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Taxation of ISOs, NQSOs and Restricted Stock

Taxation of ISOs, NQSOs and Restricted Stock

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Stock options are growing in popularity as a way for companies to compensate their employees. Three of the most common types of stock options that are offered are Incentive Stock Options (ISOs), Non-Qualified Stock Options (NQSOs), and restricted stock. While some of the characteristics of ISOs, NQSOs and restricted stock are similar, all three are taxed in different ways. If the employee is not familiar with the taxation of ISOs, NQSOs, and restricted stock, this may lead to unforeseen tax liabilities.

Incentive Stock Options (ISOs)

ISOs are usually only offered to executives and/or key employees of a company. The advantage of ISOs is that there is no income tax when the company grants the ISOs to the employee or when the employee exercises the ISOs (however, there is an AMT implication, which will be discussed below). Income tax is generated only when the employee sells the stock. For the company, ISOs cannot be deducted on the company’s tax return.

Example: A is granted 1,000 shares of ISOs. Upon exercise, the fair market value is $10,000, and exercise price is $5,000. A exercises the ISOs and holds them for 18 months, and then sells the stock when its value is $12,000. In this situation, there is no income when A exercises, and $7,000 of long term capital gain income upon sale of the ISOs.

However, if a disqualifying disposition occurs, the favorable tax treatment of ISOs disappears. Disqualifying dispositions occur when the stock that was acquired is sold within either two years after the ISO is granted, or one year after the ISO is exercised. If this occurs, the employee has to report the income in the year of the disqualifying disposition as ordinary income.

Example: Same facts as above, however A sells the ISOs after 8 months. The $5,000 bargain element upon exercise is treated as ordinary income in the year of the sale.

In addition to tax ramifications associated with disqualifying distributions, ISOs impact alternative minimum tax (AMT). When ISOs are exercised, the spread upon exercise is a preference item for AMT purposes. For example, if the spread per share at exercise date $2 and 10,000 ISOs are exercised, there will be an AMT preference amount of $20,000. This may or may not affect the employee’s actual income tax liability, depending on his or her overall tax situation.

Non-Qualified Stock Options (NQSOs)

NQSOs are normally offered to non-executive employees and outside directors or consultants. They are similar to ISOs in regards to taxation, with some differences. Like ISOs, there is generally no income recognition upon grant. However, unlike ISOs, there is income recognition upon exercise of the options. For companies, unlike ISOs, they are allowed a deduction on their tax return.

Example: A is granted 1,000 shares of NQSOs. Upon exercise, the fair market value is $10,000, and exercise price is $5,000. A exercises the NQSOs and holds them for 18 months, and then sells the stock when its value is $12,000. In this situation, there is $5,000 of ordinary income when A exercises, and $2,000 of long term capital gain income upon sale of the NQSOs.

Restricted Stock

Restricted stock shares are not taxed until the shares vest. Once the stock vests, ordinary income is recognized. Then, when the employee sells the stock, a capital gain is recognized.

Example: A is granted 10 shares of restricted stock with a FMV of $10,000 in 2015. A is not required to pay anything for the shares. The shares must be returned unless A remains employed by the corporation for the next five years. When the stock vests in 2020, it is worth $14,000. A is required to recognize $14,000 of ordinary income in 2020.

An employee can also make a Section 83(b) election, which allows the employee to report income in the year the stock is transferred, despite the fact that it has not yet vested. Later, when the stock is sold, there is a capital gain.

Example: Same facts as in the previous example, except upon receiving the restricted stock in 2015, A makes a Section 83(b) election and includes $10,000 in income. In 2020, when the stock vests and its value is $14,000, no further income recognition is required. If A sells the stock in 2022 for $16,000, A recognizes $6,000 of long-term capital gain ($16,000 – $10,000 basis).

The employer is allowed to receive a deduction on their tax return equal to the amount included in income by the employee, which would be upon vesting of the stock. If a Section 83(b) election is made, however, the employer receives the deduction on the granting of the stock.

Kyle Braun, CPA Kyle Braun, CPA
T (732) 842 3113
kbraun@withum.com

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To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

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