Taxation of Stock Options: ISOs, NSOs, and Who Knows
Stock Option Basics
An option is basically just a contract between you and the company. The company says, “Hey, I’ll let you buy our stock at this price ($__) and this is valid for ___ years.” A stock option is a contract; remember that. If someone gives you a contract, no matter how much it may potentially be worth, it doesn’t really have value until you choose to “exercise” your rights under the contract to acquire the value.
If you’re working for the next big thing (think of Amazon in the early 2000s), this can be extremely valuable. Imagine having the option to buy 10,000 shares of Amazon stock for only $10/share when it’s currently trading at around $1,000 per share; that’s a $990 discount per share. With only $100, you could acquire 10 shares of Amazon stock worth $10,000. That’s an instant profit of $9,900 since you only paid $100 for stock worth $10,000. That’s the power and value of stock options.
A stock option is a contract between you and the company that allows you to purchase a stated number of shares for a pre-determined price that is binding upon the company regardless of how much the stock is actually worth. This contract gives you the “option” the purchase stock, and you can choose to “exercise” your contractual rights under this contract for a stated period of time. If you exercise the option and acquire stock for only $10 when it’s actually worth $100, that’s a $90 discount: this is called the “bargain element.” The bargain element is your instant gain: you bought stock worth $100 for only $10; instant gain of $90 if you sell the stock. It’s basically like trading a Ten Dollar Bill for a One-Hundred Dollar Bill.
Who wouldn’t want to trade $10 for $100? And it’s this obviousness that creates a lot of potential for abuse. Fort that reason, the government decided to step-in. Now, the government does not regulate stock options: we have a free market capitalist economy. Instead, the government simply said, “Hey, stock options are great, and if you follow these sets of rules to offer what we’ll now call ‘Incentive Stock Options,’ we’ll make stock options even better by taxing them more favorably.”
There are two types of stock options: Incentive Stock Options (ISOs) that are entitled to preferential tax treatment and Non-Qualified Stock Options (NSOs) that are every other type of stock option. As explained in the paragraph above, the concept of ISOs was created by Congress.
Why would the government go out of its way to create a special type of stock option that’s given preferential tax treatment? Why not treat all stock options the same? By creating the concept of Incentive Stock Options and giving them preferential tax treatment, the government is giving companies an incentive to treat its employees fairly. In the “good old days,” only company founders received stock options. Companies didn’t realize that this was actually discouraging all other employees from investing in the company. This article is focused on the employee, so we won’t go into too much detail on the company side of the issue, but that’s the basic idea: the government created tax incentives for companies to more fairly grant options to all employees (not just founders) and create incentives for the employee as well so employees contribute to the capital and growth of the company, which improves the overall U.S. economy. It’s a very carefully crafted type of stock option that creates a win-win result for the company, executives, employees, and the U.S. economy.
If you remember anything, just remember this: ISOs good for everyone; NSOs good for founders and executives.
Taxations of ISOs
ISOs are great; there’s no tax until you sell the actual stock, which is obviously after you acquired the option and after you’ve exercised the option to acquire the stock. Remember this: no tax related to ISOs until the actual stock is finally sold; except for AMT issues (discussed later).
When the ISO (contract to purchase stock at a pre-determined price) is granted, there’s no tax. When you exercise the ISO (contractual optional right to acquire the stock at a pre-determined price; usually at a discount), there’s also no tax. The only catch is that, if you’re subject to the Alternative Minimum Tax (AMT), then the “bargain element,” which is the discount on the stock (actual value minus price you paid), has to be reported as income; but only for AMT purposes. Don’t worry too much about the AMT part; seriously. It’s way too much to get into without turning this article into a thesis.
The two main benefits of ISOs are that there is no tax when the option is granted and no tax even when the option is exercised with a bargain element allowing you to buy the stock at a discount.
How will I be taxed when I sell the stock? Is it ordinary income or long-term capital gain? Whether the gain from the stock sale is taxed as ordinary income or long-term capital gain depends on two time periods, and you have to satisfy both; not just one.
There are 3 dates to keep in mind:
- Option Grant Date: the date the option was granted.
- Option Exercise Date: The date the option was exercised and the stock was actually acquired.
- Stock Sale Date: The date the stock was actually sold for cash.
In order for the gain to be taxed at the lower preferred long-term capital gains tax rate, you must meet two factors; both of which focus on the Stock Sale Date.
First, the Option Exercise Date (when you acquired the actual stock) must be at least 12 months before the Stock Sale Date, which is pretty standard: you always have to hold the actual stock for at least one year to get long-term capital gains tax treatment. Second, the Option Grant Date must be at least 24 months before the Stock Sale Date. It’s this second requirement that’s unique to ISOs. The entire period between option grant and stock sale has to be at least 24 months.
In other words, ask these two questions: from the date you were granted the options to the date you sold the actual stock, was it at least 24 months? And, did you hold the actual stock for at least 12 months? If the answer to both is yes, you're covered.
For example, having the option for 1 month, then exercising and holding the stock for 23 months totals to 24 months. The entire period is 24 months, and you held the stock for 23 months, so you're covered.
Another example, having the option for 12 months and then exercising and holding the stock for 12 months before selling totals to 24 months. Total period is 24 months with stock held for 12 months, so you're covered.
If you satisfy both requirements, you pay a much lower rate of tax on the gain, which we call long-term capital gains tax rates. Many online articles refer to this as the “capital gains rate,” but this is confusing because there’s also short-term capital gains, which are taxed as ordinary income. This confuses people. There are two types of capital gain: long-term, which is preferred, and short-term, which is treated just like your salary income and taxed as “ordinary income.” It’s long-term capital gains that are taxed at lower rates.
Again, why would the government care whether the ISO period was at least 24 months? Why would the government treat long-term gains differently than short-term gains? Well, if you’re really interested, keep reading.
More Government Policy Discussion
Economic stability. When you buy stock, you’re basically giving money to that company and saying “Hey, I don’t know what to do with this money, but I’m certain you can use it in your business and probably double it for me, so here you go.” Well, how would you feel if someone invested let’s say $100,000 in your business, but then 2 days later said they wanted it back? That’s not cool. You probably already made plans on how you were going to use those $100,000 and now the investor is saying they want it all back? Well, that’s what many Americans do in what is referred to as “day trading.” Selling stock as fast as they bought it; back and forth. Companies hate that. So does the government. But we’re a free market capitalist economy, so we can’t outlaw it. So how do you discourage people from doing that? Well, if you say “penalize them,” that’s not cool either. You’re trading one bad thing for another. Plus, that’s basically saying you’re okay with the government saying you have to continue to own something that you don’t want anymore; the government having the power to deny you your right to sell something. No way. So how do you discourage it? This is how: create something more attractive.
Regular capital gains are taxed as ordinary income just like everything else, right? Well, let’s create something more attractive. We’ll tell people that, if they hold the stock for at least 12 months (thus giving the company you invested in time to actually use the investment to expand their business), then instead of paying ordinary rates up to 39.6%, they’ll only pay 20%.
Now, for day traders, they’ll never do this. But if you own stock you’ve held for 10 months and need cash, you’ll likely not sell the stock since you only need 2 more months to qualify for a lower tax rate on the gain, so you’ll probably resort to a loan or credit card for liquidity. And that is the government’s goal: to incentive you to hold onto the stock longer so that the company has more time to effectively use the investment to grow their business and improve the overall U.S. economy.
Taxation of NSOs
NSOs is the catch-all term of every other type of stock option that exists other than the government-created concept of ISOs.
There’s no tax when the option is granted. If you read above, you’d understand fully why. But just to recap, a stock option is just a contract. A contract is not income. A contract can certainly have value. For example, if Acme Stock is worth $10 and I give you the option to buy it for $10, is there value? Of course not, you’re saying I can buy something worth $10 for $10; what’s the point? But if the stock jumps up to $100 tomorrow, now that option has value, right? But is it income? Of course not, just because someone offers to sell you something at a discount doesn’t mean you’ve actually gained anything; it’s still contingent on you coming up with the money to actually make the purchase. Nothing says you have to buy the stock; that’s why it’s called an “option.” You have the option to purchase; you have the option not to purchase. It’s your option.
But, with NSOs, what happens if you exercise an option to buy stock for only $10 when it’s actually worth $100. Well, you experienced an instant gain of $90. Now, you don’t actually have $90 of cash gain until you sell the stock, but you just traded $10 for something worth $100; that’s a $90 bargain discount. Unlike ISOs, however, with NSOs, that $90 bargain element is taxed as ordinary income. But don’t worry, the obligation is on the company to report that on your Form W-2, Box 1 for wages. There’s no accounting required on your part.
The bargain element of NSOs is treated and reported as salary income. That’s not good. However, the good news is that you paid tax on the acquisition of the stock, so the basis is not the $10 you paid for it; it’s the value of the stock when you acquired it. So your stock basis is $100. Why? Well, it was worth $100, you bought it for $10, and paid tax on the $90 of gain when it got included on your Form W-2 as wages, so the gain has already been taxed. It would be unfair for the government to tax that gain again, so your new basis for calculating future gain is $100. If you hold the stock for more than a year, it’s long-term capital gain taxed at preferred lower rates. If you hold it for less than 12 months, it’s short-term capital gain taxed as ordinary income.
Here's the problem: the broker might not know the stock was acquired via an NSO. Why does that matter? Well, the stock broker only see that you purchased stock for $10 and sold it for $100, so they’re going to report $90 of gain on IRS Form 1099 to the IRS. If you don’t have a quality tax adviser, they’ll enter that Form 1099 information into your tax return without asking you any questions, which means you’ll pay tax on that $90 twice! First because it’s already been included on your Form W-2 as wages and second because the tax preparer will include it on Schedule D as capital gain.
It’s called a basis adjustment. You need to manually increase the reported basis on Schedule D so that you don’t pay tax twice. Believe me, the IRS will not contact you to let you know you made a mistake. This is why going cheap on your tax advisor can cost you thousands.
Give us a call if you have questions.