Incentive Stock Options

What are Incentive Stock Options?

Incentive stock options, or ISOs, are a valuable tool for employees to participate in the success of their company. These stock options come with certain tax benefits that can help minimize the tax burden for employees. The tax treatment of incentive stock options is important for employees to understand, as it can have a significant impact on their overall tax liability. Unlike non-qualified stock options (NSOs), which are subject to ordinary income tax upon exercise, ISOs are generally taxed at the time of sale. By holding onto the shares for at least two years from the grant date and one year from the exercise date, employees may qualify for long-term capital gains tax rates. To determine the taxation of employee stock options, it is advisable to consult a tax professional or use a stock option tax calculator. Being aware of the tax implications and learning how to minimize taxes on stock options can maximize the benefits of incentive stock options for employees.

What are Non-Qualified Stock Options?

Non-qualified stock options (NSOs) are a popular form of employee compensation. Compared to restricted stock units (RSUs), NSOs offer certain advantages. Firstly, NSOs provide employees with the opportunity to purchase company stock at a specified price, regardless of its current market value. This can be advantageous if the stock price increases in the future. Secondly, NSOs are not subject to the more restrictive rules that apply to incentive stock options (ISOs). However, it's important to note that NSOs may be subject to the net investment income tax. When employees exercise NSOs, the compensation is reported on Form W-2, which is used to report wages and salaries. The tax treatment for employers issuing NSOs is slightly different from ISOs.

What are Restricted Stock Units?

Restricted stock units, or RSUs, are earned, rather than purchased. They’re more common at late-stage startups preparing to go public, or at companies that have already gone public.

For example, back in 2011, Facebook stopped issuing incentive stock options, and instead began offering employees RSUs. In 2011 alone — one year before the company went public — Facebook issued 55.1 million shares to employees and board members as RSUs.

With RSUs, a company will typically agree to give employees a specific value in the form of shares.

For example, an employee’s stock option grant might specify that they earn $20,000 worth of RSUs each year on Jan. 15. On that date, if the company’s shares were trading for $100 each, the employee would earn 200 shares. One year later, if the shares were trading for $200 each, they’d get 100 shares.

RSUs carry less personal financial risk upon exercise, as employees don’t have to spend their own money to acquire shares. There is likely a more liquid market for the company’s shares, giving employees the ability, in many cases, to turn around and sell their shares for cash.

Because RSUs are typically offered at larger startups and publicly traded companies, they usually experience less upside, but also less risk. RSUs are taxed at exercise, with companies reserving some portion of their value to pay taxes on their employees’ behalf, similar to a cash bonus.

ISOs v. NSOs

The main difference between the two lies in the tax treatment.

ISOs are generally more beneficial from a tax perspective. When an ISO is exercised, the employee does not have to pay regular income tax on the difference between the exercise price and the fair market value of the stock at the time of exercise. Instead, the employee may be subject to alternative minimum tax (AMT) if certain conditions are met. In addition, if the employee holds the stock for at least two years after the grant date and one year after the exercise date, any gains from the sale of the stock are treated as long-term capital gains, which are typically taxed at a lower rate than ordinary income.

On the other hand, NSOs do not qualify for the same tax advantages as ISOs. When an NSO is exercised, the employee is generally required to pay regular income tax on the difference between the exercise price and the fair market value of the stock at the time of exercise. This can result in a higher tax liability for the employee.

It's important to note that there are other factors to consider when choosing between ISOs and NSOs, such as the vesting schedule and the potential for future value appreciation. Consult with a tax professional or financial advisor to fully understand the implications of each type of stock option.

Want to learn more about stock options? Check out Secfi’s Complete Employee Stock Option Starter Guide.