ISOs and NSOs Explained
There are two types of options, Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs). Before you exercise your options, it’s best to understand the type of options you have, and how they work.
ISO and NSO Tax Rates
First, ISOs are the tax-favored option type. When you exercise an ISO, there is no applicable income tax. More importantly, if you hold the shares long enough, as explained below, the profit is a long-term capital gain. The long-term capital gains tax rate ranges from 15 to 20 percent.
Second, when you exercise an NSO, you will report compensation income. Compensation income tax rates are as high as 37 percent. When selling the shares, any profit has a capital gains tax rate. Short-term or long-term capital gains rates apply depending on the holding period.
ISO and NSO Amounts
Only the first $100,000 of ISOs granted to an employee that vest in one calendar year is eligible for favorable ISO treatment. Options granted that exceed $100,000 are NSOs for tax purposes.
Timeline
There are three specific timeline events: grant date, exercise date, and sale date.
First, the grant date is the date the company gives the employee the options. Strike price value is determined on this day.
Second, the exercise date is the date you choose to exercise the option to buy the shares. The difference between the market price on exercise date and the strike price is known as the bargain element.
Finally, the sale date is the time when you sell the shares. The amount of time between exercise and sale determines if the gain or loss is short or long term.
ISO Holding Period Requirements
First of all, the rules for ISOs are complicated. The ISO holding periods are from grant to sale and from exercise to sale. There are two ISO holding period rules and both must be satisfied to prevent a disqualifying disposition. To start with, the first rule is the grantee must hold the exercised ISO shares at least one year from the date of exercise before selling them. On top of this, the second rule is that the grantee must hold the shares from an ISO exercise at least two years from the grant date before selling them. If there is a violation of either rule, then it is a disqualifying disposition. For tax purposes, the ISO becomes an NSO.
Most often, the event that triggers a disqualifying disposition is the sale date. If a sale occurs less than two years from the grant date or less than one year from the sale date, there is a disqualifying disposition.
Dispositions
As long as ISOs meet the rules above, in return, the IRS imposes no income tax at grant date or exercise date. Moreover, when employees hold the shares for longer than one year, they are taxed at the long term capital gains rate.
Additionally, NSOs don’t have any holding period requirements. At exercise, income tax is due on the difference between the strike price and the share’s current market price. There is capital gains tax at sale, on the difference between the share price at acquisition and the sale price.
To sum up, NSOs have two tax implications, at exercise and at sale. ISOs have one tax consideration at sale and are not subject to regular tax when exercised, as long as they meet the holding requirements.
Timing of Dispositions and Taxes
If there is an ISO sale in the same calendar year as they were exercised, the bargain element is taxable compensation subject to FICA and FUTA. Remember, the bargain element is the difference between the market price on exercise date and the strike price.
To start with, FICA (Federal Insurance Contribution Act) taxes fund Social Security and Medicare. The tax rate for Social Security is 6.2% for the employer and 6.2% for the employee, totaling 12.4%. Furthermore, the rate for Medicare is 1.45% for the employer and 1.45% for the employee, adding up to 2.9%. Additionally, employers are responsible for withholding 0.9% Additional Medicare Tax on an individual’s wages paid in excess of $200,000 in a calendar year.
Next, FUTA (Federal Unemployment Tax Act) is a federal payroll tax that helps fund state workforce agencies and programs, such as unemployment insurance. The FUTA tax rate is 6.0%. The tax applies to the first $7,000 paid to each employee as wages during the year. Your state wage base may be different based on the respective state’s rules.
In addition, when there is an ISO sale within 12 months of exercise, but in the following calendar year the bargain element is ordinary income and not subject to FICA or FUTA.
Here’s a table that outlines the taxation differences between ISOs and NSOs.
ISO and NSO Comparison
| Event | ISOs | NSOs |
|---|---|---|
| Option Granted at $10 | No taxes | No taxes |
| Vesting Period | Vesting is 1 year | No vesting period |
| Exercise at $50 | Bargain element is $40 and is an AMT add back item. Basis is $10. | Difference of $40 is taxable at ordinary income tax rate. Basis is $50. |
| Holding Period | Sale at least 1 year from exercise date and 2 years from grant date | Over 1 year from exercise to sale for long term capital gains tax |
| Sale at $100 | Excess above basis is a capital gain of $90 | Excess above basis is a capital gain of $50 |
Helpful Examples
Example 1
The grant date for an ISO is April 2018 for $10 per share. In June 2019, you exercise the option when the market value is $50 per share. Then, in December 2019, you sell the shares at $100 per share.
In this instance, the shares were sold within one year of exercise, so they lose their ISO status and are treated as NSOs. Furthermore, the exercise and sale took place in the same calendar year, the bargain element of $40 is compensation and taxed as wages and subject to FICA and FUTA. The $50 gain is taxed as a short term capital gain because the shares were held for less than a year from exercise.
Example 2
The grant date for an ISO is April 2018 for $10 per share. In December 2018, you exercise the option when the market value is $50 per share. Subsequently, in June 2020, you sell the shares at $100 per share.
In this situation, the shares were sold within two years of the grant date, so ISO status is lost, and are treated as NSOs. In addition, the exercise and sale did not take place in the same calendar year, the bargain element of $40 is taxed as wages and not subject to FICA and FUTA. The $50 gain is taxed as a long-term capital gain because the shares were held longer than one year from exercise.
Example 3
The grant date for an ISO is April 2018 for $10 per share. In June 2019, you exercise the option when the market value is $50 per share. Following this, in September 2020, you sell the shares at $100 per share.
In this case you observed both holding period rules and the shares retain their ISO status for tax purposes. The $40 is an Alternative Minimum Tax (AMT) add back item and the $90 is a long-term capital gain.
Planning Strategies
Tax timing issues are very important with options. With NSOs, at the time of exercise, you pay ordinary income tax, and potentially FICA and FUTA taxes. The employee must have ample cash to purchase the shares and pay the tax at exercise.
ISOs have no ordinary income tax due at time of exercise. However, the bargain element is an AMT add back item. More on the AMT next time.
Each financial situation is unique, and you need to decide based on your own financial goals and desires what to do with your options. By understanding the difference between ISOs and NSOs, you will be able to make tax-savvy, long-term choices to help meet your goals. To chat further about your ISOs and NSOs, you can set up a free consultation.