Stock Options Tax Planning: What You Need to Know About ISOs and NQSOs

Discussing your compensation package with your employer is an exciting time, especially as a new hire. During your orientation meeting, you will get an opportunity to learn about pay cycles, retirement plans, insurance coverages, incentives, and other perks. A lot of it, like your annual salary, will be fairly intuitive. Aspects like bonus rewards are also a straightforward concept. They are usually rewarded once a year and are based on your performance, the company’s revenue overall, or a combination of both. 

What may not be quite so straightforward are your stock incentives. While you may have a sense of what stock grants involve, it will behoove you to spend a little more time and effort acquainting yourself with these benefits, and to consider consulting outside advisory resources to properly address your stock options tax planning strategy.

Stock options tax planning when your company rewards you with stock

Companies have many good reasons to reward employees with stock incentives as a component of their compensation packages. For example, stock grants give employees the opportunity to purchase ownership in the company at a discounted rate if they stick around through the vesting period. It’s a simple truth: we tend to take better care of the things we own or have worked for, and we maintain them more diligently than things we borrow or rent. This principle translates to stock grants as well; when employees are empowered to gain a sense of pride in ownership, they are more motivated to work harder on behalf of the company’s success. 

If you receive stock grants, it’s imperative to know how they can benefit you and what the tax implications are, so they won’t harm you financially when it’s time to file.

There are two types of stock options:

1. Nonqualified stock options (NQSOs)
2. Incentive stock options (ISOs)

Tax implications for NQSOs

Nonqualified stock options are not performance-based stock grants. It doesn’t matter how well the company stock is trading or how often you get promoted. When you start at a company, the exercise price is set on the grant date, and you receive a guarantee that you can purchase your pool of stock after the vesting period has passed. Assuming your company stock continues to climb, you will have purchased stock at a discount off the current market price. How many shares you purchase at a time, up to your grant limit, is up to you. It’s as simple as having the funds deducted from your paycheck, or you can also purchase them using a personal account.

Options with a readily determinable Fair Market Value (FMV) at the grant date are treated as compensation (i.e. taxed as ordinary income), and no income is recognized at the exercise date. For options without a readily determinable FMV at the grant date, no income is recognized. Instead, income is recognized on the exercise date. In this case, the amount to include as compensation is the difference between the price you paid for the options and the FMV. Your employer will deduct the necessary taxes from your income to pay the IRS. In either case, subsequent income from stock sales is considered capital gains. You don’t want to ever exercise your stock options or sell your stock unless you are certain you will have earnings after taxes, trading fees, and the cost of purchasing the shares. Checking in with a tax planner before making any major decisions regarding your stock is important. 

Tax implications for ISOs

The second type of stock option, incentive stock options (ISOs), have special tax treatment because income from them isn’t subject to Social Security and Medicare taxes. If your employer has granted you enough shares to total a current market value of $100,000, congratulations, you have reached the federal maximum limit! However, if you leave the company, you must exercise your rights within 90 days or you permanently lose the grant.

You must hold ISO stock at least 2 years from the grant date and 1 year from the date you exercise your options to qualify for the lower, long-term capital gains tax rate when you sell the stock. Not meeting the holding period requirements can result in gains taxable at ordinary rates. ISOs can also be subject to alternative minimum tax (AMT) if you exercise options and hold the shares. In one scenario, part of your ISO income can become taxed at the long-term capital gains rate while the rest falls under the higher AMT rate. Unused AMT credit can be rolled forward for future tax bill credit on your other investment gains. An unusual scenario would be if the company suffers an unexpected market loss. If you are facing decisions about a complicated ISO matter, consulting with an experienced financial planner can help you determine the best course of action. You could end up being stuck with an AMT bill on stocks which have lost value, and that would be a bad situation, so preemptive action is important. 

Getting expert advice on your stock options tax planning

Navigating how stock options can be used for taxes and financial planning can be challenging, even for expert investors. Seeking the guidance of an experienced tax professional if you have been granted NQSOs, ISOs, or any combination of stock incentives from your employer can help you make the most informed decisions possible about these benefits.

Stock options are a great asset to get excited about, and at SD Mayer we would like to help you to maximize your compensation benefits. Our tax professionals are experts at how taxation rules affect stock options. They, in collaboration with our wealth advisors, will create a plan for you to maximize the financial usefulness of supplemental income generated from your equity shares.

SD Mayer is a team of full-service wealth managers who can maintain, consult, and categorize all of your holdings, including your stock options. We offer a free 30-minute consultation to first-time clients. Just tell us a little bit about yourself by contacting us here and an SD Mayer professional will reach out to you within 24 hours.

Image Credit | g0df4ther | Shutterstock