For many employees in the US, especially those at startups, stock options are a part of their compensation packages. While the right to buy stock in a company at a set price is an attractive form of compensation, stock options have more complex tax implications than straight cash.
Stock Options: NSOs and ISOs
The two basic types of stock options are Non-qualified Stock Options (NSOs) and Incentive Stock Options (ISOs) and they both have different tax provisions.
Both NSOs and ISOs are subject to a vesting schedule during which employees can buy a certain number of shares each year over a period of several years. Regardless of the duration of the vesting schedule, the employee is generally locked into the grant price at which options were granted to him/her. This means that even if the value of the company skyrockets, the employee will still be able to buy stock options at the pre-determined grant price.
Employees are more likely to receive NSOs – an option that lets you buy shares of the company’s stock at a predetermined price (aka grant price) within a specific time frame. If the value of the stock goes up, the employee will be able to sell it for a profit.
On the other hand, an ISO is a corporate benefit that gives an employee the right to buy shares of company stock at a discounted price with the added benefit of possible tax breaks on the profit. The profit on qualified incentive stock options is usually taxed at the capital gains rate, and not the higher rate for ordinary income. ISO exercises qualify for special tax treatment only if the employee meets certain requirements, and the tax scheme depends on when the employee decides to exercise and sell the stock options that were granted to him/her.
Tax implications on NSOs and ISOs
NSOs give employees the right, within a designated time frame, to buy a set number of shares of their company’s shares at a preset price. It may be offered as an alternative form of compensation. The employee pays ordinary income tax on the difference between the grant price and the price at which the option was exercised.
On the other hand, ISOs have more favorable tax treatment than NSOs because they require the employee to hold the stock for a longer time period.
| NSOs | ISOs |
| When is the tax levied? | Tax is levied at the time of both exercise and sale | Tax is levied only at the time of sale |
| Conditions on exercise | If FMV > Strike price- The company reports the difference as an extra income to the IRS.
- The employee pays ordinary income tax and additional payroll tax on (FMV on Exercise Date – Strike Price)
| - The company is not required to report this to IRS
- No tax is levied from the employee
|
| Conditions on sale | If NSOs are sold within 1 year of exercise,- The employee pays short-term capital gain tax on (Selling Price – FMV on Exercise Date)
If NSOs are sold after 1 year of exercise, - The employee pays long-term capital gain tax on (Selling Price – FMV on Exercise Date)
| If ISOs are sold within 1 year of exercise,- Profit is treated as ordinary income
If ISOs are sold 1 year from the date of exercise and 2 years from the date of grant, - The employee pays long-term capital gain tax on (Selling Price – Strike Price)
|
Examples of how stock options are taxed
NSOs
Assume that a startup grants 500 ISOs to Harry on December 1, 2019. Assuming all his options have vested, and he goes on to exercise 500 NSOs in December 2020 at $1 each when the FMV of shares was $5 each. In this situation, Harry will pay an ordinary income tax plus payroll taxes on [500 x ($5 – $1)] = $2000
Suppose Harry sells all 500 shares in March 2021 for $10 each. In this situation, Harry will pay a short-term capital gains tax on [500 x ($10 – $5)] = $2500
If Harry sells all 500 shares in March 2022 for $20 each, he will pay a long-term capital gains tax on [500 x ($20 – $5)] = $7500
ISOs
Assume that a company grants 500 ISOs to Harry on December 1, 2019. Harry may exercise the option according to his vesting schedule, and buy the 500 shares, after a certain date, say December 2021. Harry can sell the options at any time on or after December 2022 to be eligible to treat the profit as capital gains.
As of 2020 and 2021, the capital gains tax rates are 0%, 15%, or 20%, depending on the income of the individual filing.
In general, taxes are not implied on employees until shares are sold. However if shares are not sold in the same year in which they were exercised, the employee might have to pay an AMT (Alternative Minimum Tax) – a tax obligation designed to make sure everyone, especially high earners, pays an appropriate amount of income tax. AMT calculation depends on income filing status, strike price, FMV, and how many options have been exercised or are to be exercised.
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FAQs
Statutory stock options
You have taxable income or deductible loss when you sell the stock you bought by exercising the option. You generally treat this amount as a capital gain or loss. However, if you don't meet special holding period requirements, you'll have to treat income from the sale as ordinary income.
How are NSO stock options taxed? ›
Taxes for non-qualified stock options (NSOs)
When you exercise an NSO, any spread between the FMV on the date you exercise and the price you are paying for the stock is considered ordinary income to you. Your company will usually withhold ordinary income tax (including federal, payroll and any applicable state taxes).
How is equity stock taxed? ›
You may have to pay capital gains tax on stocks sold for a profit. Any profit you make from selling a stock is taxable at either 0%, 15% or 20% if you held the shares for more than a year. If you held the shares for a year or less, you'll be taxed at your ordinary tax rate.
How are ISOs taxed? ›
While it is true that ISOs are not subject to ordinary income tax on exercise, the spread between the strike price and fair market value of the stock at exercise is subject to the alternative minimum tax (AMT) on exercise.
Are options taxed like stocks? ›
How Are Options Taxed? If an equity option is a short-term capital gain or loss, it is taxed as income. If it is long-term, gains and losses are taxed as capital gains.
How to minimize tax on stock options? ›
Stock Option Planning to Mitigate Your Tax Burden
There are two common strategies to convert stock option wealth to long-term capital gains: Exercise and hold incentive stock options (ISOs) Early exercise and file an Internal Revenue Code Section 83(b) election on your nonqualified stock options (NQSOs)
Are non-qualified stock options taxed as ordinary income? ›
A non-qualified stock option (NSO) is a type of employee stock option wherein you pay ordinary income tax on the difference between the grant price and the price at which you exercise the option.
How to minimize taxes on NSO? ›
If you exercised at least a year prior: long-term capital gains rates. This is the best tax case. Your remaining gain is taxed at long-term capital gains rates, which is lower than ordinary income rates. This means your net gain is higher and you maximize your NSO earnings.
What is the difference between NSO and stock options? ›
What are Non-Qualified Stock Options (NSOs)? Non-qualified stock options are a type of stock option that do not have the restrictions that ISOs have. NSOs can be granted to employees, contractors, directors, vendors, and other parties. There is also no limit on the value of NSOs that can be granted in a year.
What is the difference between ISO and NSO tax? ›
However, exercising an ISO is subject to Alternative Minimum Tax (AMT), which comes into play for wealthier tax payers or when the spread is large. NSOs are subject to the higher ordinary income tax rate on the spread as well as the payroll taxes (Medicare , FICA, etc.) for both the employee and employer.
Income from exercise or vesting appears on IRS Form 1099-NEC (“Nonemployee Compensation”) as self-employment income. This is shown in Boxes 1 and 7 of Form 1099-NEC. You report that income on Schedule C of your Form 1040 tax return.
How to report NSO on tax return? ›
The tax reporting for NSOs is entirely different. In the year the NSOs are granted or become vested, the employee includes nothing in income. However, in the year the NSOs are exercised, the spread (fair value less strike price) is included as W-2 income to the employee.
Are ISOs taxed twice? ›
A short recap of how your ISOs are taxed: You pay AMT when you exercise them (unless the AMT you owe is lower than your AMT threshold) You again pay tax when you sell them (or, to be precise, when you sell the shares you bought by exercising them) and make a gain.
What is the ISO 10 year rule? ›
Section 422(b)(2) defines an ISO as an option granted to an individual for any reason connected with his employment by a corporation, if granted by the employer corporation or its parent or subsidiary corporation, to purchase stock of any of such corporations, but only if, among other requirements, such option is ...
Are ISO reported on w2? ›
†ISOs have no tax withholding and no Social Security or Medicare tax. Income is reported on Form W-2 only with a disqualifying disposition.
Are RSUs taxed twice? ›
So how do RSUs get taxed? You'll owe taxes on your equity compensation twice, at vesting and when you sell. Vesting - On your vesting date, you automatically own shares of the company stock. The stock has a fair market value which is your cost basis.
Do you pay taxes on stock given by an employer? ›
Shares of stock received or purchased through a stock plan are considered income and generally subject to ordinary income taxes. Additionally, when shares are sold, you'll need to report the capital gain or loss. Learn more about taxes, when they're paid, and how to file your tax return.
How to calculate gain on stock options? ›
To calculate your gain or loss, subtract the original purchase price from the sale price and divide the difference by the purchase price of the stock. Multiply that figure by 100 to get the percentage change.
