Key point. The two tax planning objectives cannot be allowed to override the more fundamental financial planning objective of making as much money as possible on the deal without taking excessive risks. Flavor No. Incentive stock options are also sometimes called qualified options or statutory options. They are entitled to preferential federal income tax treatment.

Topic No. 427 Stock Options

But incentive stock options are also subject to some special restrictions and Log in to view full article. You'll be able to read the full article and get instant access to the last few issues of the Tax Reduction Letter. Search Help Enter one of more keywords to search. Article Date:. February Employer Stock Option Tax Planning Objectives You will eventually sell shares you acquire by exercising employer stock options, hopefully for a healthy profit.

Your two tax planning objectives are to 1. The meaning of the term "value" may not be the same for all clients. For some of them, value may be defined as maximizing cash from the sale of the stock or minimizing taxes. Other clients may wish to limit their cash outlay upon exercise of the options. Still others may seek to hold a large equity stake in the issuing company. Not only is it important to understand the tax ramifications of these events, but also it is equally important for the CPA, as the trusted adviser, to proactively use this information to develop a long - term plan that assists clients in realizing all potential value in line with their ultimate goals.

There are generally two classifications of stock options: 1 nonqualified stock options NQSOs and 2 qualified stock options, which are more commonly known as incentive stock options ISOs.

Tax Guide to Nonqualified Stock Options (NSOs)

The principal difference between these two categories is their treatment for income tax purposes. NQSOs are the right to purchase shares of stock at a specified exercise price within a certain period. In most cases, a grant of NQSOs is not a taxable event for the recipient. However, in the relatively rare circumstances where an NQSO has a readily ascertainable fair market value FMV on the date of grant, such as where the options are actively traded on an established market, they are taxed upon grant, and the recipient has ordinary income equal to the FMV on the date of grant of the option received less the exercise price paid.

In most cases, they are not exercisable until the underlying stock vests, with vesting occurring pursuant to a plan document approved by the issuing company. If stock is vested at the time NQSOs are exercised, the option holder has ordinary income in the amount of the bargain element in the stock received, which in this case is the stock's FMV at exercise minus the exercise price paid.

Employee Stock Options Basics

However, in some cases, the stock received when NQSOs are exercised is not vested because the stock is subject to a substantial risk of forfeiture. In this situation, if a Sec. In that event, eligible employees can elect to defer the recognition of income from exercising stock options for up to five years Sec.

However, for most clients, a five - year deferral of income tax consequences will not be an available choice. Most planning strategies associated with NQSOs are mechanically simple. However, this does not mean those strategies cannot yield a substantial benefit. The following are some common courses of action associated with NQSO planning:.

For risk - averse clients who want to minimize exposure to a concentrated position, or who simply do not wish to tie up substantial amounts of cash, exercising their options and immediately selling the underlying shares may be a viable strategy. Upon exercise, the bargain element will be taxable to the option holder as ordinary income. The basis in this stock will be the exercise price paid plus the income recognized at exercise. The capital gain or loss, if any, associated with the immediate sale of the shares will be short - term in character. Some clients have a higher tolerance for concentrated positions and will want to hold the stock to capture appreciation in the company's value.

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This could be an attractive choice, as, after the initial inclusion of ordinary income upon exercise, appreciation in the stock price will be taxed as a long - term capital gain, assuming the holding period requirement is met. The two strategies discussed above may not independently capture the value that all clients seek. An alternative is immediately selling a certain portion of the stock and holding the rest for long - term appreciation. This is commonly done to raise cash to pay taxes associated with the exercise.

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This will somewhat minimize capital outlay while allowing for the potential capture of future growth in the stock's value. In certain situations, where a taxpayer receives substantially nonvested NQSOs with a readily ascertainable FMV at grant, there can exist an opportunity to make a Sec. A Sec. This is an alternative to the standard NQSO treatment that includes the bargain element in income at the post-vesting exercise date of the options. Under the election, any appreciation of the stock, beyond the FMV at the time of the election, will be taxed at preferential capital gains tax rates rather than ordinary rates.

In some cases, this could result in a large income tax savings. It is important to note that the election must be made no later than 30 days after the property transfer, and if the stock received is later forfeited, no deduction or refund of tax previously paid is allowed. Careful analysis and research should be done before making the election. A unique opportunity associated with NQSOs is the ability to gift the options. Unlike Sec. Additionally, Sec. The bargain element income from the exercise will be recognized by the individual who performed the services to earn the options.

The donee will not be subject to income tax on this amount. The tax paid is not a taxable gift to the donee, as it is a personal liability of the donor. The issuing company's plan must allow for gifting of such options. ISOs are similar to NQSOs in that they represent a right to purchase shares at a specific price within a certain period.

What are non-qualified stock options? - Valeo Financial Advisors

For the option holder to reap these benefits, the options must qualify as ISOs under Sec. The following list illustrates some of the requirements that must be met for an option to be an ISO:. This list is not all - inclusive , but it provides a general idea of the types of rules that must be complied with for an option to qualify as an ISO. Qualifying disposition: If options that meet the requirements to be ISOs are disposed of in a qualifying disposition, the owner of the ISOs will receive the following tax treatment upon exercise of the options and the subsequent sale of the stock:.

Disqualifying disposition: If the ISO stock is disposed of in a disqualifying disposition i. Thus, the income attributable to the exercise of the option the FMV of the stock at the time it is substantially vested less the exercise price is treated by the option holder as ordinary compensation income for regular tax purposes in the tax year the disqualifying disposition occurs. However, if the disqualifying disposition of the stock is a sale or exchange for a price less than the price of the stock at exercise, the amount that is includible as compensation attributable to the exercise of the option is limited to the excess if any of the amount realized on the sale or exchange over the adjusted basis of the stock.

If the disqualifying disposition occurs in the same year as the exercise, the tax treatment is similar to that for an NQSO, with the bargain element in the stock at the time of exercise being ordinary income for the option holder in the year of exercise for both regular tax and AMT purposes, so that no AMT adjustment is necessary in that year. If the stock is disposed of in a disqualifying disposition for an amount greater than the FMV of the stock at exercise, the character of the amount of gain is determined under the Sec.

AMT considerations and planning opportunities. Between the limitation and removal of typical itemized deductions that have caused taxpayers to be subject to the AMT, plus an increase in the AMT exemption amount, an environment has been created where many individuals who have historically been subject to the AMT will no longer find themselves in that situation. Individuals with high ordinary income, such as wages, could be even further immunized from the AMT regime.

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On the surface, a taxpayer's being subject to the AMT in the year of exercise seemingly thwarts the strategy behind owning ISOs. This situation somewhat hinders the option holder's enjoyment of the coveted ISO benefits. It is important to remember that all is not necessarily lost if clients find themselves subject to the AMT during the year of exercise due to the AMT credit, which is explored further below. The following are some planning options associated with ISOs:.

Exercising and immediately selling will trigger a disqualifying disposition. Similar to the strategy discussed in the NQSO section, this strategy may appeal to those clients looking to limit their cash outlay or exposure to a concentrated position in company stock. The options are exercised and the shares are sold more than two years after the grant date and more than one year after exercise.

The tax results of a qualifying disposition are described above. As noted, in this scenario, appreciation in the value of the stock above the exercise price will be taxed at long - term capital gains rates. Intentional disqualifyingdisposition. Prior to the dot - com bubble of the late s, many individuals in the tech industry exercised highly valued ISOs, incurring a large AMT liability on top of the price paid to exercise options. After the market crash and subsequent rapid devaluation of their position, some were left holding stock worth significantly less than the price they paid to acquire it and were unable to pay the AMT incurred due to the exercise of the ISOs.

A method to potentially avoid a disaster like this would be to exercise early in the year, or some other time that is deemed advantageous, and track the stock value throughout the year.