Incentive versus nonqualified stock options

In short

A friend of mine once held a stock option letter for three years before he asked anyone what it meant. If you have a letter like that in a drawer, this page is for you. An option is a right to buy company stock at a fixed price, and the two kinds are taxed in very different ways. A nonqualified option, often called an NSO, is taxed as pay on the day you exercise, which means the day you buy. An incentive option, called an ISO, can defer regular tax, but it can trigger a second tax system called the alternative minimum tax. Before you exercise anything, find your grant price, your expiration date, and the current value of the shares. Then ask your plan administrator which kind you hold. That one answer shapes every step after it.

The whole of it

What it is

I once watched a neighbor sell a barn for far less than it was worth, simply because nobody told him what the land beneath it was worth. Stock options can feel like that barn. You hold something of value, but the paperwork hides it. A stock option gives you the right to buy a set number of company shares at a set price, called the strike price or grant price. You do not have to buy. The right lasts until an expiration date.

There are two main kinds. The nonqualified stock option is the plain version. Any company can offer it to anyone. The incentive stock option is the special version. It is only for employees, and it must follow the rules in Section 422 of the Internal Revenue Code. Those rules are why the tax treatment can be better, and also why the traps are deeper.

You earned these. That matters. Knowing what you hold is a way of respecting your own hard work.

How it works

You have probably heard the word vesting, and it simply means the date you become free to exercise. Say your grant vests over four years. Each year, a slice of the option becomes yours to use.

With a nonqualified option, the tax comes at exercise. The gap between the market price on that day and your strike price is called the spread. The spread is treated as wages. It is subject to income tax, Social Security tax up to its yearly wage cap, and Medicare tax. Your employer usually withholds some of it. Then, when you later sell the shares, any further gain or loss is a capital gain or loss, measured from the market price on the day you exercised.

With an incentive option, the picture changes. At exercise, you owe no regular income tax on the spread. That sounds wonderful, and it can be. But the spread counts as income under the alternative minimum tax, a parallel calculation that makes sure higher earners pay at least a floor amount. Then comes the sale. If you hold the shares for more than one year after exercise and more than two years after the grant date, the whole gain is taxed as a long term capital gain. That is called a qualifying disposition. If you sell sooner, it is a disqualifying disposition, and part of the gain is taxed as ordinary pay.

Timing matters. So does patience.

The numbers, and where to find yours

If you are holding an option letter, start with four figures. Find the strike price, the number of shares, the vesting dates, and the expiration date. Your plan administrator or the stock plan website will list them. Your grant agreement will also say whether the option is an ISO or an NSO.

Some limits are set by law and change over time. The yearly cap on how much ISO value can first become exercisable in one year is the current figure, which the official source publishes each year, and anything above that is treated as nonqualified. The alternative minimum tax exemption amount is the current figure, which the official source publishes each year, and it shrinks at higher incomes starting at the current figure, which the official source publishes each year. The AMT rates are the current figure, which the official source publishes each year. The Social Security wage cap that applies to your option pay is the current figure, which the official source publishes each year. The holding periods I mentioned are one year from exercise and two years from grant, and your tax advisor can confirm them against Section 422.

For the rules themselves, read IRS Publication 525, called Taxable and Nontaxable Income, and Form 6251, which is the form used to figure the alternative minimum tax. Form 3921 is the statement your company sends after you exercise an ISO. It records the dates and prices you will need later.

A worked example

Let me tell you about a woman I will call Dana. She earns a salary of 220,000 dollars. Her company granted her 1,000 options with a strike price of 10 dollars a share. Two years later the shares are worth 40 dollars, and she decides to exercise all 1,000 options.

First, suppose they were nonqualified. The spread is 40 minus 10, which is 30 dollars a share. Multiply 30 dollars by 1,000 shares, and you get 30,000 dollars. That 30,000 dollars is added to her pay for the year. Her pay becomes 220,000 plus 30,000, which is 250,000 dollars. Suppose her top bracket is 32 percent. The extra income costs her 30,000 times 0.32, which is 9,600 dollars in regular income tax. Medicare tax adds 30,000 times 0.0145, which is 435 dollars. So the exercise costs about 10,035 dollars in tax, before any state tax, and she also has to pay 10,000 dollars to buy the shares. The cash needed is near 20,000 dollars.

Now suppose the same options were incentive options. Her regular tax at exercise is zero. But the 30,000 dollar spread goes into her alternative minimum tax calculation. Whether she owes anything extra depends on her exemption and her other income, so she should run Form 6251 or ask a tax professional before she acts. If the AMT does apply, she may owe a few thousand dollars in a year when she received no cash from selling anything. She may later claim a credit for AMT paid, but that credit comes back slowly.

If she then waits the full holding period and the shares are worth 50 dollars when she sells, her gain is 50 minus 10, which is 40 dollars a share. Times 1,000 shares, that is 40,000 dollars, all taxed at long term capital gain rates. That is the best case the incentive option offers.

Where it goes wrong

I have seen smart, careful people stumble here. The most common stumble is exercising an incentive option and owing alternative minimum tax on money they cannot touch. If the shares then fall in value, the tax bill can be larger than the shares are worth. That hurts. It is also avoidable with a little planning before you act.

Another stumble is missing the expiration date. An option that expires is worth nothing. Mark that date somewhere you will see it.

A third is leaving the company. Most plans give you a short window after your last day to exercise, often ninety days. For an incentive option, the law itself ends ISO treatment if you exercise more than three months after leaving. After that, the option is treated as nonqualified.

A fourth is forgetting that the company's stock may be thinly traded or private. Then you may owe tax on a paper value with no market to sell into. Look at whether your plan allows a sale to cover the tax.

Last, many people assume their employer withheld enough. Withholding on option pay is often a flat rate. If your bracket is higher, you may owe more at filing time. Check your estimated tax payments.

Questions to answer before you leave this page

Do you know whether your grant letter says ISO or NSO, and have you found the strike price and the expiration date? Have you looked up how many shares have vested and how many are still waiting? If you exercised today, could you pay both the purchase price and the tax without borrowing or stretching? Have you asked your plan administrator whether your company lets you sell some shares to cover the tax? Have you estimated whether the alternative minimum tax might apply to you, perhaps by trying Form 6251 with your own numbers? And have you set a date on your calendar to talk with a tax professional before you exercise, not after?