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Understanding the Basics: Incentive Stock Options & Non-Qualified Stock Options

Today many companies grant employees stock purchase rights as a form of incentive. These rights are often one part of a total compensation package.  Employers use these incentives to attract and retain valuable employees. These grants are given through a stock plan and grant agreement.  They can come in two different forms: incentive stock options (“ISOs”) and non-qualified stock options (“NQSOs”). When you “exercise” these stock options, it means you are buying a set number of shares granted at a set price during a specified period.  Your rights cannot be exercised until a vesting period has lapsed.  Vesting is either time-based or performance-based or both. Additionally, vesting schedules can be on a cliff or graded schedule. Options expire at the end of the term provided in the stock plan – at that time they are no longer exercisable. Job termination typically halts vesting.

While both NQSOs and ISOs are forms of employer offered option grants, they have differences.  NQSOs are the most common type of option. Non-qualified refers to the fact that they do not qualify for any favorable tax treatment.  They can be granted to employees, but unlike ISOs, can also be granted to independent contractors.  NQSO exercise income, which is equal to the market price of the stock over the exercise price on the date of exercise (the “spread”) is considered ordinary income and included in your gross income for the year of exercise.  When you sell the shares you acquired in the exercise of the option, you pay capital gains tax on any appreciation over the stock’s value at exercise.  The holding period starts on the day after your acquisition date and you stop counting on the day you sell the shares.

ISOs are offered less frequently than NQSOs, but have greater potential tax benefits than NQSOs. The taxation is somewhat complex and can trigger the Alternate Minimum Tax, but if certain requirements are met, all appreciation over the exercise price is taxed at the favorable capital gains tax rate.  ISO’s can only be granted to employees. There is a $100,000 limit on the aggregate value that may vest in any calendar year.  ISOs over the $100,000 threshold are treated as NQSOs.  One must not dispose of the stock within two years of the time it is granted and must hold the stock for at least one year after the option is exercised to receive the favorable long-term capital gain treatment on all appreciation over the exercise price.  If you don’t meet the holding periods, your spread is taxed as ordinary income.

Stock options can be a great form of compensation, but it is important to understand how to best maximize those benefits.  We hope this explanation helps and don’t hesitate to reach out to the THOR team if you have questions.

Written by

Allisha Curtis

Allisha has worked in the investment industry since 1993. Currently, as a Wealth Advisor at THOR, Allisha is responsible for portfolio management, financial planning and relationship management.

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