What are Statutory Stock Options?
Statutory stock options, also known as incentive stock options (ISOs), are issued by a corporation to its employees as a form of compensation. Employees purchase (exercise) shares of stock at a predetermined price specified in their stock option agreement.
However, the difference between exercise price and fair market value (FMV) isn’t immediately taxed as ordinary income. Instead, it is subject to tax preference item treatment under the alternative minimum tax (AMT) rule.
ISOs need approval from a corporation’s board and shareholders through a written plan exempt from purchase plan limitations. Moreover, the ISOs can be granted only to employees, not independent contractors.
What are Nonstatutory Stock Options?
A nonstatutory stock option, or non-qualified stock option (NSO), is most commonly granted by an employer to employees, consultants, and other service providers.
NSOs are deemed “nonstatutory” because they are not subject to special tax rules that apply to statutory stock options (ISOs).
Employees exercising NSOs are taxed on the difference between FMV and exercise price. Depending on an employee’s tax bracket, the spread grows at a higher rate, meaning that if the employee is taxed at a 35% rate, they get only 65 cents for every dollar in shares.
Employers have more freedom when granting NSOs because there are no limits on who can receive them or how many can be granted. However, ISOs are more attractive to employees due to their tax benefits.
Employers often use NSOs to retain or entice employees to return after leaving the company.
Is There Any Tax Liability When You’re First Granted Stock Options?
Generally, no tax is owed when you receive ISO or NSO stock options since the IRS does not consider the option as income. However, employees may have to pay taxes later if they exercise and incur taxes under AMT laws.
Like ISOs, NSOs are not taxed when the option is awarded.
How are Taxes Different for ISOs vs NSOs?
ISO Taxes
No taxes are due on the grant or exercise of ISOs. However, taxes are due on stock sales.
If specific holding period requirements are satisfied (held stocks at least two years from date granted and one year from exercise date), the gain is taxed at the lower long-term capital gains rate.
NSO Taxes
NSOs are treated like income and taxed under ordinary income tax rules on the difference between fair market value and exercise price.
That may be reported as income on the W-2 form and is subject to capital gains tax if the stock is later sold for a gain.
When Do You Pay Taxes on NSO Options?
Exercising NSO options results in ordinary income to the extent that the stock’s FMV when exercised exceeds the exercise price. Therefore, the difference, or spread, from exercising NSO options is reported as income from which taxpayers can take deductions using Form 1040.
Employees will find this amount reported as ordinary income on their W2s.
Any gain in the stock above the NSO FMV price after you exercise the options counts as a capital gain subject to capital gains tax when you sell stock.
The rate of tax that you will pay on this gain (if the stock is ever sold) depends on whether you hold the stock for the short term (i.e., less than the statutory holding period of usually less than one year) or long term (more than the holding period).
Ordinary tax rates apply to short-term capital gains, and discounted long-term capital gains rates apply to long-term capital gains.
Are There Any Tax Advantages for ISO Options?
Unlike NSOs where you owe income tax upon exercise, you do not owe taxes when you exercise ISOs. Another advantage is the potential for sale profits of ISOs to be taxed at a lower long-term capital gains rate if the ISO holding period is applicable.
In addition, ISOs are not subject to FICA taxes at the time of exercise, which can provide additional savings relative to NSOs, which are taxed upon exercise.
Even though ISO exercising could trigger AMT for some taxpayers, mainly if the spread between the exercise price and the fair market price of the stock were large, many ISO holders will avoid AMT altogether.
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