There are two kinds of options-statutory and nonstatutory. “Incentive stock options,” or ISOs, as they’re commonly known, are statutory options, because they’re specifically provided for in the Internal Revenue Code and are subject to numerous qualification requirements. Options that don’t meet these requirements are nonstatutory stock options or NSOs (also known as nonqualified stock options or NQSOs).
Option grant: If you have ISOs, you are not taxed on option grant. The same is generally true of NSOs. An NSO is taxed at grant only if it has a “readily ascertainable” fair market value (FMV), which is seldom the case. IRS rules say that an option doesn’t have a readily ascertainable value at grant unless: (1) the option is actively traded or (2) (i) the option is immediately transferable; (ii) the option is fully exercisable; (iii) the option and the option stock are unrestricted; and (iv) the value of the “option privilege” is readily ascertainable. In the unlikely event that an NSO is taxable at grant, you have compensation (ordinary) income at that point.
The grant of an ISO isn’t subject to the Code Sec. 409A rules, which impose income inclusion and a penalty tax where a deferred compensation plan fails to meet certain technical requirements. The Code Sec. 409A rules may potentially apply to the grant of an NSO, but the option can be structured to avoid the application of Code Sec. 409A.
Option exercise: No regular income tax is owed on the exercise of an ISO, but the alternative minimum tax (AMT) may apply.
Any remuneration that arises when stock is transferred on the exercise of an ISO isn’t subject to FICA (social security and Medicare) or FUTA (unemployment) taxation.
When you exercise an NSO that wasn’t taxed at grant, you’re taxed at ordinary income rates on the difference between the value of the option stock at that time and the price you paid for it (plus any price you may have paid for the option, although generally that will be zero). This is compensation income that’s subject to payroll taxes and income tax with-holding. Taxes may be withheld from your salary or other compensation income, or you may have to sell some of the stock to cover the withholding or make some other arrangement with your employer.
If the option stock is nontransferable or subject to a substantial risk of forfeiture, then you aren’t charged with compensation income until those restrictions no longer exist. However, you can choose to pay tax on exercise so that all gain from that point on would be capital gain.
Sale of option stock: When you sell ISO stock, you generally are taxed at favorable long-term capital gain rates on the difference between the price you paid for the stock and the amount you realize on its sale. However, if you sell the stock within two years of the option grant or within one year of the option exercise, you’ll have compensation income to the extent of your bargain element at exercise. The balance of your gain is capital gain, which will be taxed at favorable rates if you’ve held the stock for more than one year on the sale date.
When you sell stock acquired by exercise of an NSO, you have capital gain if you were subject to tax either at option grant or exercise, or when restrictions on your option stock lapsed. Otherwise, you have compensation income at the time of the sale.