In my earlier post regarding considerations when creating your option plan, I briefly referenced the tax advantages, from the recipients’ perspective, of “incentive stock options” (ISOs), which can only be granted to employees, relative to so-called “nonqualified options” (NQOs), which can be granted to employees or consultants. Although there a number of web resources regarding the distinctions between ISOs and NQOs, these resources are often heavy with tax jargon and thus poorly understood. Accordingly, we have put together the below quick reference guide, which is intended only as a high-level summary of the current US federal tax consequences.
I. TAX CONSEQUENCES – TO OPTION HOLDER
- At date of grant: no tax to option holder (assuming exercise price is at least equal to fair market value of underlying stock at time of grant)
- At date of exercise:
- option holder taxed on difference between fair market value of stock on date of exercise and exercise price
- ordinary income gain and loss rates apply plus, if option holder is an employee, employment tax
- At date of sale of underlying stock (following exercise):
- option holder taxed on difference between fair market value of stock on date of sale and fair market value of stock on date of exercise
- capital gain or loss rates apply depending on holding period since exercise
- At date of grant: no tax to option holder (assuming the exercise price is at least equal to the fair market value of the underlying stock at the time of grant)
- At date of exercise:
- no tax to option holder for regular tax purposes
- however, difference between fair market value of stock on date of exercise and exercise price treated as income for purposes of alternative minimum tax (AMT) unless option holder disposes of underlying stock in same calendar year as exercise
- At date of sale of underlying stock:
- if sale occurs both more than two years after option granted and more than one year after option exercised, option holder taxed, at capital gain or loss rates, on difference between (i) sale proceeds and (ii) exercise price plus any amounts taxed as ordinary income for AMT purposes as noted above
- if do not meet above holding period requirements, (i) difference between fair market value of stock on date of exercise and exercise price taxed as ordinary income and (ii) difference between fair market value of stock on date of sale and fair market value of stock on date of exercise taxed as capital gains or losses.
For purposes of illustration, assume that, on January 1, 2011, you are granted an option to purchase 100 shares at an exercise fair price of $1.00 per share. On January 2, 2012, when the fair market value of the underlying stock is $1.50 per share, you exercise the option and purchase all 100 shares. On January 3, 2013, you sell all 100 shares for $2.00 per share. Assuming an ordinary income tax rate of 35%, a capital gains rate of 15% and ignoring the complexities of the AMT, the following chart illustrates the disparate tax consequences, under the above scenario, if the option is an ISO versus a NQO.
Tax on ISO
Tax on NQO
|Date of grant||None||None|
|Date of exercise||None||$17.50
=($150 – $100) x 35%
|Date of sale||$15.00
=($200 – $100) x 15%
=($200 – $150) x 15%
II. TAX CONSEQUENCES – TO COMPANY
A. NQOs: Company takes deduction equal to amount taxable as ordinary income to option holder on date of exercise.
B. ISOs: Company entitled to take deduction only if option holder fails to satisfy holding periods and taxed at ordinary income rates; otherwise, company is not entitled to a deduction.
Because the tax regulations governing option grants and exercises are highly complex and subject to change, companies considering option grants or employees receiving grants should consult with their attorneys and/or tax advisors before taking definitive action.