Decisions, Decisions: Incentive vs. Non-Qualified Stock Options
Originally published on January 30, 2017
Updated on October 31st, 2023
Attracting the best employees to your company takes more than a challenging job, competitive salary and corner office with a nice view. Among the most popular tools at a firm’s disposal are stock options, which often provide financial value without requiring the company to spend actual cash.
Unlike actual stocks, a stock option is a contract that gives an employee the right to buy company stock at a set price by a certain date. The act of actually buying the stock is called exercising, the date it’s purchased is the exercise date, and the price at which the stock is purchased is the exercise price. Depending upon the kind of option offered, this price can be well below the fair market value (FMV) of the stock; the difference between these two prices is called the spread.
The two most popular ways to issue options are incentive stock options and non-qualified stock options. Incentive stock options, or ISOs, can be issued only to employees of the company and are generally nontransferable. There are additional requirements for employees who are shareholder owners of 10% or more of the company, such as an exercise price that must be at least 110% of FMV at the time the options are granted.
ISOs often have more favorable tax treatment, but there are stricter rules in granting them. For example, an employee with ISOs does not pay taxes on this option until the date he or she actually sells the stock, at which point any gain is subject to the long-term capital gains rate (which is in most cases lower than the individual’s ordinary income tax rate). However, several conditions must be met, including but not limited to:
- The employee has to hold the stock for at least one year after exercise date and two years after the date the option was granted.
- The employee can only exercise up to $100,000 of stock options per calendar year (as determined by their fair market value on the date the options were granted to the employee).
- The exercise price must be equal to or greater than the FMV of the company’s stock on the grant date.
- Sale of the stock must abide by a written plan (approved by shareholders) indicating who can buy the options and other restrictions.
The company is not entitled to a federal tax deduction unless an employee sells his or her stock before the holding period expires. In this case, the employee must also pay taxes on the profit at the ordinary income tax rate. Note that an employee holding ISOs can also be subject to the Alternative Minimum Tax (AMT) on the spread, which can increase his or her tax obligation.
Non-qualified stock options, or NQSOs, can be granted to anyone – not only employees but also contractors, consultants, board members and anyone else the company deems appropriate. The only stipulation is that the issuance should be approved by the company’s board of directors and abides by a written agreement.
The AMT does not apply to any gains made on the sale of NQSOs, but overall they have fewer tax advantages for the recipient. When the recipient exercises their option, income is recognized equal to the difference between the exercise price and the FMV of the stock at that time; that income is subject to ordinary income tax withholding. If the stock is sold less than one year from exercise, short-term capital gains tax rates apply (which can be higher than the long-term rates that would apply if the recipient holds the stock longer than one year). The company issuing the option does have one additional advantage in that it will receive a deduction on the spread of the exercise.
The type of stock option you choose depends not only upon the tax implications, but also on your entity structure. There are countless stipulations and caveats for entity structures, so it’s best to consult with your CPA to determine what works best for your business.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
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