Understanding Employee Stock Options: ISOs and NSOs

Some companies offer stock options as a means of letting their employees take a vested interest in the business while reaping the rewards of its success. Two common plans are incentive stock options and nonstatutory stock options, also known as nonqualified stock options. Here’s a look at stock options

A stock option is a financial instrument that gives employees the right to purchase shares in the company they work for, under conditions set by the employer. This can result in employees making money above and beyond their annual salaries or it can be a means for them to start a savings plan.

Stock options have a vesting schedule, outlined in the stock option agreement, that details the amount of time it takes for employees to become entitled to an increasing percentage of their company stock options. Some companies offer new employees immediate vesting as a type of sign-on bonus. Others structure their plans so that options vest over a period of years, creating an incentive for employees to remain with the company. Still other businesses reward employees for hard work through performance-based stock option plans that vest incrementally when certain performance goals are met.

Ideally a company awards the option to buy company stock some time in the future at the price it is selling at the time. The assumption is that the company will be successful and the price will go up in the future. The current price is called the exercise price.

Let's say that after one year an employee decides to exercise his or her option to buy the company's stock. If the exercise price of the stock was $20 a share when the employee received the option and the stock is now selling at $25 a share, that $5 difference is called the spread.

The key difference between ISOs and NSOs is the way in which the spread is taxed. ISOs offer the possibility of being taxed under long-term capital gains (if the employee holds the stock for at least two years from the date the option was granted and at least one year from the exercise date), whereas NSOs are taxed as both income and capital gains. With NSOs, the spread is viewed as income and is treated as compensation, which is taxed at a higher rate. With ISOs, the tax is deferred and they are taxed as long-term capital gains when the stock is sold, providing the employee follows the rules as set down in the tax code.

There’s one big catch to the seemingly rosy ISO tax scenario. Exercising ISOs can trigger the alternative minimum tax. A large spread alone can result in AMT payment, while in some instances, exercising ISOs will have no AMT consequence at all.

The following compares ISOs and NSOs.

ISOs

• Employees don't have to report any income when they exercise the stock option, unless they sell the stock soon after they buy it.
• Holding the stock for a period of time ensures that the profit will be treated as long-term capital gains, meaning the seller can qualify for the 15 percent maximum rate.
• Because ISOs must conform to section 422 of the tax code, they must follow certain guidelines that NSOs are exempt from.
• ISOs may trigger the AMT.
• Only employees may be granted ISOs.

NSOs

• Employees must report their taxable income when they exercise the option to buy stock.
• The income is treated as compensation, resulting in higher taxes.
• NSOs have fewer regulations and restrictions than ISOs.