In general, a stock option is a financial instrument giving an employee the right to purchase shares in his or her own company, under conditions set by the employer. 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 (ISOs) and nonstatutory stock options (NSOs), also known as nonqualified stock options.
The key difference between these two types of stock options is the way in which they are taxed: ISOs are mainly taxed under long-term capital gains and its inherent advantages, whereas NSOs are taxed as both income and capital gains.
Ideally, the company you work for awards you the option to buy company stock sometime in the future at the price that it is currently selling. This current price is called the exercise price. The exercise price set in the option is usually the market price of the stock at the time the option is granted. The assumption is that the company will be successful and the price will go up in the future.
Let’s say that after one year you decide to exercise your option and buy the company’s stock. If the exercise price of the stock was $20 a share when you received the option but the stock is now selling at $25 a share, then that $5 difference is called the spread.
It is with the spread that the tax differences between ISOs and NSOs become apparent: 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 taxed as long-term capital gains when the stock is sold, providing the employee follows the rules as set down in the tax code. To be eligible, the stock must be held for at least two years from the date when the option was granted, and at least one year from the employee’s exercising of the option.
Incentive Stock Options:
– You don’t have to report any income when you exercise the stock option, except if you sell the stock when you buy it.
– Holding the stock for a period of time ensures that your profit will be treated as long-term capital gains, meaning you can qualify for the 15 percent maximum rate.
– Because ISOs must conform to section 422 of the tax code, they are required to follow certain guidelines that NSOs are exempt from.
– Only employees are eligible to be granted ISOs.
Nonstatutory Stock Options:
– You must report your taxable income when you exercise the option to buy stock.
– The income is treated as compensation, resulting in higher taxes.
– NSOs have less regulations and restrictions than ISOs.
Note: Something to keep in mind when exercising ISOs is that you can sometimes be taxed the alternative minimum tax (AMT). However, this is still less than the income tax of NSOs and can be recovered by claiming an AMT credit.