As we sign on the dotted line and say yes to a job offer, many of us do not completely comprehend the full effect of what we are signing. Aside from income tax on the base salary, we often overlook the tax consequences caused by the other big variable—stock options—before it is too late to fix. By wading into the details of the equation more deeply, we can be better prepared for tax season! Let us begin with defining the different types of stock options and their tax treatment. There are two types of stock options: Incentive stock options (ISO) and non-qualified stock options (NQO or NSO).
ISOs give the employee the right to buy a predetermined amount of company stock at a set price (strike price). That price is the fair market value of the stock as of the date it was granted to the employee. Once the strike price is set, the employee has the right to buy the stock for that price even if the fair market value of the stock goes up in the future. That means that over time an employee may have the right to purchase ISOs which are below the current market value of the stock.
In addition to being able to purchase shares at a discounted price, when ISOs are sold, the proceeds may be taxed at long term capital gains rates, instead of the higher ordinary income tax rates. To qualify for this treatment the stock must be held at least one year from the date it was purchased and two years from the date it was granted. It is important, however, to be aware that if an employee plans to hold this stock for at least one year, they will still have to report AMT taxable compensation in the year of exercise. That calculation will be covered in Part II of this post.
ISOs can only be granted to employees, it is a way for employers to attract and retain qualified employees. As discussed above, the potential for beneficial tax treatment is very appealing. Unlike ISOs, NSOs can be granted to anyone. But even though NSOs are another form of stock option used by employers to attract and retain qualified employees, NSOs are different from ISOs because the exercise of NSO shares will trigger a taxable event to the employee.
The “discounted amount” is the difference between the strike price of an employee’s option and the fair market value of the company stock at the time of exercise. With NSOs, at the time of exercise, the discounted amount will be included on the employee’s W2 as compensation and will be subject to employment taxes as well as income tax. While this type of option may be less appealing to employees, employers usually prefer granting this type of stock option because it allows the employer to deduct the full amount the employee must include as compensation income.
In Part II of our discussion we will dive deeper into the tax consequences of ISOs and provide some concrete examples.