hey Joe, Really Nice summary and the chart you provide very helpful for stock options. This is the perfect one, what is required to make money in this trading market. Thanks!
By Josh January 27, 2018 - 1:49 pm.
Hi Joe, nice site you have here, thanks for sharing your insights. Given the end of the year tax preparation I am struggling to figure out what I need to give to our employees here are the 3 examples of types of exercises during the year:
1.) Normal ISO Exercise once shares vested – I have prepared Form 3921.
2.) Early Exercise of ISO – Section 83b elected at time of exercise (strike price = FMV) – do I also need to prepare a 3921?
3.) Early Exercise of NQO – Section 83b elected at time of exercise (strike price = FMV) – Anything else that I need to file (ie. 3921, etc.?)
By Joe Wallin February 27, 2018 - 8:55 am.
Sorry for the late reply. Would be happy to chat with you on the phone about this if you like. 206 669 0997.
By Lydia January 19, 2018 - 4:02 am.
Thanks for the explanation but seeing as how so many Start-ups are using employees or contractors accross international borders, I’d really appreciate a break down for how NQSOs are treated for citizen and non-citizen non-residents. In our company, the employees of a consulting firm have stock in the US commpany we consult. We are all scratching our heads about how this will effect our personal taxes as some of us are US citizens living in Europe and some are European citizens also living in Europe.
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