Introduction

When reviewing U.S. stock option plans for our foreign clients, we are constantly asked to explain the difference in tax consequences between incentive stock option (ISO) plans and nonqualified stock option (NSO) plans. This is a frequently asked question as many U.S. companies offer their employees options to buy company stock at a specified price (commonly referred to as the option’s “strike price”). This post will provide a general summary of the tax consequences both to the recipient of an ISO or NSO and to the issuing company.

Incentive Stock Options

Subject to certain exceptions as discussed below, an ISO is generally eligible for the following tax benefits: (i) the employee doesn’t recognize any taxable income upon either the grant or exercise of the ISO and (ii) gain on the subsequent disposition of Company stock acquired upon exercise of an ISO is treated as long-term capital gain.

The employee is eligible for these advantageous tax consequences only if the employee does not dispose of the shares received pursuant to the exercise of the ISO within 2 years from the date of the granting of the ISO nor within 1 year after the ISO was exercised. We note that in practice, ISOs are generally only granted by public companies where liquidity could be obtained by the recipient prior to a sale of the company and therefore the required share holding period of 1 year after exercise can be satisfied. In addition, the employee must exercise the ISO within three months after ceasing to be employed by the company (or its subsidiary or parent) or one year in the case of cessation of employment caused by permanent disability.
For an example of the benefits of an ISO, assume that a company issues an option to purchase 1 share of stock with a strike price of $5, which is also the share value on the grant date. One year later, the employee exercises the option and pays the company $5 to purchase 1 share of stock when the share value has increased to $50. Although the employee has realized an economic benefit of $45 (i.e. the $50 share value less the $5 strike price) at the time of exercise, the employee will generally not recognize any taxable income. One year after exercising the option, the employee sells the stock acquired when the share value has increased to $100. The employee has $95 of gain (i.e. the $100 amount realized on the sale less the employee’s $5 cost for acquiring the share of stock) which is treated as long-term capital gain (currently taxed at a maximum rate of 23.8%). Here is a summary describing this hypothetical, using the date of issuance as May 10, 2016:

  1. May 10, 2016- share value is $5: company issues an option to purchase 1 share of stock with a strike price of $5.
  2. May 11, 2017- share value is $50: employee exercises the option and pays the company $5 to purchase 1 share of stock.
  3. May 12, 2018- share value is $100: employee sells the share for $100. Employee has $95 of gain that is treated as long-term capital gain.

If the employee satisfies the holding period requirements, the company issuing the ISO receives no deduction at either the time of grant or exercise of the ISO.

In addition, based on the Internal Revenue Code(the Code), the following requirements must be met in order to be properly considered an ISO:

  • The option must be granted to an individual in connection with his or her employment by the company (or a company subsidiary);
  • The option must be granted within 10 years from the earlier of the date the ISO plan is adopted or the date the ISO plan is approved by the stockholders;
  • The option must not be exercisable after 10 years from the date the option is granted;
  • The exercise price must equal or exceed the fair market value of the underlying stock at the grant date;
  • The option must not be transferable;
  • If the option is issued to a stockholder holding more than 10% of the voting stock of the company (or a subsidiary or parent of the company), the exercise price must be at least 110% of the fair market value of the stock subject to the option on the grant date, and the option cannot be exercisable after 5 years from the grant date;
  • The option must be granted pursuant to a plan which includes the aggregate number of shares which may be issued under options and the employees (or class of employees) eligible to receive options, and which is approved by the stockholders within 12 months before or after the date the plan is adopted; and
  • Only the first $100,000 in aggregate fair market value of shares (determined on the grant date) covered by a stock option, which is exercisable for the first time during any calendar year, qualifies as an ISO and receives preferential tax treatment.

If any of the above requirements are not satisfied, then the options are generally treated as nonqualified stock options, which are discussed in further detail below. It is also important to note that the benefits described above may be limited when the recipient is subject to the alternative minimum tax because the excess of the ISO’s stock value over the exercise price may be included in alternative minimum taxable income of the recipient.

Nonqualified Stock Options

Nonqualified stock options (NSOs) do not meet all of the requirements of the Code to be qualified as ISOs. Unlike ISOs, NSOs can be issued to anyone, including employees, consultants, vendors, and members of the board of directors. From a tax perspective, the recipient generally recognizes ordinary income upon exercise, equal to the excess of the fair market value of the stock at the date of exercise over the exercise price of the option. Thus, using the numbers described above, let us assume that an option to buy 1 share of stock is granted at an exercise price of $5 when the fair market value of a share is $5. The option is exercised for a $5 amount when the fair market value of a share has increased to $50. The recipient recognizes $45 (i.e., the excess of the share value on the exercise date over the exercise price) of ordinary income on the exercise date. The company is required to withhold income and employment taxes at the time of exercise and will generally receive a tax deduction equal to the amount of ordinary income recognized by the recipient. Here is a summary describing this hypothetical, using the date of issuance as May 10, 2016:

  1. May 10, 2016- share value is $5: company issues an option to purchase 1 share of stock with a strike price of $5
  2. May 11, 2017- share value is $50: recipient exercises the option and pays the company $5 to purchase 1 share of stock. Recipient has $45 of gain that is taxed as ordinary income
  3. May 12, 2018- share value is $100: employee sells the share for $100. Employee has $50 of gain that is treated as long-term capital gain.

Depending on the terms of the grant, an NSO may also be subject to the penalty provisions in Section 409A of the Code for deferred compensation.

Conclusion

As discussed in this summary, whether an option issued by a company is treated as an NSO or ISO will directly impact the tax consequences upon exercise to the recipient as well as the company.