RSUs, NSOs, and ISOs: Understanding Your Stock Options
Presently, it is common practice for companies, especially startups, to issue equity compensation to attract and retain employees. However, equity compensation comes in various shapes and sizes, primarily, it comes in the form of RSUs, NSOs, and ISOs. Each of these types of equity compensation attracts a unique tax treatment and offers benefits suited to different individuals.
To enable you to make an informed decision, in this article, we will explore what RSUs, ISOs, and NSOs are, and how exactly they differ from one another. Read on to know more!
What are incentive stock options (ISOs)?
Incentive stock options (ISOs) provide employees a tax-advantaged way to participate in their company’s growth as long as they meet the holding requirements. ISOs have a minimum vesting period of at least two years and the resulting stocks must be held for at least one year before they can be sold. ISOs can only be issued to employees and cannot be issued to non-employee service providers such as independent contractors, consultants, and board members.
Let us understand the tax treatment of ISOs in different scenarios.
| 1. Meet the holding requirements and the exercise price is not lower than FMV on the exercise date. | |
| 2. Meet the holding requirements and the exercise price is lower than FMV on the exercise date. | |
| 3. Do not meet the holding requirements. | The ISOs will be treated as NSOs for tax purposes. |
Calculating AMT on ISOs
Now, let us understand what alternative minimum tax (AMT) is and how it is calculated. AMT is meant to enforce a minimum tax and prevent individuals from misusing tax write-offs to pay significantly lower taxes. Currently, income below a certain threshold attracts an AMT of 26%, and income above that threshold attracts an AMT of 28%. However, AMT is a lot more complex than this.
Following are the steps for calculating AMT on ISOs.
1. Calculate the alternative minimum tax adjustment:
Bargain element = FMV on exercise date – Exercise price
AMT adjustment = Bargain element × Number of stocks received
2. Calculate your alternative minimum taxable income (AMTI):
AMTI = Regular taxable income + AMT adjustment + Other AMT-specific adjustments specified in Form 6251
3. Subtract AMT exemption:
For 2025, the AMT exemption amounts are:
- Single or head of household: $88,100
- Married and filing separately: $68,500
- Married and filing jointly: $137,000
You can subtract the applicable exemption from your AMTI.
4. Apply AMT tax rates:
For 2025, the AMT tax rates are:
- 26% if the AMTI is less than:
- $239,100 for a single person or head of household
- $119,550 for married and filing separately
- $239,100 for married and filing jointly
- 28% for income higher than the mentioned thresholds
5. Calculate ordinary income tax liability:
Ordinary income tax for ISO on exercise = AMT adjustment × Ordinary income tax rate
6. Pick the higher tax liability:
You must pay whichever is higher, the AMT or the ordinary income tax.
Taxation of ISOs can be complex and requires a high degree of familiarity with IRS regulations. Connect with Eqvista’s accredited tax advisors to move forward with clarity.
What are non-qualified stock options (NSOs)?
Non-qualified stock options (NSOs) do not provide the same tax benefits as ISOs but also do not have the same holding requirements. Additionally, unlike ISOs, NSOs can be issued to employees as well as non-employee service providers.
- Upon exercise, you will owe ordinary income tax on the difference between the exercise price and the fair market value (FMV), and
- Upon sale, you will owe capital gains tax on the difference between the FMVs on exercise and sale dates.
Prior to the introduction of AMT on ISOs in 1969, ISOs were advantageous since the entire income was taxed at the long-term capital gains tax rate while in NSOs, a part of the income was taxed at the ordinary income tax rate. However, since the introduction of AMT on ISOs, a person may end up with higher taxes on ISOs than on NSOs even if the holding periods, FMVs, number of stock units, and exercise price were all exactly the same.
This can happen when the person’s ordinary income tax rate is lower than their applicable AMT.
Let us understand this with an example. John Deere is an entry-level analyst at DB Wealth Managers and Advisors. His income is $100,000 and the company wants to offer equity compensation. He must decide whether to accept this compensation as NSOs or ISOs.
Stock option details:
| Particulars | Amount |
|---|---|
| Number of stock options | 1,000 |
| Exercise price | $10 per share |
| Fair market value (FMV) at exercise | $50 per share |
| FMV at sale | $80 per share |
| Holding period | 2 years |
NSO tax liability:
First, we will calculate the tax liability upon exercise.
| Particulars | Amount |
|---|---|
| FMV | $50 |
| (-) Exercise price | $10 |
| Net gain per share | $40 |
| (×) Number of shares | 1,000 |
| Income recognized | $40,000 |
| (×) Tax rate | 24% (Based on income of $100,000) |
| Tax owed | $9,600 |
Now, we will calculate the tax liability upon sale.
| Particulars | Amount |
|---|---|
| FMV | $80 |
| (-) FMV on exercise | $50 |
| Capital gains per share | $30 |
| (×) Number of shares | 1,000 |
| Income recognized | $30,000 |
| (×) Tax rate | 15% (Based on income of $100,000) |
| Tax owed | $4,500 |
Therefore, if John Deere chose NSOs, he would owe $14,100 in taxes.
ISO tax liability:
Once again, we will calculate the tax liability upon exercise.
| Particulars | Amount |
|---|---|
| FMV | $50 |
| (-) Exercise price | $10 |
| Net gain per share | $40 |
| (×) Number of shares | 1,000 |
| Income recognized | $40,000 |
| (×) Tax rate | 26% (AMT for income of $100,000) |
| Tax owed | $10,400 |
AMT Calculation:
| No. | Step | Details | Calculation | Amount |
|---|---|---|---|---|
| 1 | Calculate Bargain Element | FMV on exercise - Exercise price | $50 - $10 | $40 |
| 2 | AMT Adjustment | Bargain element × Number of shares | $40 × 1,000 | $40,000 |
| 3 | Calculate AMTI | Regular taxable income + AMT Adjustment | $88,100 (assumed) + $40,000 | $128,100 |
| 4 | Subtract AMT Exemption | AMT exemption (for Single person) = $88,100 | $128,100 - $88,100 | $40,000 |
| 5 | Apply AMT Tax Rates | 26% (for AMTI < $239,100) | $40,000 × 26% | $10,400 |
| 6 | Calculate Ordinary Income Tax | AMT Adjustment × Ordinary Income Tax Rate (24%) | $40,000 × 24% | $9,600 |
| 7 | Pick the Higher Tax Liability | Compare AMT Tax vs. Ordinary Income Tax | Higher of $10,400 (AMT Tax) or $9,600 (Ordinary Income Tax) | $10,400 |
Now, we must calculate the tax liability upon sale.
| Particulars | Amount |
|---|---|
| FMV | $80 |
| (-) FMV on exercise | $50 |
| Capital gains per share | $30 |
| (×) Number of shares | 1,000 |
| Income recognized | $30,000 |
| (×) Tax rate | 15% (Based on income of $100,000) |
| Tax owed | $4,500 |
Therefore, if John Deere chooses ISOs, he will receive $14,900 in taxes.
Thus, we can see that he will incur a lower tax liability if he chooses NSOs since the AMT for him is higher than his ordinary income tax.
What are restricted stock units (RSUs)?
Restricted stock units (RSUs) are a type of equity compensation that converts into stocks upon vesting. Unlike stock options, there is no exercise price to be paid to receive the stocks. When RSUs get vested and converted into common stocks, the employees will owe ordinary tax on the fair market value (FMV) of the stocks received.
The tax upon sale depends on whether the employee made a profit and the length of their holding period. If the employee makes a loss, they can write off the losses to reduce their taxable income. If the employee makes a profit, they will owe long-term capital gains tax if they held the common stocks for over 12 months.
A significant advantage of RSUs lies in their simplicity, which makes it easier to understand their value. Employees can understand them as stocks that are granted periodically as per a vesting schedule. Also, RSUs are more accessible to employees as RSUs put less financial strain on employees due to the lack of exercise prices.
Employees have no control over the timing of stock grants is the major disadvantage of RSU. If an employee would like to reduce their overall income tax liability by exercising early when the fair market value (FMV) is low, they cannot do so with RSUs.
To learn more about early exercise, read this article.
What are the key differences between RSUs, NSOs, and ISOs?
The key differences between RSUs, NSOs, and ISOs are summarized in the following table.
| Particulars | RSUs | NSOs | ISOs |
|---|---|---|---|
| Definition | Stock units that vest over time or upon meeting conditions. | Stock options for buying company stocks at a discount | Stock options for buying company stocks at a discount |
| When are you taxed? | 1. Ordinary income tax upon vesting. 2. Capital gains tax upon sale | 1. Ordinary income tax upon exercise. 2. Capital gains tax upon sale | 1. Ordinary income tax or AMT upon exercise (whichever is higher) 2. Long-term capital gains tax upon sale |
| Holding requirements | None | None | 1. Stock options must be held for at least 2 years. 2. Stocks must be held for at least 1 year |
| Advantages | 1. Simplified structure 2.No upfront cost | Flexibility to control the timing of exercise and sale | Flexibility to control the timing of exercise and sale, albeit less than that of NSOs |
| Disadvantages | No control over timing | No tax benefits | 1. AMT nullifies tax benefits 2. Strict holding requirements |
| Best for | Employees who prefer simple compensation and tax structure, and do not wish to pay exercise prices | Service providers who wish to control the timing of exercise and sale to maximize gains | Employees who are willing to hold and can afford the AMT implications |
Eqvista- Expert guidance for minimizing taxes and ensuring compliance!
Restricted stock units (RSUs) represent an accessible way for most employees to participate in their company’s growth. Employees who would prefer a higher degree of flexibility may prefer stock options to RSUs. Prior to the introduction of AMT on ISOs, ISOs had a beneficial tax treatment since the entire income was taxed at the long-term capital gains tax rate. On the other hand, NSOs attract ordinary income tax upon exercise and capital gains tax upon sale.
However, post-AMT, ISOs may attract a tax rate higher than the ordinary income tax rate upon exercise. Thus, under the current tax structure, employees may prefer receiving NSOs over ISOs.
Meticulous record-keeping of issuance, valuations, exercises, and other key events is necessary to ensure tax compliance when issuing equity compensation such as ISOs, NSOs, and RSUs. This critical task can be streamlined and automated with equity management software such as Eqvista. Our solution helps you make informed equity decisions while staying fully tax-compliant. Contact us to know more!
