Non-qualified stock option

The answer depends on your comfort level with tax complexity and risk. However, understand first that you may be eligible to receive only nonqualified stock options NQSOs to begin with.

Many companies find incentive stock options ISOs not worth the administrative complications , and under the rules of the tax code they cannot be granted to nonemployees, such as directors, consultants, and contractors. Whether one type of option is better than the other depends on what you do with the shares that you acquire at exercise and whether you feel comfortable with the complexities of the alternative minimum tax AMT , which can apply to ISOs.

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• Nonqualified Versus Qualified Stock Options;

If you immediately sell the shares at exercise, the taxation is essentially the same i. If you plan to hold the shares, some tax benefits exist with ISOs as long as the stock continues to appreciate. If you hold the shares for more than one year after exercise and two years after grant, ISOs can provide favorable long-term capital-gains tax treatment on all the stock-price appreciation at sale over the exercise price see the related FAQ.

If you sell ISOs after the tax year of the exercise and at least 1 year after the exercise and at least 2 years after the ISO grant date, then you will be subject to AMT for the year of the exercise AND be subject to long term capital gains tax. Those taxes are calculated based on the spread between the final sale price and the exercise price despite already having paid AMT on the spread between the exercise and the FMV at the time of exercise. However, if you are already subject to AMT in the year of the final sale then the final taxes will only be on the difference between the FMV at the time of exercise and the final sale price.

If you have paid double tax on any portion of the spread, then see this page for details on how to recover the AMT via credits which could take a long time.

When shares resulting from an ISO are sold at least 1 year after the exercise and 2 years from the grant date, then the sale qualifies for long term capital gains treatment on the spread between the exercise price and the final sale price. When ISOs are sold in a disqualifying disposition, then ordinary income tax is paid on the spread between the final sale price and the exercise price. NSOs are similar when sold within a year of exercising. For NSOs, ordinary income tax was paid on the original exercise but short term capital gains was paid on the spread between the final sale price and the FMV at the time of exercise.

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ISO's are not subject to payroll taxes and the short term capital gains on the portion of the income above the FMV from the sale of NSOs can be offset by other capital losses you may have that tax year. Another subtle difference involves payroll taxes. This impacts both the employer and the employee although only the employer pays FUTA.

This negates some of the benefit of investing since the employer's portion of the Medicare tax becomes the employee's responsibility. This makes your overall optimization challenge to be a good spreadsheet problem.

The Differences between ISOs and NSOs | ESO Fund

This last scenario means that in a given year, you may want to exercise and sell NSOs and use the money to exercise ISOs for long term capital gains eligibility because the AMT will be lower or zero. This is calculated by multiplying the number of shares eligible for exercise in any given year by the exercise price. Individuals who have both should consider item 10 to maximize their benefits.

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. 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. 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.

All content provided in this article is for informational purposes only.

Requirements for an Option to Qualify as an Incentive Stock Option

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.