When a company grants stock options, it might grant non-qualified stock options (NSOs) or incentive stock options (ISOs). While both are stock options that provide the right to purchase stock at a predetermined price at a future date in time, they have different restrictions and might have different tax consequences for both the company and the grant recipient.
Incentive Stock Options (ISO's)
Incentive Stock Option Limitations
Incentive stock options can only be granted to employees. A company can grant a maximum of $100,000 per year in ISOs as determined by the strike price. Any options in excess of $100,000 automatically become non-qualified stock options. The strike price of an ISO must be at least the current fair market value of the stock. Options cannot be transferred to anyone else unless the employee dies.
Traditionally if an employee leaves the company, he must exercise his options within three months, or 12 months if he leaves on disability. All incentive stock options expire 10 years after the grant date.
Exercising Incentive Stock Options
Incentive stock options have two potential tax liabilities. When an employee exercises ISOs, he must include the spread to calculate his alternative minimum tax liability if he holds the shares he acquired through the ISOs at the end of the tax year. AMT liabilities can be substantial, and companies are not required to withhold any tax when an employee exercises options.
Selling Incentive Stock Option Shares
After an employee exercises incentive stock options, she can qualify for favorable tax treatment when she sells the shares if she remains employed by the company that granted the options for up to at least three months prior to the stock sales date, if she waits for at least two years from the grant date to sell the stock and if she holds on to the stock for at least one year after she exercises her options. If she satisfies all of these criteria, the entire gain, from the strike price to the sales price, is taxed at the most favorable long-term capital gains rate.
When this happens, the company is not entitled to a tax deduction for the ISO grant. If she doesn't meet the criteria for a qualifying distribution, the options are taxed identically to a nonqualified option, and the company is entitled to a similar tax deduction for the amount of ordinary income it provides the employee.
Nonqualified Stock Options (NSO)
Nonqualified Stock Option Limitations
There are no similar limitations for non-qualified stock options. A company can grant NSOs to anyone, including employees, directors and external consultants or vendors. However, if the strike price of an non-qualified option grant is less than the fair market value of the stock when it's granted, the difference in price is treated as deferred compensation, and might be subject to an additional 20 percent federal income tax plus interest and penalties.
Exercising Nonqualified Stock Options
When a grant recipient exercises non-qualified stock options, he pays tax on the difference between the strike price and the exercise price, called the spread, at the ordinary income tax rate. The company must withhold shares from the transaction for his federal income tax liability. The company is also entitled to take a tax deduction for the amount of the spread.
Selling Nonqualified Stock Option Shares
When a grant recipient sells shares she acquired through non-qualified options, she is taxed on the stock's appreciation at either the short-term or long-term capital gains rate, depending on how long she held the stock.
Stock Option Taxes
Tax Consequences at Grant and Vesting
Provided that the strike price represents the current fair market value of the stock when an option is granted, there are no tax consequences to the grant recipient when either incentive stock options or non-qualified stock options are granted, or when they vest.
Tax Advantage of Incentive Stock Option
When an employee doesn't incur any AMT liability and meets the qualifying criteria, an incentive stock option can be more tax advantageous to the employee than a non-qualified stock option. However, if he doesn't meet the qualifying criteria, she forfeits her tax advantage but retains the more complicated income tax reporting requirements of ISOs.
