by Katie E. Exchange, CFP® | Associate Wealth Manager
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Employee compensation can come in many forms outside the typical W2 income. Employers of both publicly traded and private companies use stock options as an alternative form of compensation to incentivize employees to actively participate in the growth and profitability of the company. While there are many benefits for employers to offer stock options as a form of compensation, there are equally as many benefits to employees who are granted these options. Let’s explore a few of the more common forms of stock options:
Qualified Incentive Stock Options (ISOs)
An ISO is a form of compensation that gives an employee or contractor the ability to exercise (buy) shares of company stock, at a specified price, at a future date. The specified price is determined by the employer and is typically the fair market value (FMV) of the stock at the time of the grant. This price is often referred to as the grant price or the strike price. The future date when the stock can be purchased is determined by the vesting schedule or the timeline in which the shares become vested, or eligible to exercise. Employees must exercise ISOs within 10 years of the grant date otherwise the ISOs will expire and become worthless.
In addition to the opportunity to buy shares at a discount, ISOs offer the potential for favorable tax treatment on appreciation. If an employee holds an ISO two years from the grant date and one year from the exercise date, the difference between the grant price and the FMV of the stock at the time of sale will be taxed at long-term capital gains (LTCG) rates, rather than at ordinary income tax rates. The caveat to the LTCG treatment is that Alternative Minimum Tax (AMT) may be triggered when the employee exercises and holds ISOs depending on his or her tax situation.
Non-Qualified Stock Options (NQSOs)
NQSOs are like ISOs in that they are a form of compensation that enables an employee to buy shares of company stock, at a specified grant price, at a future date determined by a vesting schedule. When an NQSO is exercised, the bargain element becomes taxable as ordinary income. If an employee sells the stock at the time of exercise, there are no additional taxes due. If the employee does not sell the NQSO at the time of exercise, the cost basis of the NQSO is adjusted to the FMV of the stock on the exercise date. The subsequent sale of the NQSO will be taxable as a capital gain. Whether the sale receives favorable long- or short-term tax treatment depends on if the NQSO is held longer than one year after exercise. Unlike ISOs, there is no immediate tax benefit or tax deferral by exercising and holding NQSOs. For this reason, cashless exercises are common with NQSOs. A cashless exercise uses the proceeds from the same-day sale of the stock to cover the exercise cost of the NQSOs. This strategy can be beneficial because it does not require the employee to come up with the cash necessary to cover the cost to exercise.
The major difference between ISOs and NQSOs is the taxation at the time of exercise. There is no income tax due upon exercise of an ISO. The bargain element is used to calculate potential AMT but is not reportable as gross income for income tax purposes at the time of exercise. It is not until the ISO is sold that it is taxable for regular tax purposes and the rate at which it is taxed, ordinary income or LTCG rates, is determined by whether the holding period was met prior to the sale.
Restricted Stock Units (RSUs)
RSUs are another form of compensation that involves the issuance of company stock to employees. Like ISOs and NQSOs, RSUs have a vesting schedule that dictates when the shares become available to the employee. However, unlike ISOs and NQSOs, RSUs typically require that some form of performance metric or length of employment is met prior to vesting. RSUs are not exercised at a grant price. Instead, shares are distributed to the employee upon vesting and assigned the FMV of the stock on the vesting date. A portion of the shares is withheld by the employer and sold to cover taxes generated by the distribution. RSUs are taxable as ordinary income upon vesting. If the employee holds the net shares after distribution, the shares will be subject to capital gains rates upon disposition. The holding period to determine the long- or short-term capital gains treatment begins at the vesting date.
While there are many benefits to receiving these alternative forms of compensation, it is important to handle them properly based on your specific situation. We recommend talking with a tax professional about your specific situation. Boston Financial Management can help facilitate those conversations.
The team at Boston Financial Management is always available for questions. Please do not hesitate to contact your Wealth Manager directly or call our main line at 617-338-8108 and someone from our team of specialists will be happy to speak with you. If you enjoyed this article and have suggestions for future topics, please let us know.