If you work for a corporation, you may be awarded employee stock options at some point. That’s good news because you can make extra money if the company’s stock goes up in value in the future. Employee stock options can be either incentive stock options (ISOs) or non-qualifying stock options (NSOs). ISO stock options provide a tax break that NSOs do not. The rules for each type of stock option are different.
ISOs and NSOs
NSOs, also called non-statutory stock options, allow you to buy stock in the company at a predetermined exercise price, usually for a period of several years. If the company stock goes up, you can exercise the stock options to buy shares and then sell them at the market price. NSOs can be awarded to non-employees such as consultants or members of the board of directors as well as to employees. ISOs, also called statutory stock options, work the same way, but may only be awarded to employees of the company, a parent company or a subsidiary. The big difference is that ISOs are tax advantaged. If you follow Internal Revenue Service rules, all of your profits are treated as long-term capital gains with a maximum tax rate of 15 percent. NSO profits are considered ordinary income and are taxable at a rate of up to 35 percent.
It’s easier to understand the differences between ISO and NSO stock options if you first take a look at how NSOs work. When you exercise NSOs, the difference between the exercise price you pay and the market price of the stock on the date of the exercise is your profit and is referred to as the bargain element. Suppose you were granted NSOs with an exercise price of $15 per share and exercise the options after the price rises to $25 per share. Your bargain element is $10 per share. The bargain element is considered compensation and is taxable as ordinary income in the year the options are exercise. Your employer must list the bargain element as income on your W-2 form, which is not required for ISOs.
In order to get the tax advantages of ISOs, you have to wait one year or longer after you are awarded the options before you exercise them. After you buy the stock, you have to hold it for at least one additional year. You normally do not have to pay taxes on the bargain element in the year you exercise ISOs. The bargain element, plus any additional gain in the stock’s value, becomes taxable only when you sell the shares. Provided you meet the holding time requirements, all of your profit qualifies as a long-term capital gain. If you do not satisfy the holding requirement, the ISOs will be treated as NSOs and you’ll have to pay ordinary income tax rates on the bargain element.
Other ISO Rules
ISO stock options are governed by some additional rules that don’t apply to NSO stock options. If you leave your job with the company, you have three months to exercise your ISOs or they revert to NSOs. If you are subject to the alternative minimum tax, you may have to pay ordinary income taxes on the bargain element in the year you exercise ISOs. However, you normally get an AMT tax credit you can use in future years.