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Stock Options: To Qualify, or Not to Qualify? That is the Question

Options to purchase the stock of an employer continue to be a popular form of equity-based compensation, particularly among start-ups and other privately-held companies.

One perennial question companies face in designing stock option programs is the extent to which they should grant nonqualified stock options, known as “NQSOs,” or statutory stock options, known as “incentive stock options” or “ISOs.”

The differences between NQSOs and ISOs are all tax-related. The two types of options are governed by separate sections of the Internal Revenue Code (“Code”) and they can have significantly different tax consequences to both the recipients and the issuers of the options. In deciding whether to grant NQSOs or ISOs, employers should take into consideration, to the extent possible, the likely tax outcomes.

The tables below summarize some of the key differences between NQSOs and ISOs. Readers of this article should keep in mind that the tax treatment and consequences of NQSOs and ISOs will depend on individual circumstances, so they should consult with their own tax advisors to determine the applicable tax treatment and consequences.

Nonqualified Stock Options (NQSOs)

Description & Common Features

Tax Treatment

Key Differences from ISOs

An NQSO is an option to purchase shares of company stock at a price equal to 100% (or more) of stock’s fair market value on date of grant (“option price”). The option will often have a vesting schedule – 3 to 5 years is typical – and a 10-year term.

If the option price is set below 100% of fair market value, NQSOs generally must be structured to be compliant with the restrictive timing rules of the tax regulations on deferred compensation (Code Section 409A), or the option holder will incur Section 409A penalties, including a 20% extra income tax.

The fair market value for this purpose is often established by what is known as a “409A Valuation.” The topic of 409A Valuations is discussed further at our earlier article, The Section 409A Valuation: Do You Really Need One?

 

Established by Code Section 83.

Service Provider:

At grant: No tax consequences.

At exercise: The excess of the stock’s fair market value over the option price is taxed as ordinary income and is subject to FICA and income tax withholding (if the option holder is an employee).

At sale of acquired stock: Any appreciation occurring after calculation of the exercise tax obligation is taxed as either:

  • A long-term capital gain if the stock is held for more than one year, or

  • A short-term capital gain if the stock is held for one year or less.

____________

Company:

At grant: No tax consequences.

At exercise: Deduction allowed for the amount the executive recognizes as taxable income in the year executive is taxed. For employees, tax deduction is contingent on satisfying withholding requirements.

At sale of acquired stock: No deduction allowed.

  • Gain at exercise is taxed as ordinary income, rather than (potentially) a capital gain.

  • Option holder may, depending on plan terms, need to borrow money or sell shares to finance tax obligation on exercise (as well as the exercise price). If shares are sold, future upside appreciation is lost. However, NQSOs may be made eligible for cashless exercise if the issuer and the plan terms permit.

  • Company may receive a tax deduction at the time of exercise.

  • May be granted to certain non-employee service providers (e.g., non-employee directors)

  • Generally, to be exempt from Code Section 409A, may only be granted with respect to common stock of the entity receiving services from the option holder (or a parent entity)

  • Not subject to the qualification requirements that apply to ISOs (see table below)

Incentive Stock Options (ISOs)

Description & Common Features

Tax Treatment

Key Differences from NQSOs

An ISO is an option to purchase shares of company stock at 100% (or more) of stock’s fair market value on date of grant (“option price”) for a period of up to 10 years, typically subject to a vesting schedule of 3-5 years, and designed to meet various other statutory requirements to qualify for ISO tax treatment. For example:

  • $100,000 limit on the amount of ISOs that may vest in any year for an individual option holder

  • Holding period (i.e., stock cannot be sold until two years after option grant and one year after exercise)

  • Limit on post-termination exercise (e.g., one year after disability terminations, three months after other terminations except for death).

ISOs issued to 10% stockholders must have option price of 110% of fair market value and a term of no more than 5 years.

ISOs may be exercised by cash payment or by tendering previously owned shares of stock, depending on plan terms.

Shareholder approval of plan required within 12 months of plan’s adoption.

May only be granted to employees.

Not available for LLCs.

Not deferred compensation for purposes of Code Section 409A.

 

Established by Code Section 422.

Employee:

At grant: No tax consequences.

At exercise: No regular income tax is owed. However, the excess of the stock’s fair market value over the option price– i.e., “spread”– may trigger an alternative minimum tax (AMT) obligation.

At sale of acquired stock: Gain (i.e., excess of sales price over option price) is taxed at long‑term capital gains rate if shares are held at least two years from grant date and one year from exercise (“qualifying disposition”). If holding period requirements are not met and a disqualifying disposition occurs, the spread (from grant to exercise) is ordinary income; remainder is potentially capital gain.

No FICA.

____________

Company:

At grant: No tax consequences.

At exercise/sale: No tax deduction is allowed for an ISO (at either exercise or sale) unless a disqualifying disposition occurs. The company may deduct the “spread” as measured at exercise in the year of the disqualifying disposition.

No FICA or withholding.

  • No tax to option holder at exercise (other than possible AMT); taxation delayed until stock is sold and at that point gain may qualify for long-term capital gains rate (see “Tax Treatment”).

  • However, ISOs are generally an adjustment item for AMT at the time of exercise, and that may neutralize the tax benefits for some employees.

  • Employer must report the exercise of an ISO on a special form (Form 3921)

  • Typically, no corporate tax deduction is allowed if the option holder makes a qualifying disposition of the ISO shares.

  • Potential favorable ISO tax treatment for employees may lessen pressure on the employer to help employees finance option exercises, since taxes are not owed until stock is sold (although exercise price must still be raised by the option holder).

  • Various restraints are imposed to realize ISO tax treatment. Among them:

In the abstract, the potential for capital gains tax treatment can make ISOs seem appealing at a surface level. However, as summarized in the tables above, ISOs have many special requirements and potential drawbacks, including the possibility of triggering the alternative minimum tax for the option holder and loss of a tax deduction for the employer. In addition, because stock options are often exercised in connection with a transaction in which there is no opportunity to satisfy the one-year post-exercise holding period requirement for ISOs, ISO status is frequently lost at the time of exercise. Based on these considerations and others, some companies conclude that NQSOs are preferable due to their relative simplicity and flexibility, even though they have no potential for capital gains tax treatment.

© 2022 Foley & Lardner LLPNational Law Review, Volume XI, Number 322
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About this Author

Joshua A. Agen, Foley Lardner, Litigation Lawyer, Attorney,
Of Counsel

Joshua A. Agen is a senior counsel and business lawyer with Foley & Lardner LLP, where he focuses his practice on assisting public and private companies in the areas of executive compensation, employee benefits, corporate transactions and securities law compliance. He is a member of the firm’s Employee Benefits & Executive Compensation, Transactional & Securities, Commercial Transactions & Business Counseling, and Labor & Employment Practices.

414.297.5535
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