Stock Option Taxation: What you need to know

Stock options represent a rare opportunity for the general public to enter the private equity asset class which offers stupendous wealth creation potential. Another benefit of stock options is that employees get taxed at the long-term capital gains tax rate which can be much lower than their marginal income tax rate.

Offering stock options doesn’t benefit just the employees but also the employers. In recent times, the use of stock options as a tool for attracting and retaining talent has been popularized.

To fully harness the benefits of stock options, it is important to understand the different types of stock options and how they are taxed.

How are stock options taxed? ISO and NSO Explained

Employee stock options can be broadly categorized as incentive stock options (ISOs) and non-qualified stock options (NSOs). ISOs can be issued only by corporations to employees while NSOs can be issued by corporations, limited liability companies (LLCs), and partnerships to any service provider including directors, advisors, and even consultants.

Typically, there are two instances when a stock option can be taxed, when it is exercised and when the resulting stock is sold.

When an NSO is exercised, the service provider must include the difference between the fair market value and the exercise price as their ordinary income. On the other hand, employees need not pay taxes when they exercise their ISOs.

The capital gains on stock sale are taxed as capital gains for ISOs as well as NSOs.

An ISO will be treated as an NSO if the employee doesn’t hold the stock option for at least 2 years and the resulting stock for at least 1 year. Since the individual income tax rate can be as high as 37% but the long-term capital gains tax rate tops off at 20%, typically, employees should try to meet their ISOs’ holding requirements.

The employer doesn’t receive any tax benefits from ISOs. However, when an NSO is exercised, the employer can make a tax deduction equal to the income recognized by the employee upon exercise.

Summary of ISO and NSO

Particulars	Incentive Stock Options (ISOs)	Non-qualified stock options (NSOs)
Who can offer to whom?	Corporations can offer ISOs to employees.	Corporations, limited liability companies (LLCs), and partnerships can offer NSOs to any service provider including directors, advisors, and consultants.
What are the holding period requirements?	Options must be held for 2 years and the resulting stock must be held for 1 year.	No holding requirements.
What is the tax treatment on exercise?	No tax on exercise.	The difference between fair market value (FMV) and exercise price must be recognized as ordinary income. (max. tax rate of 37%)
What is the tax treatment on the sale of assets?	Capital gains are taxed as per the long-term capital gains tax rate. (max. tax rate of 20%)	The holding period determines if gains are taxed as long-term (max. tax rate of 20%) or short-term capital gains (max. tax rate of 37%).
What is the tax benefit to the employer?	No tax benefit.	Income recognized by the service provider upon exercise can be deducted.
Who should you offer them to?	Employees who can adhere to the holding requirements.	High-income service providers who prefer the flexibility to exercise whenever they please.

When should you exercise your stock options?

The timing of exercising stock options should depend on your dividend expectations and the stock option type. If there are no immediate threats to your company, it makes sense to adhere to the holding requirements of your ISOs.

However, if the gains from expected dividends outweigh the taxes paid upon exercise, you may want to exercise early. Let us visualize this with an example where we own options for 100 shares.

Scenario	Details	Outcome
Choice 1: Do Nothing (Hold the Option)	Stock Price: $60 Option Fair Value: $10 Dividend: $2 Stock Price Post-Dividend: $58	The option value will drop to $8 (in parity with the stock price). Loss - $2 per share ($200 total).
Choice 2: Exercise Early	Stock Price: $60 Option Fair Value (Intrinsic): $10 Dividend: $2	Exercising will lock in $10 intrinsic value. Stock price drops to $58 post-dividend, but you receive a $2 dividend. Hence, No loss occurs.

Since the tax treatment of NSOs is slightly more complex than ISOs, we shall explore when to exercise NSOs in the following section.

Effective tax planning with Capital Gains Tax & Ordinary Income Tax

When you get compensated in NSOs, a part of your income will be taxed as ordinary income and the other part will be taxed as capital gains. Since the maximum tax rate on ordinary income is higher than that on capital gains, it makes sense to reduce the ordinary income component. You may recall that the ordinary income component is equal to the difference between the fair market value (FMV) at the time of exercise and the exercise price.

Typically, a company’s FMV increases with time. This is especially true for startups that tend to grow manifolds with funding rounds and liquidity events such as initial public offerings (IPOs).

Hence, by exercising NSOs as early as possible, employees can reduce the ordinary income component and effectively reduce their tax liability. Let us understand this with an example.

Here, we will observe the differences in tax liability for early exercise and late exercise.

Scenario	Details
Exercise Price	$5 per share
Shares	100
FMV at Early Exercise	$8 per share
FMV at Late Exercise	$20 per share

Tax at Exercise

Exercise Timing	Exercise Date	FMV at Exercise	NSO Spread	Tax Impact
Early Exercise	07/01/2022	$8 per share	$8 x 100 - $5 x 100 = $300	Lower ordinary income tax ($300 spread taxed) at 37% (assumed) = $111
Late Exercise	07/01/2023	$20 per share	$20 x 100 - $5 x 100 = $1,500	Higher ordinary income tax ($1,500 spread taxed) at 37% (assumed) = $555

Capital Gains Tax on Sale

Sale Example	Exercise Date	Sale Date	Sale Price	Cost	Capital Gain	Tax Impact
Long-Term Holding	07/01/2022	08/01/2023	$25 per share	$800	$25 x 100 – $800 = $1,700	Long-term capital gains at 20% (assumed) = $340
Short-Term Holding	07/01/2023	01/01/2024	$25 per share	$1,500	$25 x 100 – $1,500 = $1,000	Short-term capital gains (taxed as ordinary income) at 37% (assumed) = $370

Option Opted	Total Tax
Early Exercise + Long-Term Holding	$111 + $340 = $451
Late Exercise + Short-term Holding	$555 + $370 = $925
Tax Savings by Opting for Early Exercise + Long-Term Holding	$474

Timing Strategy	Tax Benefit
Exercise Early	Reduces ordinary income by limiting NSO spread at exercise.
Hold >1 Year After Sale	Long-term capital gains are taxed at a lower rate than ordinary income.

Frequently Asked Questions (FAQs)

Some of the queries that frequently come up when stock options are discussed are as follows:

What are the holding period requirements for qualifying dispositions of ISOs?

To qualify for the beneficial tax treatment of ISOs, you must hold the stock options for 2 years and the resulting stocks for 1 year.

What happens if I assign my stock options to someone else?

Employee stock options are generally non-transferrable as they are earned by an employee by serving their company. However, under extreme circumstances such as the employee’s death, terminal illness, or disability, companies may allow a transfer to heirs or dependents under good faith.

How do I calculate the gain from exercising stock options?

The gain from exercising stock options can be calculated as the difference between the total exercise price paid and the fair market value (FMV) of the total stocks received.

How does the exercise price affect my basis in shares?

When you exercise stock options, your cost basis is calculated as the exercise price multiplied by the number of stocks received.

What factors influence the value of my stock options?

Factors such as economic conditions, industry conditions, company-specific risks, exercise price, vesting period, dividend expectations, liquidity event expectations, and interest rates can influence the value of your stock options.

What are the tax benefits of holding ISOs versus NSOs for more than a year?

When an ISO’s holding requirements are met, they are taxed as long-term capital gains whereas a part of the income from NSOs is taxed as ordinary income. The maximum tax rate is 20% on long-term capital gains and 37% on ordinary income.

Eqvista – Empowering you to navigate equity with confidence!

For employees, stock options are an attractive wealth creation opportunity that comes with tax benefits. At the same time, a well-crafted stock option plan can benefit employers by boosting morale and improving employee retention.

To fully communicate the tax benefits of stock options, employers must understand the differences between incentive stock options (ISOs) and non-qualified stock options (NSOs).

ISOs have a tax advantage over NSOs because the entire income from ISOs is taxed as capital gains but a part of the income from NSOs is taxed as ordinary income. You can reduce the ordinary income component from NSOs by exercising them as early as possible.

You may want to issue both, ISOs and NSOs, to cater to the differing needs of your employees and service providers. However, this can prove challenging when you have a high number of employees with differing vesting schedules and exercise prices. This is where Eqvista comes in. On our platform, you can track vesting schedules, issue equity compensation, and seek board approval for the same. Contact us to know more!